The Margin of Safety Quarterly Fall 2022
Third Quarter Key Takeaways
- The rebound in equity markets in July and August based on investor hopes of easing inflation was short-lived.
- Absolute returns for the quarter were disappointing, but our tactical allocation to non-traditional assets was a positive contributor during the quarter.
- We are reminded that today’s market environment is very similar to what we have experienced in the past. The exact reasons for the volatility may differ, but market performance over the long-term is driven by fundamentals of the underlying businesses you own—not what is on the news.
- The newsletter includes a list of financial planning tips and advice that we provide our own family members, especially in times like now.
Third Quarter 2022 Investment Commentary
After a very difficult first half of the year, equity markets rebounded in July and August on investor hopes for an easing in inflation and a Fed pivot or pause. The reprieve was short-lived however, as stocks tumbled to fresh lows in late September amid further aggressive central bank rate hikes and statements of further tightening to come.
Global stocks (MSCI ACWI Index) fell 6.82% for the quarter and are down 25.63% for the year. The S&P 500 dropped 4.88% for the quarter and is down 23.87% for the year. In sharp contrast, U.S. large value stocks as measured by the Russell 1000 Value were up 1.20% for the quarter and are down “only” 16.77% for the year. We have discussed in prior newsletters that value stocks are attractively priced and should fall less in a downturn. Through the end of August per Morningstar, across the globe small and large cap value stocks outperformed growth stocks. For the trailing 3 years through the end of August, as reported by Morningstar, value stocks are outperforming or in line with growth stocks.
Developed international markets (MSCI EAFE Index) fell 9.36% for the quarter and 27.09% year to date. Emerging Market stocks (MSCI Emerging Markets Index) dropped 11.57% for the quarter and are down 27.16% year to date. Foreign stock market returns were negatively impacted by the sharp appreciation of the dollar. The U.S. Dollar Index was up 7.1% for the quarter and a stunning 17.3% on the year, hitting a 20-year high (for US based investors, a stronger US dollar is a headwind to foreign equity returns). A reversal in the dollar would be a major tailwind for unhedged foreign equity returns going forward. The good news is that diversification is now hurting less then it did earlier in the year even if it has not yet started to help.
Core investment-grade bonds didn’t avoid the Q3 carnage. The 10-year Treasury yield hit a decade high of 3.97%, causing the Bloomberg U.S. Aggregate Bond Index (the “Agg”) to drop 4.75%. This puts the “safe-haven” Agg down an incredible 14.61% for the year to date. In other segments of the fixed-income markets, high-yield bonds (ICE BofA Merrill Lynch U.S. High Yield Index) dropped 0.69% and floating rate loans (Morningstar LSTA Leveraged Loan index) gained 1.37% for the quarter. For the year to date, floating rate loans have been one of the best performers, down just 3.25%.
It was a challenging quarter for traditional stock and bond investments. While absolute performance was disappointing, we were able to soften the blow somewhat with investments in “non-traditional” asset classes such as flexible bond funds and floating rate loans. We seek to balance our risk and return objectives by creating diversified portfolios, and many of these “non-traditional” investments have been bright spots in this tough year. Floating rate loans, whose coupons adjust with changes in interest rates, were one of the best performing asset classes in the third quarter, generating a positive 1.37% return (versus a 4.75% loss for the AGG). However, at this point we think that floating rate loans don’t offer as attractive returns going forward and we are in the process of reviewing a possible trade to exit floating rate loans and add the dollars back to core bonds. At current prices and yields, core bonds look reasonably attractive and could provide better portfolio “ballast” than floating rate loans.
We find that most investors don’t understand the role of bond investments in a diversified portfolio and so we thought it would be useful to talk a bit about what is going on in the bond market. The current decrease in bond prices is related mostly to interest rate increases. As interest rates increase, currently issued bonds fall in price to compensate investors who now are demanding a higher yield. The good news today is that the yields going forward on bonds are much higher. DoubleLine Total Return, one of our bond funds, now has a yield of almost 5%. Osterweis Strategic Income, another bond fund that we own has a yield of over 7%. Although it will take patience to earn back the current year decline (through higher yields and possible appreciation if interest rates decline), bond performance going forward should be much better than it has been in the low interest rate environment that has persisted for a long time. We also may be able to play offense in bonds if prices continue to drop as we did in 2008 by investing in high yield bonds. The movement from floating rate to core bonds is a defensive move as core bonds should do better if we do get a recessionary environment next year. Although the past year has been a hard period for bonds, one of the lowest returns since 1945, we continue to view them as providing good protection in negative economic environments. Although cash provided a better protection in the most recent environment, cash does not provide attractive long term returns like bonds do.
We are getting a lot of questions on the economic environment, the election, inflation, and the odds of a recession. These questions are fun to opine on but the truth is that no one knows the real answer. Although the odds of a recession have increased this is not a surety. Economists are terrible at predicting recessions and this is pretty much their job. They, along with weathermen, are the only professionals that can get the forecast wrong more than they get it right and still make large salaries. Then there is the issue of whether a recession would actually result in an equity price decrease from this point. As mentioned earlier in the newsletter it is around 25% less expensive to buy stocks today then it was last year. This seems to indicate that the market is already saying that there will at least be a slowdown in growth. We find that for many the term recession drives up fear and creates a desire to sell risk assets. However, markets often recover well before the recession is over. Investing based on emotions (and not discipline) typically means investors sell out well before they should have and buy back in well after they should have, resulting in permanent loss of capital (i.e. selling low, buying high). Success as an investor is not predicated on getting these kinds of calls correct, it is predicated on maintaining discipline.
A lot of news flow has focused on inflation and how high it currently is. We think it is safe to say that the Federal Reserve made mistakes holding interest rates at record low levels from the Great Recession until 2016 and then put-ting them back at near zero levels after COVID. The Fed Funds rate is not high by historic standards at current levels. Many readers of this newsletter probably remember times in the 1980s when mortgage rates were 13-15%. We would remind everyone that the 1980s were a relatively good period for stocks and many still talk about how great they did on CDs from this period (before inflation). Few of the news stories that we have seen mention that good quality stocks provide one of the best ways to profit from inflation. This is because they will be able to pass rising prices on to consumers. Consumers can only trade down so much in terms of what they are willing to buy. Dollar Stores, for example, can do very well through periods like this as consumers trade down. Also, what few focus on is that inflation destroys those that are saving in “safe” areas like cash. Although cash may not lose value in terms of “a dollar is a dollar”, if that dollar only purchases 90 cents worth of goods that is a 10% loss of purchasing power.
The next topic that probably comes up the most is the election and politics. First, let’s be clear that we are not making political comments here as these are highly charged times. However, what we see is that many people on both sides want to make investment decisions based on politics. This is an area we want to be perfectly clear on since this can do immeasurable harm. As can be seen from the chart below, markets have been up irrespective of whether Congress and/or the Presidency are controlled by Republicans or Democrats. If we really think about this we can understand why this is true. While there are issues that the President and Congress control (taxes, spending, war) these factors only explain a relatively small piece of what goes into investment returns. One of the biggest things that they don’t control is the drive of people to improve their standard of living. The economy is made up of millions of people all trying to do better over time. No matter who is in power citizens still go to work, care for their families, grow or start a business and want to have a good life. Innovation does not stop because a particular party is in office.
We are hearing and reading about predictions of how the market will do if “X” party wins. That prediction is likely to be wrong. We saw this in 2016 when the consensus was that the markets would go down if Donald Trump was elected. He did get elected (against prediction) and (against prediction) markets went up. We know people that sold in 2016 based on Trump taking office and people that sold in 2020 based on Biden taking office. Both later regretted these decisions. Voting is still important and we would encourage you to vote. If you have a strong desire to influence, you can even go further by volunteering for campaigns or donating money. However, we would encourage that politics not be used to inform your investment decisions.
Probably some are asking at this point, if you can’t predict events then what should be done? While we can’t predict, we can prepare. What we can do is look at where stocks and bonds are currently trading and use their fundamentals to evaluate whether we are buying them when they are on sale or when they are expensive. We do this in a number of ways – by looking around the world for assets that are underpriced and also by hiring managers that look for individual positions that are underpriced. We diversify portfolios many different ways as part of our portfolio risk control process so that our clients can achieve their financial goals.
Here are some thoughts from some of our managers and others we trust about the current period:
Market drawdowns and heightened volatility enhance our ability to uncover undervalued securities, creating an actionable environment for those of us who invest with a long time horizon. The companies we invest in will inevitably experience recessions, but even a few years of below trend earnings will typically result in a rather modest impact to long-term business value. Indeed, these periods often sow the seeds of future outperformance. – Bill Nygren, Oakmark
We are finally seeing some attractive bargains and have started to deploy our capital selectively. – Carl Kaufman, Osterweis Strategic Bond
You can actually take a relatively conservative risk asset portfolio and get a return that is close to 8%. And, you’re talking about prices that are down very substantially … many of these have a very strong possibility of rallying from those prices. – Jeff Gundlach, DoubleLine Total Return Bond
Meanwhile, a good deal of the current economic weakness has already been priced into markets. This presents an opportunity for active management to take advantage of better prices for high-quality companies and structural growth exposure and position portfolios for a subsequent stock market recovery. – Dr. David Kelly, J.P. Morgan
This last quote is particularly interesting as the headline that was produced from J.P. Morgan a week ago is as follows: “U.S. is headed for a recession, says head of JP Morgan Chase Bank: ‘This is serious’.”
Meanwhile what they are telling their clients is to buy. One could wonder if either the reporter is trying to generate more views or if J.P. Morgan is trying to create more of a downturn to help their clients buy the dip!
We remind our client’s that their portfolios consist of real ownership interests in hundreds of businesses with real profits and assets. Temporary declines in the value of a stock, bond, or fund are expected and for investors that stick with a long term investment game plan, you are rewarded with what some call the “eighth wonder of the world”: compound growth. This is the only reliable way to beat inflation over the long term and trying to predict the short term direction of the markets usually results in eroded returns.
At River Capital Advisors, we like to say we eat our own cooking, meaning the advice we provide to clients is the same advice we follow ourselves and provide to family and friends. We know especially in times like now, when the market has experienced a significant downturn, that it can be challenging to stick to a long term investment game plan. We invest the majority of our personal net worth in the same funds we use for River Capital Advisor clients.
Below you will find some helpful tips and advice that we provide to our own families.
- Fluctuations in the Market Are Normal—Short-term fluctuations in the market will occur. For those with a long term investment horizon (generally we would say 10-plus years–including any non-working/retirement time period—is long-term), the short-term fluctuations in the market will not prevent you from meeting your goals if you follow a disciplined, investment game plan.
- Buy Low, Sell High—With investing, you want to buy low and sell high. In times of a market downturn, our inclination is often to sell all of the most volatile positions as it feels good to end the “pain”. Unfortunately, history proves that market timing is difficult for even seasoned, professional investors to do correctly. Some of the best market days occur immediately after the worst days.
- Proper Asset Allocation—If you set a proper investment allocation (stocks, bonds, cash, etc.) based on your investment goals (education, retirement, etc.), you can get past the short-term market fluctuations. We emphasize that having a proper cash reserve is important as it can allow those close to an important goal (education, retirement, etc.) to delay withdrawals from their investment portfolio if it needs time to recover.
- Save Now, Not Later—If you set an adequate investment savings goal early in your career, the power of compounding can work for you. If you find yourself at the point in life where you have not saved enough for your goals, don’t blame yourself for what happened in the past. We cannot change what has transpired, but we can look forward. We recommend you reset your goals and expectations for what your portfolio can reasonably sustain in withdrawals over the remainder of your life. We help clients (and our own families) design goal projections to help them achieve realistic goals.
- Don’t Aim for Home Runs—In addition to the previous tip, it is important to remember that if you find yourself in the position of not having enough assets saved to meet your goals, the answer is not to find the investment “home run” to bail you out. Very often these “home runs” promise big returns (whether it is real estate opportunities, initial public offerings, private lending that is not vetted, etc.), but they also come with great risk of losing one’s principal. This could spell disaster for your goals if the opportunity turns against you and you counted on this to bail you out.
- Focus on a Sustainable Withdrawal Rate—When it is time to withdraw from your portfolio to meet a goal (such as paying for college education or retiring from work), you need to set a reasonable, sustainable withdrawal rate based on the time horizon for the goal. For example, it may be reasonable to withdraw 25% of a 529 college savings account each year to pay for a four-year degree. If you applied the same withdrawal rate to a retirement goal, you’re likely to find yourself well short of meeting your goal, unless you only planned on a 4-5 year retirement time horizon. If you need withdrawals over a 25 to 30 year time period, in general a 3% to 4% withdrawal rate on average is considered sustainable. Downturns in the market are inevitable and a withdrawal rate that is too high may make it difficult for your portfolio to recover in value.
- Earn Higher Yields on Cash– If you have material cash reserves that are earning little to no interest in a bank account, we recommend you consider moving some or all of your cash reserves to a higher yielding account. With interest rates rising over the past several months, there are many online, high yield savings accounts that are FDIC insured and currently receiving an attractive yield compared to your average bricks and mortar bank. Additionally, you can consider certificates of deposit (CDs) or money market funds (the latter is not FDIC insured).
- Tax Planning is a Year-Round Topic—We believe that tax planning shouldn’t be reserved for just January 1st through April 15th. There are many opportunities throughout the year to do tax planning to maximize tax efficiency as there is almost no area of your financial life that isn’t affected by taxes.
- Give Attention to Proper Risk Planning—Something that can easily derail one’s ability to meet their short– and long-term goals is to ignore proper risk planning. Proper risk planning includes making sure you have adequate home, auto, and business liability protection for you and your family, obtaining life and/or disability insurance to protect your family from serious illness/injury or premature death, and discussing with your family a long term care philosophy in the event you need this level of care (including whether you can self-insure, need to purchase insurance, or will spend down assets for Medicaid eligibility).
- Maintaining Your Estate Plan– Just like maintaining your car through oil changes, tire rotations, etc., it’s important to maintain your estate plan. Generally we recommend you review your estate plan with an attorney at minimum every five years (or sooner if there have been material changes in your life like the birth of a child, marriage, divorce, etc.). Federal and state laws governing your estate (both during and after your life) do change over time and it’s important to review your estate planning documents with an attorney to make sure you and your family will not be caught by changes in the law. If you do not already have a last will and testament, durable power of attorney, health care surrogate, and living will (sometimes a living trust is also recommended), we recommend discussing this important topic. We can refer you to an attorney if needed.
We hope these tips and advice are helpful to clients and we want you to know that when we advise clients, we look to you as if you were our own family members.
We are excited to have Dana Carney, MSFP, AFC® join our team this past quarter as an Associate Wealth Manager. Dana is an Accredited Financial Counselor® and holds her Bachelors and Masters degrees in Financial Planning from the University of Georgia (considered one of the pre-eminent universities in the country for this major). Prior to joining RCA, she worked as an educator where she assisted individuals across their lifespan in improving their financial well-being. Dana is excited to help clients with their holistic planning needs. If you speak with Dana, please welcome her to the firm.
For our clients, 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.
It’s been a tough year, with most investors (ourselves included) braced for more to come. But all bear markets come to an end, and it is worth remembering that the bottom is by definition the point at which things collectively feel worst. We think long term and remain confident in our ability to deliver the long-term returns required to meet financial objectives while balancing risk.
It is in times like this that we most appreciate the trust and confidence you have placed in us as your advisors. We understand that concerns about investment and portfolio returns are legitimate and we want to hear from you if you have concerns. Also, please remember that our value to clients extends past our investment advice. We are available to help you with additional planning needs for you and your family such as cash flow planning, debt management, insurance needs analysis, estate planning, retirement planning, and more.