Q3 2022 Letter
The following is an excerpt of a letter written to clients during October 2022. Trading activity is excluded in public excerpts. A PDF formatted version is available here.
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They attach much more importance to where things stand now, treating a reduction in their current wealth significantly differently from reductions in future gains. – The Myth of the Rational Market, by Justin Fox
The third quarter marked a rough quarter in what has been a very rough year. How rough? Market price declines have affected bonds and equities alike, at magnitudes we have not seen since the 1930s. Investors typically rely on bonds as a safe-haven asset, holding value when a bear market hits stock prices. The combination of price declines across both assets represents the 2nd worst drawdown for a balanced portfolio since 1931.
Exhibit 1: Ten Worst Years for Balanced (60/40) Portfolio
A scene from the movie A League of Their Own comes to mind. Manager Jimmy Dugan (played by Tom Hanks) sees his team’s catcher, Dottie Hinson (Geena Davis), packing her car to drive home instead of boarding the team bus. Jimmy tells Dottie that she’ll miss the game and regret her decision. Dottie responds, “It just got too hard.” “It’s supposed to be hard,” Jimmy scolds. “If it wasn’t hard everyone would do it. The hard is what makes it great.”
This applies to investing, too. Over the long-term, equities have generated great returns. Without risk – which manifests itself through price declines from time to time – everyone would allocate entirely to equities. Why own bonds, or CDs, or cash if equities returned a consistent and predictable 9% or 10% per year? Investors – everyone – would respond, bidding up equities to levels where forward returns were compressed and more in line with other ‘zero volatility’ investments such as T-Bills or CDs.
Historically, bear markets have given way to several positives:
100% of the time markets realized new all-time Highs.
Forward-returns in the years following a bear market have outpaced long-term average returns.
For bear markets involving recessions, bottoms were reached during the recession, not after. Often, substantial stock market returns were realized before the economy returned to growth.
Justin Fox, author of The Myth of the Rational Market, was citing the findings of Amos Tversky and Daniel Kahneman when we wrote about our bias to react to today at the cost of tomorrow. This behavior manifests itself in many aspects of our lives, not just investing. We subscribe to annual gym memberships, but we’ll start going tomorrow – not today. It’s much easier to commit to a diet next week than it is to order the salad instead of the steak tonight. Good decisions are often painful in the present and reward us in the future.
In the world of investing, we constantly find reasons to go to cash at seemingly every twist and turn in the market, let alone during periods like today where substantial price declines have become the rule rather than the exception. There are always reasons to sell. It’s the same show with a different script.
Exhibit 2: There’s Always a Reason to Sell
The 3rd Quarter saw price declines across almost every sector, leaving large cap stocks down 24% for the year, technology-oriented stocks (as measured by the NASDAQ Composite) down 32% and small/mid cap stocks down 25%. Consumer Discretionary and Energy sectors posted small gains in the quarter and only Energy is up for the year (+34%). Bonds were not spared, posting high single digit or low double-digit declines across various bond classes. The Ten Year Treasury rate, a key figure influencing asset prices, rose from 3% to just under 4% during the quarter. Treasuries yielded 1.5% at the start of 2022.
Exhibit 3: Ten Year Treasury Yields Exhibit 4: Yield Curves since Last Year
In the short-term, two of the biggest drivers of aggregate stock prices are 1) Risk-free interest rates which the 10-Year Treasury often serves as a reasonable proxy, and 2) Risk spreads which are estimated using the difference between High Yield (Junk Bond) yields and Treasury yields. Either one of these metrics can affect how the market is priced. Higher discount rates (Risk-free rate + Risk Spread) mean lower price to earnings ratios for equities and therefore lower stock prices. So far, this year has seen both rising risk spreads and sharply rising risk-free rates. Discount rates, as defined above, have risen from ~5% during 2021 to 9% today. Over the past 10 years, the same metric averaged 6.5%.
Exhibit 5: S&P 500 vs. Risk Spreads Exhibit 6: S&P 500 vs. 10-Year Treasury Yields
What About Inflation?
The Federal Reserve’s mandate is threefold: Price stability and maximum employment are often highlighted by those citing a dual mandate but the Federal Reserve Act also states the goal of “moderate long-term interest rates”. Most economists recognize that succeeding in the first two (price stability and full employment) results in moderate long-term rates.
Price stability has implied an inflation target of approximately 2% per year. Influencing Federal Reserve policy lately has been inflation in the ~8% zip code, as measured by the Consumer Price Index (CPI). Recall that inflation is a rate of change, not a price level. The rate of change is measured by comparing price levels in one period with that of another period. Importantly, early signs of month-to-month price stability are materializing.
Exhibit 7: Consumer Price Index Changes
As another indication that ~8% inflation may not persist, various raw material and input prices – used to create finished good and services – have seen declines. CPI is based upon prices that consumers pay to consume goods and services. These “finished goods” saw price increases partly in response to higher input costs. As input costs abate, there are fewer reasons for producers to continue to raise finished goods’ prices.
Exhibit 8: Select Raw Material & Input Costs Changes
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Trading activity is excluded from the public excerpt of this client communication.
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Following below are the usual tables with various sector, asset class, and economic data. Please reach out if there’s anything you’d like to discuss.
Brian J. Glenn, CFA
Olcott Square Investment Partners, LLC
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