Q3 2022 Market Commentary
The SP500 has long been the index tracked for research purposes and for a benchmark of the US Equity markets. The SP500 represents the largest 500 stocks in the US market. Looking at this chart that dates back nearly 30 years, we have seen many periods of volatility. As the SP500 has reached a high point, the P/E ratio has ranged from 15.1 in October of 2007 to 25.2 in March of 2000, the peak of the tech bubble. The SP500 bottoms have ranged from as low as 10.4 in March of 2009 to 15.9 in Dec of 1996. We currently sit at about 15.1, not expensive but also not inexpensive. Keep in mind that this is specifically the large cap US market.
As I mentioned, the current P/E ratio for large caps is not expensive and here we see that vs. the 25 year average of 16.84 it could be considered to be moderately inexpensive. We have seen large caps hit this price point many times in the past, most recently in early 2020 and prior to that in late 2018. In both of those market environments we saw a substantial bounce in valuations, leading to significant market growth. Keep in mind, valuations are only one indicator of market direction.
October has always been a special time of year. Upstate NY welcomes the Fall season with the absolutely beautiful change in the trees and my son’s favorite holiday, Halloween. If you have not had an opportunity to see the Fall landscape from our office, you should take a few minutes to stop by and get a glimpse. While we certainly enjoy the view in the Fall, the stock market, on the other hand, enjoys the Month of October far less. As a matter fact, the DOW Jones Index, the SP500 Index and the NASDAQ index have all seen far more market bottoms in the month of October than in any other month. The DOW Jones has actually realized 4x more market bottoms in October than in any other month while the SP500 and NASDAQ have seen about twice as many bottoms in October.
The SP500 is made up of two primary asset classes, Value and Growth. In general, Value stocks tend to be companies in the Health Care, Financials, Industrials, Consumer Staples, Materials, Energy and Utilities industries while Growth stocks tend to be companies in the Information Technology, Consumer Discretionary and Communication services Industries. Growth stocks are generally companies that have had 5 year average sales growth of above 15% while Value companies typically have a price to sales ratio that is below 1%. Either stock may pay a dividend, but typically the dividend of a Value stock is higher. In recent years, Growth stocks have substantially out performed Value stocks. But that has not always been the norm, as we often see periods of Value stocks out performing. This chart is helpful in demonstrating time periods where Value stocks may very well out perform Growth stocks for the foreseeable future. As you can see, we have seen a few years of under valuation of Value stocks. The first half of 2021 reflected a shift from Growth to Value in the market but that reversed course as the year carried on. 2022 has seen a similar shift. Although all US equity asset classes are negative, Value stocks have seen a far less challenging downturn.
Here we have the valuations along with some interesting rate of return by asset class details. Let’s start with valuations that are on the right hand side of the screen. The top number is the current P/E ratio for the asset class and the bottom number is the 20 year average. Looking at every asset class you can quickly see that Large Cap Growth is the only asset class that remains expensive vs. its 20 year average. Interestingly, Small Cap Growth is by far the least expensive. Small Cap Growth is the most aggressive domestic asset class and while it may present the most opportunity on the upside from a valuation standpoint, it also has the greatest potential for loss especially in an increasing interest rate environment. Looking at the two charts on the left side we see the 10 year annualized returns of Growth far outweighing that of Value, on the large cap side by about 4.5% annualized. YTD is a different story where Value has been far stronger than growth, by nearly 13%. It is also interesting to see the returns since the market peak in February of 2020 have been quite a bit stronger for Growth but a mere month later at the market bottom the results are in favor of Value, especially Small Cap Value where the spread is nearly 40%.
I have always found this piece of great value. We often forget what happens throughout the year when we are fortunate enough to finish the year in positive territory. But, every year comes with some volatility. This chart reflects the SP500 performance year by year in the black bar chart with the black numerical value representing the rate of return for the year. The red numbers represent how much of a downturn occurred from the markets peak that year to the markets bottom. As you can see, most of the last 20 years have had a double digit decline within the year even if it finishes the year in positive territory. This piece goes a long way in explaining why market timing is pretty much impossible. That is the very reason we not only stay invested but also approach investing with a focus on diversification.
Let’s talk for a minute about how unique the year 2022 really is in terms of history. There are many charts that appear distorted as a result of the substantial efforts to address the COVID crisis. Some of those charts are in todays presentation. This one, in particular, really drives home the point of how significantly the market environment has been impacted. There has only been 5 times in history since 1928 that we have seen the year end with the SP500, the 10 Year Treasuries and a 60/40 portfolio ending negatively. 1931, 1941, 1969 were all rather challenging years in the market. We then saw a nearly 50 year period before we experienced this again in 2018. We didn’t get a 50 year break this time as a mere 4 years later we are anticipating 2022 to be marred with the same frustrating result. That is by far the shortest time period between such volatile results. Now…if you look closely, in all years with the exception of 1931, all three of these investments saw strong results for the two years that followed. There are many things that indicate that the same may be ahead for us.
Let’s look at consumer confidence going back to the early 1970s. We recently hit a low point in the consumer confidence, the likes of which have not been seen since 1980. Believe it or not, the consumer confidence level fell below where it was in 2008 when we were facing potential financial collapse as a Nation. I find that hard to believe as I do not see things being as problematic for our Country as they were back in 2008. In 2011 we saw another drop in confidence as a result of US debt being downgraded. In previous time periods where we have seen such a dramatic drop in consumer confidence it was followed by a sizeable improvement. At times that improvement lasted only a couple of years but in most cases it extended for 4+ years. There is no telling when we will see consumer confidence strengthen to at least the average of 85, but if history is any indicator we should start to see a steady improvement that continues for a couple of years.
As we wait for our confidence to improve we must contend with the markets and the economy at hand. I have been at this for 25 years come January. The one thing I have realized is that all bear markets are the same. The cause for the bear market may be different, and actually it is always different. But all bear markets are the same in that they have a tremendous impact on our emotions. While it is easy to recognize the value that a large sale presents at our favorite shopping establishment, it is far more difficult to recognize that in our portfolio. When you own something prior to it being on sale, it is admittedly more painful to see it go on sale because you would prefer to always get at least the highest value at which you ever owned that particular item. We know that just is not the case in life whether it be a piece of technology we bought a year ago or positions in our portfolio. In times like this, our role is more important than every. We must consistently review every position in your portfolio to determine if we should hold the position, put it on our watch list or put it on our replace list. Believe it or not, the most difficult decision is to determine if it should go to our replace list. Sometimes that decision is easy if a manager has changed courses, has adjusted their philosophy, has left the fund or whatever it might be. But, when a manager has had a superb track record and shown great results in a rebounding market but has suffered significantly during a downturn, the decision become far more difficult. We have two such positions in most of our clients portfolios and those positions are responsible for many hours of missed sleep for our team. We continue to monitor them at least weekly, speak to the managers and/or their representatives regularly and keep a close eye on the actions of the fund to ensure they maintain their philosophy, act as they did during previous downturns and retain top positions that we see as being important in the recovery. I thought you would find this chart helpful in that is clearly demonstrates the rewards of resiliency in the markets. Staying invested is never more important than it is in a down market.
This slide gives us an interesting look at the rotation from domestic equities to international equities over time. We have just experienced the longest rotation to US equities in history, lasting 15 years so far. The next longest rotation to domestic equities lasted a mere 6 years. Could this be the new norm or could this extended US dominance be taking its last breaths? In order to get our arms around this, I think it is important to understand what one of the biggest influences in these rotations has been.
The rise and fall of the US Dollar. Looking at the chart on the left, going back to the late 1970 you see that the value of the dollar rose consistently for several years and the impact on US stocks was substantial, rising by about 106% vs. the International market gains of only 49%. We then saw a decrease in the value of the dollar that lasted slightly longer and was coupled with a substantial run in the International markets, up over 430% vs. the US up about 340%. This cycle clearly repeats itself over time. Take a look at the chart on the right hand side. We see here the most recent change in the value of the dollar with the dollar dropping a bit in 2016/2017 but then rising, only to drop a bit in 2020 followed by a dramatic bounce from the 2020 US dollar lows. We were speaking with a client last week that is headed to Europe and they are ecstatic about the exchange rate verses their last visit. Several years ago the exchange rate was $1.42 per Euro…today, it is about even. Looking just over our boarder to Canada, there was a time not too long ago where we were at about par with the Canadian dollar but now we are seeing the Canadian dollar in the mid 70s vs. the US Dollar. Few and far between believe the dollar can maintain the stronghold it has on foreign currencies without causing substantial international strife. Will the reversal of the dollars value pave the way for International and Emerging Markets to spring from their extremely low valuations and dismal decade of performance?
Supporting the argument for an International rebound is the valuation of 10.8 vs. the 25 year average of 13.1. The US is far more expensive trading at a P/E of 15.1 vs a historical 25 year of 5.4. From a dividend perspective International also has a stronghold over the US with nearly a 2% strong dividend. Three strong indications – US dollar value; P/E Ratios and Dividend Yield all support the rise of International equities. We have maintained a reduced exposure to International but anticipate increasing that over time as we anticipate a rotation from US Equities to International Equities.
One more snapshot of the International markets. Earnings growth projections over the next couple of years are strongest in China and in the Emerging markets. Valuations are most discounted in Japan and Europe. Japan has suffered a valuation crisis for decades, a unique aspect of that country that I feel is best explained by their culture. I will spare you the details but Japanese Kieretsu is a big reason for this. Investopedia has a great piece on the Kieretsu for those of you interested. China and Europe present potentially attractive opportunities as we move through the current crisis facing each. Keep in mind that the best point of opportunity is not when the crisis has passed us by but instead at some point in the midst of the crisis. We will continue to research these opportunities and maintain some exposure to them, increasing the exposure as the environment seems fit.
Let’s shift our focus to bonds. This has really been the most interesting year in bonds that I can remember. We have seen most bonds get absolutely slaughtered in this market, some bond asset classes have had their worse performance by 4 fold. US Credit is down a miserable 19%. Given that so many investors carry bonds in their portfolios to support the downturn in stocks, this has been a true wake up call for investors and advisors alike. If your portfolio was invested 100% in US Credit, you should be down about 19%+ YTD. It is rare to see folks allocated 100% to bonds as they usually include an allocation to various stock asset classes to better diversify their portfolio and to ensure it is addressing inflation. Considering the majority of stock asset classes are down between 22% and 31% that means even the most conservative investors are likely down over 20% in their portfolios. Recall the slide we looked at that reflected the negative results of the SP500, the 10 year Treasury and the 60/40 investor – we have only seen the three of these negative for the entire year 4 times going back to 1928….this year potentially being the 5th. Taking a look at interest rates today and where they were a year ago, I don’t think there is anyone who would have guessed there would be such a dramatic shift in rates. From a 20 year mortgage at about 2.9% a year ago to around 7% today, more than double the interest cost on a mortgage. Look closely at this chart, the 1 year to the 10 year rates are higher than the 30 year rate. An interesting inversion to the yield curve, to say the least. As yields go up, they have a negative impact on the value of bonds. Looking at the difference in yields vs last year, there has been virtually no bond spared in this interest rate shift. This is one of those rare occasions where you would have been better off investing in Large Cap Value stocks than in bonds over the last year. Given this shift and the increased yields in the bond market place, we believe there are some great opportunities in bonds on the horizon.
Let’s take a little closer look at the bond market. The longer a bond, the more significant the negative impact of an increase in interest rates. We can see that with the chart at the top as 2 year Treasuries are down about 4.59% and 30 year treasuries are down a whopping 31%. The bottom half of the chart reflects different types of bonds with the worst performances being found in Convertible Bonds and Investment Grade Corporate Bonds. Oddly, US High Yield bonds have performed better than the IG Corps or the Convertibles. The strongest bond asset class has been the leveraged loan bonds, also known as floating rate or senior secured loans. For those who pay close attention to their portfolios, we took a position in these about 18 months ago to help protect client portfolios and especially to help insulate those who are in or are near the distribution phase of their portfolio. We are pleased to have had a strong result here but are also of the opinion that we may soon need to leave this asset class.
There are several different types of bonds in the investing world and they act differently under different circumstances. This may appear a bit confusing, but what it is reflecting how various bonds have responded once we are faced with an inverted yield curve up until the end of the recession that follows (most inverted yield curves are followed by a recession). Here you can see that the Bank loans or Leveraged Loans/Floating Rates, tend to under perform other bond asset classes as the recession forges on. The strongest reason behind this is that defaults increase and as they increase the Floating Rates often experience the higher number of defaults on their notes. This is one reason we are closely monitoring this investment and expect a trade away from Floating Rate in the not too distant future.
Another reason is the yield to worst that we are seeing in other bond asset classes being at or near all time highs versus the previous 10 years. Municipals, in particular, present with great opportunity for all income levels given the taxable equivalent. Investment grade corporates are also quite attractive. Leveraged loans, on the far right, still present attractively at 10.5% but are far from their 10 year high yield. One also has to take into account the underlying risk of the bond to best determine if the yield is justified. That gap is closing with the Leveraged Loan positions in my opinion.
Taking a closer look at the Municipal market place, this chart reflects the tax equivalent yield on municipal bonds vs. the US Treasury yield. A spread of about 1.9% on the short side and a whopping 3.7% on the long side presents an attractive opportunity for bond investors.
This is my last point on bonds, for today at least. I really though it would be helpful to show you how historically significant the 2022 bond market has been. This dates back to 1976. We saw a similar chart a little while ago for the SP500 but this one is showing in the black bar chart how the bond Aggregate performed in each respective year, with the black number reflecting the actual performance for that year. The red number reflects the downturn from the bond Aggregates peak for that given year. As you can see, since 1976 we have only experienced 4 down years in the Agg Bond, not including 2022. Even more interesting, looking over those down years but also the downturns in any given year, the worst was -9% but the majority fall at a -2% to a -3%. 2022 is clearly at -15% YTD as of Sept 30, and has fallen from there in October. This piece makes it clear how truly dramatic the sleepy bond market has been for 2022.
I think the media does enough talk about the economy that you don’t really need to hear from me on the topic. But, many times the media focuses on how to best get your attention as opposed to how to best educate you on what is going on. If you were to ask me, I would say that we are likely already in a recession. Typically, you do not know if you are in a recession until well after it has started. If we look at the leading indicators, we can see that the 3 most influential: Weekly Manufacturing Hours worked; ISM index of new orders; Consumer expectations; are all suggesting a recession. My guess is we will see others turn in this direction as well in the coming months. Yield spread may be the next to fall in line.
Here is the 50+ year yield spread chart reflecting the movement in yields as well as recessionary periods in grey. More specifically this is showing the 10 year yield minus the 3 month yield. As we see the result get smaller and go negative, which it is currently, we have historically seen a recession follow not too far behind. One last comment here. It is important to differentiate between the economy and the stock market. The Stock market is a leading indicator and the economy is a lagging indicator. They are not one in the same. We typically see the markets recover well before the recession comes to an end.
It is always interesting to see when cash positions increase versus where we are in the market. The most recent increase was substantial and this was substantially influenced by the amount of money pumped into the economy by the government to keep the economy moving through COVID. If you look tack at 2000 to 2002 and at 2008 to 2009 you can see that many substantially increased their cash savings by a large amount. These are the absolute worst times to increase cash positions. Those times coincide with substantial market downturns and reflects people selling out of the markets when they are down, only to return that cash to the market when the markets have improved. This is the exact opposite of what investors should be doing if they wish to make money.
I had some hesitation to include this slide only because I assume that it will stir up some conversation. The reason I wanted to share it is to help make the point that the stock market is mostly agnostic to Red or Blue. Looking at the box at the top it helps make clear that it does not matter what party is in control over the duration. However, mid term elections do seem to have some consistency in the days leading up to the election and the days following.
Here we have a look at the midterm elections – only a few weeks away, we can see that the amount of volatility in the markets tends to reduce as we get closer and since 1946 they have never been lower 1 year after the mid term election. I’m not convinced it has all that much to do with the elections given the range of performance, but nonetheless found this rather interesting.
Here is what it all comes down to….our emotions. Investing is one of the most emotional aspects of our lives. When things are good, we all feel pretty good and are upbeat and optimistic. When things are not so good, we tend to feel all the pain and suffering the world has to offer. The media is helpful on both side of this, letting us know what we missed out on when the markets are strong and what we should have done before the downturn occurred. I am quite confident that we are somewhere in the range I circled here with the hope that we are on the far side of despair. Anytime you are feeling the pain, we are here for you and encourage you to reach out with a call or an email so we can schedule time to discuss your portfolio with you. Our goal is to help protect you from making the mistakes that so many investors make over and over again.
Looking more closely at those mistakes, this is a common piece we see from various firms in our industry. This one happens to be from JP Morgan. They look back at the 20 year period ending Dec 31, 2021 and give a snapshot of the various indexes and then reflect the average investors performance over that same time period. As you can see, the only indexes that have done worse over the last 20 years are inflation, commodities and cash. We do not want you to be the average investor and will work diligently to help you through both the good times and the challenging times.
As I reviewed the latest Goldman Sachs market commentary I took an interest in this piece. It gives you a clear picture on how unpredictable the market is as the 1st half of the month rarely performs similar to the 2nd half of the month. As a matter of fact, take a look at June. Historically the 2nd half of the month has been softer than the 1st half of the month by a pretty substantial amount. Keep in mind that these are median numbers and certainly not information you would want to use to determine how to manage your investments. What is most important is to recognize that often the worst periods of the year are frequently followed by the best periods in the year. Missing out would have a devastating impact on a portfolio.
Let’s take another look at the impact of missing the strongest periods in the market. This is a look at the 15 year period ending Dec 31, 2021. Over that time frame had you stayed invested in the SP500 for the entire time, never touching your money, you would have grown a $10,000 investment to over $45,000. Along the way you would have encountered some pretty significant turbulence. The great recession of 2008 to 2009 where the SP500 fell over 50%; the downgrading of US Debt; BREXIT; The Trump Administration and China battle over tariffs; COVID…which has not yet earned its green box in this chart. Let’s look at what happens if you miss just a few days during this 15 year period.
The first part of the chart, in the green, you can see the information from the previous slide. Immediately under that shows the different in return if you were to have missed the best 10 days in that 15 year period. Let me emphasize that this reflecting missing only the 10 best days in that 15 year period. Your return gets cut by more than half and you end up with just under $20,000. I am a bit of a cynic so I posed the question of how it is possible for someone to miss the 10 best days to Putnam, the company who provided me this piece. They responded that it is actually quite common because more than half of the best days occur within 10 days of the worst days. So, for those who sell out during a downturn and go to cash, they are on the sidelines when the majority of those best days occur. That takes me back to the average investor and why their results are so dismal when compared to the various indexes we saw just a few slides ago.
Let’s now turn to inflation. The biggest contributors to the increases in inflation based on this chart would be housing and energy. Food has also had a substantial impact while new and used vehicles have softened in the last few months. Here is the good news, inflation expectations from both the consumer and the professional expectations are a relatively tame 2.7 and 2.8 respectively. I suspect we will see several of these areas come down in the coming months, I do believe that the inflation we saw in some areas will be locked in at their new higher rates unless demand forces them to reverse course. It is important to remember that the inflation measure is a year over year number. So, if we see an inflation number of 8.1% a year from now, that would mean that the two year number would actually be over 16 (given the most recent reading of 8.2%).
Going back to 2007 we have seen the movement of the global supply chain pressure index and the CPI pretty consistently move in the same direction. That changed wildly starting with the early months of COVID with the CPI dropping while supply chain pressures obviously sky rocketing. Things were back on track for a period of time but recent months have seen a dramatic reversal with strong improvements in supply chain pressure but the CPI increasing. The decrease in supply chain pressure is a strong indicator of where the price of goods is heading.
As a matter of fact, as we all know we saw a huge spike in the price of goods for a period of time which peaked in early 2022 and has since reversed course and seen substantial decreases. The price of goods is expected to continue its downward trend, leading some analysts to be concerned about a deflationary environment in the future. As we have seen the decrease in inflation on goods we have seen an increase in the level of inflation in the service sector. The service sector represents the largest sector of the global economy and includes consulting, training, housekeeping, nursing, teaching, etc.. As a result, if the level of inflation in this sector is not tamed quickly, the overall inflation number could get worse. Many expect that the service sector inflation level has already started to correct. The next reading on November 10 will certainly be an important one in determining not only the direction of both service and goods inflation but also the direction of the Fed for their Dec 14 meeting. The Feds next meeting is November 2 and most are expecting a 0.75% rate increase.
Inflation has been experienced by most countries across the globe. However a few countries have been spared including China, Indonesia and India who have experienced far more mild increases in inflation than most. As you could imagine, the worst levels of inflation are among the European countries including Greece, Spain, Italy, France and Germany. What you may not know is that the highest level of inflation has actually been in Russia with over 14% inflation.
In these last few slides I thought you might find interest in the level of inflation in various areas of our economy. We all need food and no doubt we have all seen a significant increase in our food budget. The latest reading on the % change in food costs came in at a whopping 13%, which is not yet reflected on this chart. Going back to 2010 the average rate of increase has been about 2.5%, making this 13% increase that much more painful.
I found the chart for the cost of medical care interesting. If I were to guess, I would have thought the cost of medical care would have increased at a faster pace over the years. This certainly does not take into account the cost of health insurance, or so I presume. The recent reading is actually in line with the average going back to 1985.
We are seeing a pretty substantial increase in the cost of rent and shelter. We saw increases of this nature back in the late 80s and what followed was a pretty big drop in the early 90s in these costs. Of course the big drop in the chart occurred as a result of the 2008 financial crisis. Keep in mind that this is for residential properties. I would assume that the chart for commercial rental rates and occupancy levels are dramatically different.
The direction of housing is often predictable based on the amount of activity that exists in the mortgage industry. Parts of both 2020 and 2021 saw dramatic increases in the number of mortgage purchase applications, note that this does not include refinancing applications only new purchases. This would indicate a slow down in housing is imminent, which many of us would probably expect given the increase in mortgage rates.