The Margin Of Safety Quarterly Summer 2022
Second Quarter 2022 Key Takeaways
- 2022 year to date has been rough for investors in both the equity and fixed income markets.
- There are external shocks to the global economy such as the Russian war on Ukraine and China’s zero-COVID lockdowns which have further exasperated things.
- The Federal Reserve made an additional increase to the Federal reserve rate during the quarter and is expected to continue tightening while they hope to achieve a “soft landing”.
- We continue to remind clients about the importance of having a long term focus and con-trolling what your can control.
- Now is a great time for a mid-year checkup on your personal financial planning to make sure you have the proper insurance and estate planning in place.
Second Quarter 2022 Investment Commentary
It’s been a rough year, with equity markets down more than 20% and “low-risk” bond markets registering low double-digit losses. Over the past few months, the economic backdrop has worsened with sustained high inflation and slowing growth, as the Feder-al Reserve and other global central banks aggressively tighten monetary policy. Exoge-nous shocks — the Russian war on Ukraine and China’s zero-COVID lockdowns – continue to further disrupt the global economy and financial markets.
The S&P 500 dropped 16.1% for the quarter and is also down 20% for the year, after being down as much as 24% through mid-June. This is contrasted with the Russell 1000 Value (U.S. large value stocks) that was only down 12.9%, outperforming the S&P 500 by almost 7% year to date. For non-U.S. stocks, the sharp appreciation of the U.S. dollar pushed less-severe losses in local currency terms into the same zip code as domestic stocks for U.S. dollar-based investors. Developed international markets (MSCI EAFE Index) were down 14.5% for the quarter and are down 19.6% YTD. De-veloped international value stocks (MSCI EAFE Value) were only down 12.2% year to date. Emerging Market (MSCI Emerging Markets Index) stocks held up a bit better, dropping 11.4% for the quarter, and down 17.6% YTD.
Core investment-grade bonds fell again in the second quarter, with the benchmark Bloomberg U.S. Aggregate Bond Index (the “Agg”) dropping 4.7%. This puts the “safe-haven” Agg down an incredible 10.3% for the year to date — its worst first-half ever. In other segments of the fixed-income markets, high-yield bonds (ICE BofA Merrill Lynch U.S. High Yield Cash Pay Index) fell 9.9% and floating rate loans (S&P/LSTA Leveraged Loan index) dropped 4.5% for the quarter.
We have written in past newsletters that core bonds are not low-risk or defensive assets in an inflationary (rising interest rate) environment. Taken together with the equity bear market, this is by far the worst first-half performance for a traditional “60/40” balanced portfolio (60% S&P 500/40% Aggregate Bond Index) in modern history, down 16.1%. The previous worst first half was 1962, down 12%. However, we don’t think that this means that anyone should abandon a diversified portfolio of stock and bonds. There were few assets that did appreciate in the first half of the year. Cryptocurrency, which had been held out as a possible way to escape inflation was among the worst performing asset classes with Bitcoin off a staggering 60%. One half of one year is not a reason to throw out a long term game plan. As will be mentioned later in the newsletter bonds need to be maintained within a diversified portfolio as they offer the best protection against a recessionary environment. For our clients, we develop portfolios with the downside in mind as we do not believe that anyone can time the markets.
There have been many times in the past where the news has been pretty grim. The most recent was 2020 and the Global COVID crisis. Since River Capital’s founding in 1998 we have taken clients through other periods of concern such as the tech bubble of 2000 and the financial crisis in 2007-2009. During each of these periods, investors without a disciplined investment process want to abandon what has worked in the past. Keeping disciplined is the way to make it through these periods. The chart below provides returns from the worst performing historical quarters for the S&P 500 and the long term returns after the quarter noted.
What we can see from this chart is that returns were generally very good for the next 10 years under all but two of these historical periods (both from the Great Depression). What this tells us is that markets will go down, on their way to going up, as stock markets are up more than two-thirds of the time. This goes with the old adage of buy low and sell high. As you will see in our Investment Outlook what this means from a forward looking view is that we are optimistic on future returns.
In response to disappointing May inflation data, the Fed turned even more hawkish, hiking the federal funds rate a larger-than-expected 75 basis points. Tighter financial conditions in turn depress consumer and business spending, reducing aggregate demand in the economy. Lower demand (lower GDP growth) should reduce overall price pressures and hence inflation. That’s the Fed’s playbook and toolkit.
The ideal outcome would be the elusive “soft landing,” in which inflation is subdued without causing a recession. But the simple economic cause-and-effect influenced by the Fed’s toolkit assumes the supply side of the economy remains steady. However, this has not been the case due to (1) the Russia/Ukraine war’s impact on energy and agricultural commodities, and (2) COVID-related supply chain disruptions. We expect (hope) these shocks will recede with time. But the Fed can’t do anything about them. BCA’s U.S. investment strategist, Doug Peta put it well: “Soft landings are extremely elusive. It is fiendishly difficult to fine-tune a complex multi-faceted economy with central bankers’ blunt tools.”
Balancing these and many other data points, we expect continued and potentially sharp deceleration in economic growth driven by rapidly tightening monetary policy in response to sustained high inflation. A recession is a reasonable conservative assumption but not a certainty.
Our best guess at this point is that if the U.S. economy does fall into a recession, it is likely to be a more “normal” type of cyclical recession rather than like the 2008-09 financial crisis, the 2000-2002 dotcom bubble bust, or the 2020 COVID recession.
Given the sharp stock and bond market declines we’ve already experienced this year, this leads us to a relatively positive medium-term (five-year) outlook for financial markets and asset class returns. And if U.S. stocks drop further this year – for example, due to increasing recession fears – we will start adding incrementally more to our portfolio allocations.
Meanwhile, our tactical views and positioning on international and emerging market (EM) stocks have not changed. Our base case five-year expected returns for EM and developed international stocks are in the low double digits, supported by low starting valuations and cyclically depressed earnings. This offers a margin of safety for investors, as a lot of bad news and negative sentiment is already priced into these markets – more so than for the S&P 500 in our view. Things don’t have to be great to generate strong returns from here; they just need to get better from currently depressed levels (and we don’t expect a pandemic and war to be permanent).
In terms of our fixed-income positioning in our balanced portfolios, we have maintained our significant underweight to traditional core bonds, reflecting our concerns about rising interest-rates and very low starting yields.
Though our fixed-income exposure has had better relative performance as interest rates have shot higher, they have not been immune to the recent broad fixed-income price declines. They also carry more credit risk than the Agg. As such, in our more conservative portfolios we still retain meaningful core bond exposure for their traditional role as recession/disinflation protection.
A key part of our fixed-income diversification has been our allocation to “Alternatives.” We believe well-managed alternative strategies with reasonable fees can add beneficial diversification and improve risk-adjusted returns as part of traditional stock/bond balanced portfolios. Alternative investments have different risk and return drivers than traditional stock and bond investments. Given the current macro risks and market backdrop, we think they are especially valuable.
We aren’t in the business of making short-term predictions, but nonetheless believe it is prudent to be prepared for more downside for the stock market over the next several months or quarters. Declines thus far have been driven by valuations coming down even as earnings have risen slightly. But we expect to see earnings impacted at some point and this could drive further shorter-term market declines. If further declines happen and reach our target, we will add incrementally to U.S. stocks at lower prices and higher expected returns.
On the other hand, if the economy avoids recession (for now) and the markets rebound, we are well-positioned to benefit with our full allocation to equities and large allocation to actively managed credit-oriented fixed income relative to core bonds.
While tilting towards our highest-conviction tactical views, our portfolios remain strategically balanced and well diversified across multiple global asset classes, investment strategies, equity styles and risk-factor exposures.
The first half of 2022 is a good reminder to investors to have a long term focus. We cannot control or predict the outcome of the markets or economy over the short term. The equity and fixed income markets are made of millions of market participants and trying to outmaneuver them over the short term is usually going to result in doing worse. This is akin to being caught in a traffic jam and using your favorite navigation app (Google Maps, Waze, Apple Maps, etc.) to find the quickest route to your destination. Oftentimes you will find that every other driver has done the same thing (looked at their navigation app) and tried taking the same detour you planned to take. The result is you may save yourself little to no time.
To echo a recent email we sent to clients, below are several items that we discuss with our clients when putting together a long term investment plan.
- Only take the risk that you can afford – we structure portfolios based on downside goals. Although there may be times that the portfolio goes down more, these times should be brief.
- For those withdrawing money we hold aside from six to twelve months of funds in cash so that we don’t need to liquidate assets when they are down in price.
- All portfolios are globally diversified, which helps manage price volatility of the portfolio.
- Market downturns are normal and many are finished within a year. Rarely are prices not back to predownturn levels within two to three years.
- Try to watch as little market commentary as you can. Media is designed to generate clicks, minutes watched, etc. to drive advertising dollars. It is entertainment and is not designed to help you be a good investor.
We think the last recommendation is especially critical for times like this. Media is a form of entertainment that drives emotional responses. It’s great if you want to be entertained, but it doesn’t help us as human beings to think rationally.
We have been taking a number of portfolio actions on behalf of our client. We have been actively selling positions to recognize losses within taxable accounts. This tax loss selling strategy, where we buy back into the original position after 31 days results in a higher after tax returns in the future as we can use these losses to offset both current and future gains. Tax loss selling strategies also improves current cash flow by reducing income taxes.
We are always reviewing our current managers and positioning. We made the decision after the end of the quarter to sell our remaining positions in longtime manager Longleaf. Although we continue to respect the disciplined philosophy employed a combination of possible management transitions and the overall risk of the portfolios led us to be less comfortable with the manager. We have added new managers that we believe will have a better risk/reward balance and in the international area we shifted further towards a balance between growth and value, using the downturn in more growth oriented names to our advantage.
Remember that the managers are also making changes to their portfolios that you will not see as you look through your accounts. They will use time periods like this to sell out of stocks or bonds that they believe are near fair value and buy stocks or bonds with greater future return prospects (read cheaper).
Mid-year is a great time to do a personal checkup. Here are some thoughts we have if you would like to do a mid-year checkup on your personal financial situation.
- Property & Casualty Insurance—When did you last do a property and casualty insurance review with your insurance agent? Do you know how much insurance coverage you have in place for your home and vehicles, if you have adequate liability insurance, or what your deductibles are in the event of a claim?
- Estate Planning—When were your estate planning documents last updated? Your wishes and desires may change over time and federal and state law are regularly changing. We recommend reviewing your estate planning documents (last will and testament, durable power of attorney, living will, health care surrogate, and sometimes a living trust) with an attorney every five years and make changes as appropriate.
- Communicating Wishes to Your Family—Do your loved ones know your wishes in the event of your death? Legal documents like a last will and testament or a trust are necessary to ensure your wishes are executed, but they can be callous and may not communicate your true intent well. For example, if you intend to leave assets for a loved one’s support, what does “support” mean to you? Some individuals may have the intent that support is providing for basic necessities (food, shelter, clothing), but a trustee or attorney could interpret this broadly to mean any lifestyle the beneficiary is accustomed to. Having a letter of instruction for your loved ones can communicate your intent behind the legal documents governing your estate and also provide direction for decisions that aren’t made by legal documents (such as what type of funeral you would like to have).
- Life & Disability Insurance—Have you done proper planning to ensure that your family’s goals are not disrupted by a premature death or long term disability? Many individuals are underinsured for life insurance and do not have any long term disability insurance. For those under the age of 65, you are more likely to be disabled than you are to die prematurely.
- Adequate Emergency Reserves—One of the most important things individuals and families can do in their personal planning is to make sure they have an emergency cash reserve in place to help protect against unforeseen circumstances like job loss, emergency medical treatment, etc. We recommend having a cash reserve equivalent to 3 to 6 months of expenses. For those who are self-employed or commission-only an equivalent of 6 to 12 months of expenses.
- Long Term Care Planning—For those age 50 and older, what planning have you done for long term care needs? While most individuals will not need skilled nursing care during their lifetime, just needing assisted living or in home care can cost thousands of dollars per year. If you do not purchase insurance for this risk, you may be transferring this risk to a spouse, partner, or other family members. You should have discussions with your family about a long term care philosophy in the event you need some form of long term care.
- Develop a Financial Plan—For many of our clients we prepare a financial plan that shows where they are today financially and how they can reach their financial goals. Sometimes we have clients who think that a financial plan only needs to be done if someone is a few years from retirement. However, it can be too late to plan when you are only a few years out from retirement. We recommend that all clients have a financial plan as a way of seeing if they are on track to their goals. The financial plan will also help in downturns like the current one to provide comfort that you are still on track and don’t need to sell out.
We are a personal CFO for our clients and if you need help with any of the areas above, we’ll be glad to discuss how your financial situation can be improved and steps to get there. We like to say that we are the quarterback on your team of professional advisors (insurance agents, attorneys, accountants, etc.) and can help you coordinate your different areas of planning to help you achieve your financial goals.
Last quarter we announced that Rob Simon, the Vice President and a Partner, in River Capital Advisors achieved the designation of Chartered Advisor in Philanthropy® (CAP®) in addition to already holding the CERTIFIED FINANCIAL PROFESIONAL™ designation. This quarter he additionally earned the designation of Accredited Estate Planner® (AEP®) and now belongs to the National Association of Estate Planners and Councils (NAEPC). He is currently completing coursework that will lead to a Masters in Financial Planning. Rob is committed to providing the best advice to clients and believes in adding to and refreshing his knowledge to be the best resource that he can be. Through his most recent training he has gained fresh incite into legacy planning and how to help clients achieve the impact that they desire in others lives and in the world at large.
We are also excited to announce two new members of the River Capital Advisors team. Wesley Martin is joining our firm as an Associate Wealth Manager. He brings experience in the finance industry, having worked at a large brokerage firm and a desire to work at a fee-only financial planning firm where he can help clients with their holistic financial planning needs. Wesley is enrolled in the Masters program for financial planning through the University of Georgia, one of the premier schools in the country for financial advisors. Wesley is excited about joining the team and fulfilling his passion to help clients.
Grace Baker is joining our firm as a Client Service Specialist. Grace also previously worked at a large brokerage firm and is looking forward to helping service and maintain client accounts, working closely with the wealth managers and getting to know the clients of River Capital Advisors. Grace is interested in expanding her knowledge into new planning areas and has a passion for providing exceptional client service.
If you have not received the book The Psychology of Money by Morgan Housel, we would like to send you a free copy. This book contains timeless lessons about money, greed, wealth, and happiness that anyone would enjoy reading. We especially recommend this if you have young adult children in your life. For those with younger children or grandchildren, we also will be glad to send you a free copy of The Four Money Bears that teaches young children (ideally ages 5-12) about how you can wisely use money: to spend, to give, to save, and to invest.
Our thoughts continue to be with the people of Ukraine who are experiencing a relentless and merciless attack on their country from Russia. Our preceding thoughts in no way diminish the reality that the Ukrainian people are experiencing every day and our hearts go out to them.
As we mentioned earlier, no one (including professional investors) can successfully time the market or predict what the short term outcomes are going to be. Those who have tried may get “lucky” once, but often it is just that; not a proven process that can be reliably repeated. By having exposure to dozens of countries and thousands of companies with real profits, we will be able to help our clients achieve their long term goals. We realize that time periods like this are painful and we are here to talk
about it with you. We are all emotional creatures and sometimes it is helpful to share distress and have someone tell you that it is ok.
We greatly appreciate the trust and confidence our clients have placed in us, especially in times like we are experiencing now. If you have any questions or concerns about your portfolio, the ability to reach your goals, or anything else financial in your life, please do not hesitate to contact us.