Q1 2023 Commentary
The first quarter of 2023 gave us so much to talk about, it was difficult to narrow it down for todays discussion. What I realized in preparing was that we should do as we always do, stay focused on the longer term. When I mention this to many people in retirement the response is often that we do not have a long time period as we are retired and our time period is far shorter than most. Without hesitation, my response is consistently that no matter what stage of life we are in we still have a long term time horizon. The reason is that we need to not only have our portfolio provide for today but we also need for it to provide for tomorrow. The money needed in the short term, which we define as the next two years or less, is intentionally allocated in a conservative manner with the funds in cash or being added to cash by way of dividends or interest being directed to cash as opposed to being reinvested. Let’s start with a brief discussion on how we manage money as you approach retirement and into retirement.
Every one of you have seen this slide in the past and some of you are quite familiar with this as it is presented regularly for those within 2 years from retirement and later. During our accumulation years the approach is quite different yet we continue to diversify and maintain most of our assets in the Blue and Yellow sections of this diagram and we reinvest the dividends and interest that you see on either side of this diagram. As we approach retirement the modeling shifts. Our income streams come to an end and we are now dependent on our portfolios and social security and for some lucky soles a nice pension as well. Given that our portfolios will provide the bulk of our annual need we have to be clear on what your level of spending is so that we can properly build out your portfolio to support your withdrawal needs. We never want to put at risk your spending needs. By managing your money so that at all times two years of withdrawals are without volatility that money must be maintained in cash or what we refer to as identifiable cash, the interest and dividends. Cash, or money markets, have given us little result in the last 15 years but we are now in an environment where short term interest rates are higher than long term interest rates and we can finally make money with your cash. As a result, we have become very active in the money market research effort and consistently look for the best options to make money on cash. When we review your account and show the performance and it is negative, it is easy to interpret that as your entire portfolio being down. But, it is important to note that the volatilility, on the upside and downside, is really the yellow portion of your portfolio which is earmarked as 7 years, the long term. This is important as we focus on volatility. I look forward to discussing this in more detail with anyone who has questions!
Another aspect of approaching retirement is the concern for bottom line performance. No longer are we swinging for doubles, triples or home runs and grandslams. It is of great importance that we swing for singles and the occasional double. When we swing for the fences we experience more volatility and volatility is the enemy of retirement portfolio management. I came across this piece a few years ago and held onto for good reason. This demonstrates two investors. Both started with $100,000 and allocated to a 60/40 portfolio while taking $5,000 out of the portfolio each year. The time periods are real although different with Mr. Smith starting in 1969 and Ms. Jones starting in 1979, the respective year in which they turned 65. Over the course of their investment time horizon, Mr. Jones had a much better annualized return of 10.5% vs. Ms. Jones of 9.6%. However, the volatility of those returns certainly mattered as Mr. Smith completely ran out of money 20 years into retirement. Ms. Jones experienced less volatility and as a result still has her portfolio intact about 30 years later, albeit with nearly 6x her original deposit even after withdrawals. Here we see the importance of not only volatility but also order of returns. Mr. Smith experienced some negative years early in his retirement while Ms. Jones did not. Since we do not know what the future holds, we must be attentive to how your funds are managed for retirement or any other major purchase including children’s education; a new home or second home; etc..
Turning to the current market environment there is really little that is very exciting about the current US Market environment as we see valuations climbing to almost 18 x earnings, taking us back above the 25 year average. That simply means that US stocks as measured by the SP500 are by no means considered cheap vs the last 25 years. Looking at the information the box capture above the chart, there are several areas of the SP500 that are less attractive than their 25 year averages. We can not make decision based on this analysis alone which is why we have not and will not sell out of the US markets entirely. Although we wish we did back in the early 2000s, the decision to sell really requires two nearly impossible decisions – when to sell and when to get back in. Although we are confident in our abilities as money managers, we have no confidence in our ability or the ability of others to make those two impossible decisions.
When we dive deeper into the US markets we do find some windows of opportunity. However, the YTD numbers are less than representative of the opportunity even though 2022 made very clear the benefits of Value investing in this market environment. As most of you know by now, last year we saw domestic value stocks outpace growth stocks by a factor of nearly 4 to 1, with a -7.5% return vs. -29.1%. This year started with an incredible run for growth stocks in January. That pace slowed dramatically still giving Growth a strong quarter with a result of 14.4% vs. 1% for Value. Our belief is that it will be short lived given the overall investment environment. Warren Buffett’s mentor, Benjamin Graham, said it best – In the short term the stock market is a voting machine but in the long term it is a weighing machine. The phrase simply means that while short-term price movements can be volatile and influenced by a variety of factors such as news events, sentiment and investor psychology. In the long run, the market tends to reflect the true value of a company based on its underlying financial and operational performance. Considering this is the long term portion of your portfolio, we do not want to be influenced by the short term headwinds.
Here is a closer look at the numbers. The top center I have circled the numbers I referenced in my comments a moment ago with the performance of Growth and Value YTD. Below that chart we see a longer time period going back to 2020. Here we can see the slight out performance of Value vs. Growth and the more remarkable out performance of small cap value vs. small cap growth. On the bottom right we see that voting machine at work with the most substantially over valued part of the market being that which has the highest recent performance. Also of note is the under valuation of the small cap categories, both value and growth.
One might think that with the under valuation of Small Caps vs. the 20 year average we would be inclined to over weight to small cap. As you could imagine, that could be a mistake. First, small cap stocks of either flavor (value or growth) are notoriously more volatile. In addition, small cap stocks in general have a much higher probability of not being profitable. As a matter fact nearly 42% of the Russell 2000 companies are not profitable. That number has been on the increase for the last 25 years. Couple that with the interest rate coverage ratio of only 2.6x and we think it is easy to understand why we tread lightly here.
You may recall from our last quarterly commentary that International has been quite attractive for many reasons and we may very well be in for a period of time where we see International outperformance. We had a very long run of out performance in the US markets vs. International, lasting about 14 years and delivering a whopping 277% return. One of the common mistakes in investing, as well as in other areas of life, is what is referred to as recency bias. This can be explained as giving more relevance to what happened recently and ignoring the data. This bias, like any, can influence our judgement and decision making. Placing too much emphasis in your portfolio on recent market trends could lead to disaster as it did for many in the year 2000.
We visited on this slide in our last commentary. Updated for the 1st quarter, it is still quite evident that international markets present with opportunity. We have seen very favorable results in our international exposure, which can be seen on your recent statements. We are excited about what the future holds here.
We turn to housing briefly. We see a potential housing crisis on the horizon. On the bottom of this page we find that rental vacancy rates are quite low and on the right the increase in multi family housing starts has really taken off to a level we have not seen since the 1980s. In my opinion, under normal circumstances this could be cause for great concern. However, the single family housing issues may allow for the multi family boom to continue as well as a very soft landing for single family home values. At the top left we see that inventories are low, couple that with the below average new starts and the indication is that we may continue to see a shortage in the single family housing market for some time. Rental rates are down but vacancies remain very attractive, about 20% below the average since 1956.
The consumer continues to spend. As evidenced by this chart, the amount of personal savings has fallen sharply from the all time high back in 2020. The historical average savings rate is 8.9% but we are currently sitting at about 4.5%, slightly higher than last year’s savings rate. On the top right we see that outstanding credit continues to climb but the bottom shows that the pace of wage increases has helped keep the percentage of disposable income used for serving that debt at a pretty modest 6.2%. Over time something does have to give. Naturally, my hope is that people will start to save for their futures but the health of the economy is dependent on consumption. It is a two edges sword…saving more means spending less and spending less means a weaker market. As always, time will tell.
I want to just spend a moment on inflation. We were fortunate enough to avoid the heavy inflationary pressures experienced in the 1970s and 1980s and the Fed increasing interest rates can be thanked for helping us through the significant harm that would have caused every one of us. Many are surprised to learn that the 50 year average inflation rate is 4%. We use 3.25% in our planning as that is near the 100 year average. The last couple of decades has been closer to 2%. We are currently at about 6%, down quite a bit from the near 9% reading we saw last year. More than likely inflation will continue to tame and within the next year or two expectations are that we will find ourselves in the 3% range.
The Feds effort to tame inflation resulted in record setting interest rate increases in 2022. As the Fed increases rates, it’s intent is clearly to tighten money supply. This has been anything but a normal market cycle as we saw rates climb faster than they ever have yet wage growth and unemployment never flinched, with unemployment falling below 3.5%. Looking forward, the Fed will not keep rates as high as they are. Once the economy begins to cool the Fed will start to reduce rates and the cost for borrowing will go down. We do not expect to see interest rates anywhere near where they were a few years ago. More than likely mortgages will fall in the 4-5% range as opposed to the 2 to 3% range we saw in 2020 and 2021.
Looking at the impact on money supply we can see how dramatic those interest rate increases really have been. This chart dates back to 1960. We can clearly see how significant the impact has been. But, this chart also demonstrates that the Fed can not hold rates as high as they are for a prolonged period without causing significant damage. Hence the expectations that lowering rates are not too far in the future, more than likely happening in 2023 or early 2024.
2022 was a record year for interest rate hikes but 2023 will also be a year for the record books. With the banking crisis that hit us a handful of weeks ago the Fed opened its emergency lending and banks drew more than they ever have in history, including during the banking crisis in 2008 and 2009. Although more funds were borrowed during this banking crisis that should not be interpreted as a concern level that is anywhere near that of what occurred in 2008 and 2009 during the Great Financial Crisis. As a matter of fact, the most recent earnings reports from big banks have exceeded expectations. This can certainly not be said of banks 15 years ago.
I know this slide is a bit off in terms of timing, but as a big College basketball fan I couldn’t help but share a fun comic I came across a few weeks back. Many were concerned that we would see a collapse of the banking system, especially regional banks. The result would be a significant number of mergers in the baking industry. My guess is that we will see some consolidation but that we will move forward with a larger number of banks to choose from.
It is important to take a global look at the environment for central banks to gain perspective on other economies and what they are experiencing. As you can see, nearly every Country on the list has increased rates in 2023. Turkey being the only exception for 2023 as they made a rate cut. I won’t speak of the economic conditions in Turkey, just know that they are horrific. Japan’s last rate action was in 2016 while China and Russia both made cuts in 2022. The 4th column reflects the inflation rate in each of these countries. You can see that it is quite a range but the majority fall between 3.5% and 9%. The Central Bank Rate in the US happens to fall near the middle when ranked against each of these countries. I truly feel blessed to be a citizen of the United States.
Focusing on the inflation rate in various countries, we can see that we have a good mix of countries that are seeing declining inflation and those experiencing higher inflation. Continuing to focus on the US, it is refreshing to see that we are in the lower half of inflation rates.
Let’s turn back to what is going on with the yield curve. Currently the 10 year treasury yield is lower than the 3 month yield by the widest margin since at least the 1960s if not in history. As a matter of fact, you were better off owning a 3 month treasury than a 10 year treasury by 1.67% not too long ago. As this became a reality toward the end of 2022 we made a significant change in the money market in your portfolio by allocating to the Fidelity 3 month Treasury money market, yielding around 5%. This will not last as we see interest rates start to fall and the yield curve return to normal. While it is rewarding us for short term money, we certainly want to take advantage of it in your portfolio.
As we come to a close, these last few slides give us a snapshot of history. The first looks at years in which the previous calendar year was negative and the first quarter of the year following that negative year was positive. Since WW2 this has happened 10 times. The good news is that in ever one of those ten occurrences the entire year finished in the positive!
Another look reflects on negative market years in which there was a midterm election. There have been 9 such occurrences including 2022. The good news is that every year that followed was positive…the even better news is that the average return was over 24% in the following year. I do not suspect that 2023 will give us a 24% return but I think we would all be happy with a high single digit or low double digit result.
Our success and satisfaction in life really comes down to focusing on the things that we can control. If we spend all our time and effort focusing on the things that are not in our control and influence we are destined for failure. Our efforts will always be focused on the areas that we can control while paying close attention to the weighing machine and far less attention to the voting machine I mentioned at the beginning of todays discussion. As always, thank you for taking time out of your day to join us and thank you for your trust and confidence in our team as we work diligently to help you meet your financial goals. I will finish with this last slide representing three new additions to our incredible team at Custom Wealth Management.