Key Take Away
2022 is shaping up to be a year for the record books, just not the type of record anyone wants to see... Midway through October, the traditional 60/40 portfolio (60% stocks and 40% bonds), which is a moderate portfolio, is off to the worst YTD (year-to-date) start since 1931, down over 20%. While LHWM portfolio models have not been unscathed in 2022, they have fared far better than their respective benchmarks. About half of the 2022 YTD model portfolio losses occurred during the first six weeks of the year. Since mid-February, when models were shifted to defensive, portfolio volatility has been significantly reduced. At this point of the year, LHWM models are significantly outperforming their respective benchmarks in every model! Source: Bloomberg
We understand that it is never pleasant to see losses in a portfolio. However, we must also recognize that this comes with the territory of investing. Markets don’t go up every single year. From time to time, Investors must withstand volatility and ride out the storm. It’s always good to take a step back and look at the big picture of where the portfolio has been and where it’s headed. Looking back, LHWM model returns continue to look excellent (especially as compared to their benchmarks) when averaged over the past three years. Additionally, the models have significantly reduced loss exposures in 2022 relative to everything going on (reducing losses in bear markets is a core focus of our investment strategy). All models remain in extremely conservative/defensive allocations. Looking forward, we must also recognize that market volatility, like we are seeing this year, brings tremendous investment opportunities for those with cash that are able to buy once the dust settles. LHWM models remain well positioned with cash and very conservative short-term treasury bond positions that provide us with ample buying power once this storm passes.
At this point, we must all remain patient and wait for the next buying opportunity. We continue to monitor markets (technical signals) and the economy (leading economic indicators) on an ongoing basis as we seek to protect and grow your nest egg for the future. The buying opportunity we seek has not yet arrived; thus, LHWM models have remained very defensive since mid-February.
U.S. Outlook
Overview
The stock and bond market retreated to new lows for the year on Friday, October 14th. This move has completely erased the July/August rally that many had hoped would start a new bull market. As we highlighted in our August market update, big stock market bounces that ultimately give way to new lows are a hallmark of bear markets. On one hand, from a volatility perspective, this bear market is proving to be no different from those of the past. On the other hand, every bear market is different, and this one is certainly unique in its own way.
One of the biggest differences in this bear market, as compared to the ’00-’02 bear and the ’07-’09 bear, is that bonds have been losing alongside stocks. In those previous bear markets, U.S. Treasury bonds were a haven relative to stocks, offering gains to counterbalance stock market losses. A balanced stock and bond portfolio has fared far worse in 2022 than in the previous two bear markets. From that perspective, this bear has been much worse. So, what’s different this time? We believe the answer is inflation.
For the last 40-plus years, inflation had been steadily moving lower; thus, interest rates had been steadily falling. Then, post-financial crisis (’07-’08 bear market), the FED kept interest rates near zero for the better part of a decade. The consequence of this low-interest rate policy led to significant increases in asset prices, even for profitless companies. Now that inflation is front and center, the FED is moving rates higher to combat the inflation surge. This has reversed market dynamics. Years of low rates allowed unprofitable companies to survive thanks to easy access to capital (without profits, companies must access new capital from investors or from debt markets to continue operations). The benefit of these profitless companies was that they employed people and supplied additional goods and services throughout the economy. This supply aided in keeping inflation low, which allowed the FED to keep rates low, which kept the unprofitable companies alive. This feedback loop was perpetuated until Covid hit.
Post-Covid, not knowing what the future held, an unprecedented amount of stimulus was pumped into the U.S. economy due to the fear of an economic depression. The combination of ultra-low rates, thanks to the FED (buying treasury bonds and mortgage-backed securities), and direct cash payments to consumers, thanks to Congress, led to a massive asset bubble in all assets as all that stimulus cash was in search of a home. Covid and the stimulus also changed the dynamics of the labor markets…people had extra money, so they decided not to go back to work for various reasons. With demand increasing due to everyone having extra cash to spend and supply constrained due to people not working, inflation took hold. More demand and less supply mean higher prices. Now with inflation high, interest rates are moving higher to fight inflation. These higher interest rates, especially relative to where we came from, are stressing the system. Profitless companies no longer have easy access to capital, and the ones that do could have problems servicing their higher interest-rate debt. The longer rates stay high (the FED has pledged to keep rates high for an extended period), the more likely it is these profitless companies will cut employees and expenses or, even worse, fall into bankruptcy. As they go out of business, that is less supply of goods and services in the system, which aid in prices remaining higher than desired. The other aspect impacting inflation is the tightness of the labor market. Companies are still having trouble finding workers in some sectors creating sticky wage inflation. This phenomenon could cause stronger financial companies to retain their employees as long as possible despite the looming recession as fears that hiring them back may be a huge challenge. Thus with inflation remaining high and the unemployment rate low, the FED will want to keep rates higher for longer, further perpetuating the negative economic and financial effects.
There really is no easy way out of the current unwanted feedback loop. The FED is pushed into a corner. If they fail to stay the course until inflation is beaten, inflation will surge higher again. Their long-term target is 2%, and the September CPI number came in at 8.2%, down from 8.3% in August…stubbornly high. The process will likely take time to unwind; thus, patience is key. Source: Bloomberg
Model Positioning
LHWM model portfolios remain defensive. Within our portfolio positioning, we’ve had some allocation changes. After CPI peaked in June and began trending lower into July and August, Treasury bonds began moving higher and appeared to be breaking out of their downtrend. After adding long-term treasury exposure back into the model, we were quickly stopped out (sold) of this position again. Inflation data in September and October has remained stubbornly high. Since being stopped out, treasury bonds have moved significantly lower. Additionally, we have also been stopped out of the gold position. Both gold and bonds typically have an inverse correlation to the dollar and real yields (nominal rate minus inflation), both of which have been moving higher. So, we are staying out of the way for now. With growth slowing faster than inflation, there are some stagflation characteristics in this market. Energy is the lone sector of the S&P 500 that is in positive territory in 2022. To replace gold in the portfolio, we have added a small energy sector position as its substitute. There are some interesting supply and demand dynamics in play for oil, with OPEC reducing production at the same time the US continues to release oil from the SPR (Strategic Petroleum Reserve). Meanwhile, global demand for oil is weakening. We’ll keep a tight leash on this, but momentum signals are positive on energy for now.
We continue to have a very small amount of stock exposure in all models, and we continue to hold short positions to hedge the risk, although our short positions have been trimmed as a bear market rally could unfold in the near term.
Keys to the Market
Price to Sales – Some in the financial media are arguing the market is beginning to look “reasonably” price based on the forward PE ratio of the S&P 500, which is now around 17 times future earnings estimates. The problem with the forward PE ratio is that it relies on forward-looking earnings estimates, which could be wrong. Another way to evaluate the market on a historical basis is by using the price of the market relative to total sales (revenues); this eliminates some of the nuances and complexities around earnings. Notice how the price-to-sales ratio has pulled back significantly in 2022 with the decline in the price of the stock market. However, the price-to-sales ratio remains historically elevated as it has now declined to the levels achieved at the peak of the 2000 market bubble... This ratio could have much lower to go.
*Red shaded areas indicate NBER-defined U.S. Recession
Household Credit Card Balances – As stimulus checks ended and inflation increased over the past year, consumers have resorted to credit card spending to maintain lifestyles. As we all know, living on credit cards can only go on for so long, especially with interest rates rising, pushing the minimum payment requirement significantly higher. Increased borrowing costs further pressure consumers to reduce future spending-a negative for a consumption-based economy.
*Red shaded areas indicate NBER-defined U.S. Recession
Dollar Index – The DXY (dollar index, which measures the value of the dollar relative to a basket of foreign currencies with the Euro and the Yen the two largest components making up over half the index) has had a significant move higher this year, up over 20% YTD. This increase has been fueled by interest rate hikes and tighter monetary policy in the U.S. relative to the rest of the world. While the dollar’s gain in 2022 is significant, it may not yet be done. If we look back to the early 1980s…the last time the U.S. pursued a major rate-hiking/inflation-fighting campaign, the dollar soared well beyond current levels. If the Fed stays on the current policy path, the U.S. dollar could go much higher. The dollar index remains a core position in our defensive portfolio strategy. A strong dollar is also correlated to weakening corporate earnings (foreign-earned profits convert back to fewer dollars). Plus, the dollar has a high correlation to yields, as can be seen by the blue line (2-year treasury yield) in the chart below. Source: Bloomberg
*Red shaded areas indicate NBER-defined U.S. Recession
Remember, patience is key; bear markets and recessions take time to unfold. Just as prices falling hurts portfolios, time dealing with the stress and volatility of the market ultimately wears down investors. Fortunately, we’ve been extremely defensive since February, thereby minimizing the impacts of falling prices and preserving mental capital by not riding the volatility rollercoaster. This downturn will bring great opportunities for investment. We remain conservatively positioned and vigilant in navigating these uncertain markets. During the course of our relationship, we have worked with you to establish a portfolio that matches your financial planning needs, risk tolerance, and investment timeline. With that said, it’s critical to remain patiently invested in the appropriate model and stick to the plan.
Please do not hesitate to contact us with any questions, comments, or to schedule a portfolio review.
Sincerely,
Lake Hills Wealth Management