Brian Glenn, CFA
Year End 2022 Letter
The following is an excerpt of a letter sent in January to clients. No part of it should be considered advice or solicitation.
There is an important and nontrivial aspect of historical thinking, perhaps more applicable to the markets than anything else: Unlike many “hard” sciences, history cannot lend itself to experimentation. – Fooled by Randomness, by Nassim Taleb
For the year ending 2022, large domestic stocks (S&P 500) returned -18% including dividends. By the same measure, small/mid cap stocks (Russell 2000) returned -20%, the tech-heavy NASDAQ 100 returned -33%, and international stocks (MSCI’s EAFE) returned -14%. Treasury bonds, which typically do not get front page real estate in this letter, returned -18%, marking their worst year in nearly the past 100. (I found data back as far as 1928.) After what was a challenging year in 2021 for our stock-specific strategy (Enterprising Equity), all three of our equity strategies drew down less than broader markets. It is indeed difficult to celebrate any sort of positives during a year in which our accounts lost value. There’s no celebration here. Let’s lick our wounds and get back to work.
Investors (somewhat arbitrarily) assign stock market intervals based on the amount of time it takes the earth to go around the sun. Almost perfectly, for 2022, the year began at what would mark the Highs for the year and ended near the Lows, marking one of the worst calendar years in history. I believe we are at a point in the market cycle where we might get paid to wait. If history is a guide, by the time the bad news recedes, payment may have already been made.
Over the longer-term, investors have been rewarded for remaining optimistic and invested when it seems intuitive to do the opposite. Often when the “coast is clear” to “safely” deploy capital, prices have already advanced. As Taleb notes, we cannot experiment to crystalize the future. But we can rely on history, which transcribes familiar patterns to investor behavior over market cycles.
Exhibit 1: How Does this Year Compare to Others?
Some of the largest and most sought-after companies of the prior few years – Tesla (-65%), Amazon (-50%), Meta/Facebook (--64%), and Google (-39%) – suffered drawdowns during 2022 that most investors assumed could never happen; let alone *would* ever happen. Lesser-known technology and software stocks were obliterated, with the high-flyers from 2021 down 80 to 90% during 2022. Within the S&P 500 alone, during 2022 $9 trillion of market capitalization evaporated, $4 trillion from just the largest 5 companies. Consequences were felt across risk assets both public and private.
Neither were bonds spared. “Risk-free” treasuries saw their largest loss since at least 1928, returning -18%. We finished the year with an inverted yield curve, that is, higher short-term yields than long-term yields. At year end, you could by one-year T-Bill yielding nearly 5% while ten-year Treasuries yielded less than 4%. Risk-spread rose as well, from 3% to 4.5% over the year, inflicting another lever for pain within bonds that carry credit risk (and for equities). I suspect we will hear in the coming months stories of shortfalls and liquidity issues within pension funds and insurance pools, two types of entities that feist on fixed-income assets owing to their risk aversion and required regular liquidity payouts.
Most investors are asking: Where do we go from here? …If we are heading into recession, should we continue to own stocks?
Indeed, headlines forecasting the “R” word – Recession – have increased over the past few months. We are all looking at the same thing: high gas prices, high interest rates, declining auto sales, cratering real estate activity, and increased layoffs at prominent technology companies, coupled with a Federal Reserve that says recession may be necessary to cool inflation.
First, this would be one of the more anticipated recessions in modern history. Every investor is aware of this possibility. It certainly doesn’t suggest it won’t happen, just that market participants, who price assets through daily trading activity, have to some extent included this risk in their daily buying and selling activity.
Recall that in 2007, the consensus subprime was supposed to be contained. Banks and their balance sheets would absorb mortgage losses. The severity of contagion and its job market implications surprised most. In 2001, technology was paving the way for a new paradigm and, despite the rapid rise and fall of technology stocks, a recession was not widely anticipated.
More surprising – and encouraging – is that stocks do not always fall when earnings decline. In fact, when corporate earnings decline, stocks have historically generated positive returns more often than negative returns.
Exhibit 2: How does the Stock Market Perform when Earnings Fall?
Third, let’s review the graph on Page 1. Since 1950, we’ve seen 83 calendar years of stock market returns. 19 of those were less than zero (including dividends and using the S&P 500 as a proxy for “the stock market”), which is 1 out of every ~4.5 years. Only 8 of those negative years saw total returns that were worse than -10%, and we just had one of those years. The average “Down” year saw -12% returns while the average “Up” year saw 20% returns. If past is prologue, then we might lose 12% once every 4 or 5 years and the other 3 or 4 years we could realize double digit gains per annum. I like those odds.
We are not out of the woods, so to speak. When we are the so-called easy money will have already been made. And there’s the rub: it’s never easy. Only in hindsight do we see large stock gains and call them easy. At the time, not unlike our situation today, no shortage of risks exist and there’s a laundry list of reasons to wait until things clear up. Investors are often paid for buying (or holding) when it’s the hardest thing to do.
There are some bright spots that the media is overlooking. Household debt service is not elevated relative to the Pre-COVID years of the prior decade. Lower interest rates, which influence a lower debt service figure for each dollar of debt, indeed has influenced today’s figures. Still, most investors I speak with believe U.S. households are bursting at the seems with all-time Highs in their borrowings. This is not the case.
Exhibit 3: Household Debt Service shows that Household Debts are Manageable
Discount Rates – update from Q3 ’22 Letter
From our 3rd Quarter letter:
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%.
We ended the year with increases in both “risk-free” Treasury yields (orange line below) and risk spreads (purple line below), as measured by the different between Junk Bond yields and Treasury yields. Through the back half of 2022, volatility remained in these metrics but through the fourth quarter, small decreases resulted – an indication that investors are getting more comfortable with the macro risks to equities and more comfortable that inflation will be tamed in the future.
Exhibit 4: Risk Spreads and Risk-free Yields through 2022
Inflation Update - What About Inflation?
To refresh some tables that we’ve published prior, the inflation picture is showing signs of improvement. Is the worst behind us? Maybe. CPI is showing declining month-over-month prices. Various raw material and input prices – far from a complete list – are showing massive price declines versus the Highs that were realized throughout 2021 and 2022. As the media tosses around various terms, I wanted to remind that Disinflation is slowing rate of inflation while Deflation is falling prices. People mistakenly use the terms interchangeably. The two terms are not at all synonymous. An example of Disinflation is the price of eggs rising but at a smaller percentage basis versus prior periods. An example of Deflation is the price of eggs declining. The latter, particularly with discretionary spending, incentivizes consumers to refrain from spending as the future price will be less. The Federal Reserve, our central bank that controls the price of money partly through interest rates, loathes deflation because of the negative feedback loop in creates in stalling economic activity.
Exhibit 5: Consumer Price Index Changes
Exhibit 6: Select Raw Material & Input Costs Changes throughout 2022
* * *
TRADING ACTIVITY is excluded from public memos.
* * *
I suspect in the coming quarters media attention will continue to transition from inflation risk to recession risk, as another reason to exit stocks. It’s not all bad news. Large technology companies may have been overearning during COVID but also were overspending. These companies are now looking to right-size their cost structure, albeit at the risk of layoffs for employees. Valuations are down quite a bit from 2021. Despite the Federal Reserve’s interest rate increases, longer term interest rates – such as the 10-year Treasury – have been relatively behaved recently. Household finances seem to be positioned better than most of the prior decade. Prices will gyrate in the short-term but in the long-term, trees grow. Let’s be patient and get paid to wait.
* * *
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
GENERAL DISCLAIMERS AND DISCLOSURE
Olcott Square Investment Partners, LLC is registered as an investment adviser with the State of New Jersey. Olcott Square Investment Partners, LLC only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. For more information about our firm, please review our Form ADV filing, which is accessible here: https://adviserinfo.sec.gov/firm/brochure/299476
This report is a publication of Olcott Square Investment Partners, LLC. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change.
Information contained herein does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information. A professional adviser should be consulted before implementing any of the strategies or options presented.
Information is not an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. At your request, Olcott Square Investment Partners, LLC will furnish of list of all securities purchased and/or sold over the preceding one-year period for the firm’s Enterprising Equity strategy. It should not be assumed any securities mentioned in this communication were, would have been, or will in the future be profitable to buy, sell, or hold.
Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), or product made reference to directly or indirectly, will be profitable or equal to past performance levels.
All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client's investment portfolio.
Historical performance results for investment indexes and/or categories generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results.
Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark.
DISCLAIMERS AND DISCLOSURE RELATED TO INVESTMENT RESULTS
Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), or product made reference to directly or indirectly on this website, or indirectly via hyperlink to any unaffiliated third-party website, will be profitable or equal to past performance levels.
All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals may materially alter the performance, strategy and results of your portfolio.