The Margin of Safety Quarterly Fall 2023

 In Client Bulletins, News

A Look Ahead:

  • Estate Planning: Creating the Legacy You Desire
  • “Magnificent Seven” Power U.S. Equity Returns
  • Investment Outlook & Portfolio Positioning
  • Firm News & Closing Thoughts


Quarterly Investment Commentary Third Quarter 2023

The S&P 500 reached a 2023 high at the end of July before selling off 7.5% through August and September to finish the quarter down 3.3%. Year-to-date the index remains up a solid 13%. Smaller-cap stocks (Russell 2000) also had momentum early in the quarter but changed course and ended the quarter down 5.1%, though are still positive 2.5% year-to-date.

Within foreign markets, developed international stocks (MSCI EAFE) declined 4.1% in the quarter yet remain up just over 7% year-to-date. Emerging market stocks (MSCI EM) fell 2.9% bringing down their year-to-date return to just under 2%. The U.S. dollar (DXY Index) climbed over 3% during the quarter, resulting in a headwind for foreign stock returns.

In bond markets, the 10-year Treasury yield climbed nearly 70bps in the quarter, ending the period at 4.59% – the highest point since before the financial crisis in 2008. As a result, core bonds (Bloomberg U.S. Aggregate Bond Index) fell sharply, declining 3.2% over the quarter. High-yield bonds (ICE BofA U.S. High Yield) managed to eke out a small quarterly gain and are up 6% year-to-date.

Finally, multi-alternative strategies (Morningstar Multistrategy Category) and managed futures (SG Trend Index) demonstrated their diversification benefits. Multi-alternative strategies returned 0.2% and managed futures gained 1.15% in the quarter.


Estate Planning: Creating the Legacy You Desire

Commonly when someone thinks about estate planning the tendency is to not want to think about it. After all, planning for your estate is planning for the certainty that you won’t be around in the future – not something most of us want to think about. However, what estate planning means has really changed over time. Although the “how” of estate planning is still important in terms of estate documents (such as Wills, Trusts, and beneficiary designations) the “why” is now taking a rightfully deserved center stage.

Proper estate planning should not only be considered with the goal of reducing costs, minimizing tax, and transferring assets efficiently, but just as much time (if not more) should be taken to understand your intent and what you are hoping to achieve. We have seen cases where assets are transferred very efficiently but the beneficiaries were never prepared to receive those assets.

Here is an example of a scenario that is fairly common: Jill and John Smith have three children Paul, Derrick, and Jane. Jill and John have built a family business, J & J Tools. J & J Tools is worth around $3,000,000 and Paul works at the company. Derrick is a teacher and isn’t involved in the family business. Jane is an artist and has had money problems for most of her life. In addition to the business, other assets include multiple IRAs and a personal home worth $1,200,000 and $600,000, respectively. They also own a beach vacation home worth approximately $300,000 that Derrick and Jane have fond memories of. John and Jill have a Will that passes all of their assets to their children equally.

There are a number of potential problems in this scenario. The business is worth the most of any of the assets. If everything is split equally (as it is currently written), Derrick and Jane receive shares of a business that they haven’t been involved with. Paul presumably is going to run it and probably would have difficulty purchasing Derrick and Jane’s shares. Meanwhile, Paul is receiving ownership of the beach house that he has no interest in. For Jane, if she receives large financial assets, will she be able to get past her money problems or will she squander what she is given?

The solution here is to open the lines of communication now and not defer estate planning until late in life. Estate planning should be the process by which the next generation is empowered with the knowledge that will enable them to live a happy, healthy life. Family gifting strategies and family philanthropy are great ways of creating more of a dialogue. As are family meetings and finding time to discuss and fully understand family values (work ethic, philanthropy, lifestyle, and savings, are examples). In the scenario above, conversations can foster an environment that provides equal value to all of the heirs while caring for their individual needs.

We can help you to think through this deeper process of “why” in addition to helping with the “how” of estate planning.


The “Magnificent Seven” Continue to Power U.S. Equity Returns

With virtually all segments of the stock market posting gains this year through September, one might think that we’re in the midst of a broad-based rally. However, stock gains have remained unusually narrow, with the largest stocks in the index leading the way. The standout performers are those sectors with the largest stocks, while most other sectors have been relatively flat. Consumer discretionary has been driven higher by a 51% gain from and a 103% return from Tesla. The information technology sector has outperformed thanks to Apple (+32%), Microsoft (+33%) and NVIDIA (+198%) year-to-date. Communication services has been propelled higher by a 48% return for Alphabet (Google) and 149% from Meta Platforms (Facebook).

Despite stalling in the latter half of the third quarter, the year-to-date performance of the “Magnificent Seven” stocks continues to explain most of the U.S. stock market’s returns. These seven stocks have increased collectively more than 80% this year, while the remaining 493 stocks in the S&P 500 are basically flat.

As a result of their massive outperformance, the “Magnificent Seven” have a combined $10.7 trillion market cap and constitute more than 30% of the S&P 500 index. This level of concentration at the top of the U.S. market exceeds what was witnessed in 2021 and the tech bubble of the late 1990’s / early 2000’s. We have to travel all the way back to the early 1970’s (some of you that have been investors for a long time may remember the “Nifty Fifty” of that era) to see a market as concentrated as it is today.


Investment Outlook & Portfolio Positioning

From a macroeconomic perspective, the big question remains whether the U.S. economy can avoid recession or not, and the timing if it does occur. It goes without saying that the answer will likely lead to meaningfully different market outcomes. If the Fed can manage to slow the economy while avoiding recession, we would expect to see the market’s gains broaden out beyond the large-cap technology-related sectors. Conversely, if the Fed’s monetary tightening cycle leads to recession, it would likely lead to broader-based declines.

There are reasons to be cautious – a base-case is for a mild recession looking out to 2024. We have seen one of the quickest and sharpest tightening cycles in history, and lending standards have tightened considerably. Both factors create recessionary conditions, particularly as the Fed has a history of raising rates too far, tipping the economy into recession. Since 1931, there have been 19 hiking cycles and in only three instances did the economy avoid a recession.

However, on the positive side, if the economy falls into recession, we believe it will be relatively mild. One consideration is that the economy has been experiencing a “rolling recession” where slowdowns are spread across industries over time, dampening the impact compared to a recession when industries experience a simultaneous slowdown all at once. For example, housing has already experienced a slowdown and detracted from GDP for several consecutive quarters. In the tech sector, layoffs have already occurred. Finally, a perhaps counterintuitive point is that this recession has been so widely anticipated for so long now, it may reduce the risk of a deep recession. Going back to 2022 and early 2023, the press termed this the “most-anticipated recession ever.” Amid all this built-up anticipation, some companies, have already laid off workers and slowed hiring. These corporate moves help loosen the labor markets and potentially ease inflationary pressures.

Speaking of inflation, it has come down meaningfully from its June 2022 high of 9.1%, thanks in part to the Federal Reserve’s rapid rate hikes. The chart below illustrates year-over-year inflation data, which recently declined to 3.7%, and suggests the Fed’s policy has been working and with time inflation could continue to fall.

At this point, it is clear the rate-hike regime is close to an end, and we believe the Fed has gotten the upper hand on inflation. The aggressive hiking cycle that started roughly 18 months ago was finally put on pause in late-July—although one more 25 basis point hike could still happen. Since March 2022, the Federal Reserve increased rates from zero to a target level of 5.25%-5.5%.

The rise in interest rates has taken a bite out of bond returns, which have suffered steep losses over the past couple years. We have mentioned in a number of past newsletters about our bond positioning and how we were investing in shorter term bonds. This has resulted in our portfolios not experiencing the large declines that longer term bond portfolios have. For example, the return on the SPDR® Portfolio Long Term Treasury ETF (SPTL) over the last three years was -15.75%, annualized (ending September 30, 2023). This compares to a return from Dodge and Cox Income (DODIX) of -3.15% annualized over the same period (a fund that we use for clients).

The silver lining is that looking forward, interest rates (and bond yields) ended the third quarter at levels not seen in nearly 20 years (the Bloomberg Aggregate Bond Index ended the quarter yielding 5.4%). Higher starting yields, all else equal, should lead to higher expected returns. As yields have shifted higher, we increased our exposure to core bonds starting in September with a slight reduction to equities in our most conservative model. Then, just over the last week, we have made a further change to remove our emerging market local currency bond exposure and add this to core bonds. We believe that these changes have increased our downside protection in case of a recession and also provide us with more “dry powder” in case attractive opportunities are presented.

In addition to core bonds, we continue to have meaningful exposure to higher yielding, actively managed, flexible bond funds run by experienced teams with broad opportunity sets. There are several fixed-income sectors outside of the traditional parts of the bond market that provide attractive risk-return potential. Some of these funds are currently yielding in the high single digits, while maintaining an eye on capital preservation and interest rate risk.

Historically, stock market returns over the next six to 12 months following a pause in a tightening cycle are mixed depending on the inflation environment. As we can see in the following chart, most of the negative outcomes occur during bouts of higher inflation when the Fed will typically maintain a more restrictive policy, i.e., it will take them longer to pivot and cut rates (i.e., pre-1980’s). On the other hand, when inflation is not elevated, the Fed can move to a more accommodative stance much sooner, leading to better equity market outcomes (i.e., post-1980’s).

Today, inflation remains elevated but on a clear path downwards. Of note, however, since the day of the Fed’s last potential rate hike, the S&P 500 began its current 7.5% drawdown. This may be a signal that the market expects inflation to persist and for the Fed to maintain interest rates “higher for longer.”

Within our portfolios, we maintain significant exposure to U.S. stocks overall. This includes many of the mega cap tech stocks mentioned earlier. We have smaller weightings to these stocks though than the overall index. Starting in August we made a number of changes in portfolios to shift more towards growth, as growth stocks outside of those top seven companies have come down in price. Other changes included selling several underperforming core/growth managers that were too valuation dependent and moving to managers with a more balanced approach. These changes were incremental, and we maintain an overweight position to value stocks.

Overall, we remain slightly underweight in the U.S. market in favor of foreign stocks. While it is true foreign stocks will likely decline as much as U.S. stocks in a recessionary scenario, foreign stocks are far less expensive than the U.S. – setting them up for attractive medium-to-longer term expected returns.

Finally, we continue to find opportunities within private markets and add investments in these areas for investors that meet qualifications for the investments. We do believe that private markets are likely to make up meaningful portions of our portfolios on an ongoing basis as public market dynamics are such that it is unlikely the advantages of the private markets are going away. There are also new opportunities in areas like infrastructure and farmland. While previously exclusively offered to those with hundreds of millions of dollars to invest, these opportunities are now being offered to high-net worth investors with lower investment capital.


Firm News

As we have focused more on private markets, we have also found innovative tax strategies we are exploring with a number of clients. Of note, a Delaware Statutory Trust (DST) provides tax efficiency for those looking to exit from investment properties (such as rental homes) tax efficiently. In real estate, it is possible to exchange a current investment property for another investment property without incurring taxation through a 1031 exchange. A DST is useful for someone that no longer wants to deal with the complexities of rental property while still deferring taxable gains. Proceeds from the sale are invested within the DST and, after a transitionary period, the client is invested in a diversified real estate portfolio that has more liquidity than a replacement property as with a typical 1031 exchange. If this is something that you think can benefit you, please let us know.

The most important thing is that if you are thinking of selling a building, business, or any other major asset subject to gain, it is beneficial for you to discuss this with us prior to entering a sale agreement. There are many cases where there may be a way to save taxation on the transaction. However, many of these advantages go away once you have completed the sale. We can help you think through your options and what possibilities exist so that you can make an informed decision. This is also something that we can do for others that you may know; we do not need to manage someone’s investments to help them.


Closing Thoughts

As we write this newsletter, global events have been rapidly developing. This includes events that were not a concern several weeks ago: war in the Middle East, deadlock in Congress and the House of Representatives, and changing dynamics regarding the war in Ukraine. From a human perspective, we are saddened by the events affecting innocent lives and hope resolutions can be found soon.

While each one of these events can be scary and there could be additional repercussions that affect the financial world, we believe that markets are resilient to global uncertainty. There have been many times in the past several decades when global stability had become more fragile. Some of these events we remember for many years, but others lose relevance quickly. The media tends to sensationalize events and make everything sound like the worst thing ever. We believe that a diversified portfolio that fits your risk tolerance is the best way to protect against events like this.


Thank you for your continued trust and confidence. 

As always, if you know of others that would benefit from our planning or investment services, please let us know and we would be glad to assist them.



Certain material in this work is proprietary to and copyrighted by iM Global Partner Fund Management, LLC and is used by River Capital Advisors with permission. Reproduction or distribution of this material is prohibited, and all rights are reserved.

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