The Margin of Safety Quarterly Summer 2023
A Look Ahead:
- The Narrowest Stock Market in 50 Years
- Investment Outlook & Portfolio Positioning
- Retirement Planning: When to Plan, How Much to Save
- Firm News & Closing Thoughts
Quarterly Investment Commentary Second Quarter 2023
Global equities continued to rally in the second quarter, led by surging U.S. mega-cap technology and growth stocks, particularly anything related to Artificial Intelligence (AI). It seemed that the market no longer cared about slower growth or higher inflation.
The S&P 500 index gained 6.6% in June and 8.7% in the second quarter, driving its year-to-date return to 16.9% overall. The technology heavy Nasdaq Composite has driven most returns in U.S. stocks, rising over 13% in the second quarter, and 32% year to date. These are staggering numbers for a market that was overvalued just a few months ago. We said last quarter that the market has consistently defied those that would try to time it and this quarter just proved that to be truer.
Outside the U.S., stocks in Europe and emerging markets have also posted solid results. Developed international stocks (MSCI EAFE Index) rallied 4.6% in June, gaining 3% for the quarter and 11.7% YTD. Emerging markets stocks (MSCI EM Index) rose 3.8% in June, resulting in a 0.9% gain for the second quarter and a 4.9% return YTD. These numbers continue to disappoint us since stocks outside the U.S. are much more cheaply priced than U.S. stocks.
Moving to the fixed-income markets, core bond returns (Bloomberg U.S. Aggregate Bond Index) were slightly negative for the quarter as interest rates slightly rose/prices fell. The benchmark 10-year Treasury yield ended the second quarter at 3.8%, up from 3.5% at the end of March. Riskier high-yield bonds (ICE BofA U.S. High Yield Index) gained 1.6% for the quarter and are up 5.4% YTD. Municipal bonds (Morningstar National Muni Bond Category) were generally flat on the quarter and up 2.3% YTD. Actively managed flexible/nontraditional bond funds (Morningstar Nontraditional Bond Category) gained around 2% and are up over 5% for the year.
Finally, multi-alternative strategies (Morningstar Multistrategy Category) and managed futures (SG Trend Index) underperformed stocks but outperformed core bonds for the quarter. Trend-following managed futures had a strong rebound after a tough first quarter, gaining around 8%.
Charitable Giving: Getting Rewarded for Giving Back
Although your first thought when giving to a worthy cause is probably not what you are going to receive out of it, there is often an opportunity to receive a tax benefit from the giving that you are already doing. This tax benefit could even potentially allow you to give more to the charity of your choosing. One common way of receiving a tax benefit is Qualified Charitable Distributions (QCD).
QCDs are available to anyone that is over age 70 ½ by taking money directly from your IRA and giving it to a qualified charity. In doing so you avoid any tax on these funds. This is superior to a deduction as a deduction only provides a tax benefit to the extent you can itemize your giving on your tax return (which is currently a high threshold). When you are subject to Required Minimum Distributions (RMDs), the QCD can be used as all or a portion of the RMD.
Another method of having a charitable contribution benefit you is to give appreciated stock from a taxable brokerage account rather than cash. Doing this allows you to avoid a later taxable gain on the stock while the charity also still gets the full amount of the stock gift.
A Donor Advised Fund (DAF) can be used to make this process even easier. With a Donor Advised Fund, you can lump two or more years of charitable giving into one charitable contribution and receive a deduction all in one tax year. This can allow for a higher potential deduction exceeding the standard deduction threshold.
If you take away anything from this discussion it should be to check with us about an optimal giving arrangement. Rob Simon is a Chartered Advisor in Philanthropy® and has gone through extensive training around giving and how it also interacts with legacy planning. We would be honored to help you figure out how giving works within your overall strategy, including strategies mentioned here.
The Narrowest Stock Market in at Least 50 Years
The market-cap-weighted S&P 500 Index’s rally this year has been one of the narrowest on record, with less than 28% of the index’s constituents beating the overall index return. As shown in the Ned Davis Research chart below, in an average year around 49% of the Index’s 500 companies beat the overall index. (The only other year comparable to this year was 1998, as the technology/internet stock bubble was inflating. That didn’t end well, but it took another 15 months before it started to burst).
More granularly, with the sudden frenzy in all things AI, the average YTD return for Amazon, Google, Meta, Microsoft, NVIDIA, and Tesla is 96%. The gains in these six mega cap tech stocks are responsible for almost the entire S&P 500 return for the year. Moreover, the combined market cap of these six stocks (plus Apple), now comprises over 27% of the total index, the largest concentration in history for the top seven stocks. We do believe that there are merits to what AI can do but we find it difficult to believe that the stocks are correctly accounting for this value. We tend to believe that it may be like other recent buzz words like ‘cryptocurrency’ and ‘the metaverse’ where the hype doesn’t live up to the reality.
It remains to be seen whether this extremely narrow market rally resolves via the rest of the market catching up or the seven companies mentioned above “catching down,” but improved market breadth would be a positive indicator for the market’s continued bull run. On a positive note, it appears the stock market rally is potentially broadening to other sectors and markets caps, the small-cap Russell 2000 index shot up 8.1% in June, while the large-cap Russell 1000 value index delivered similar gains of 6%.
Retirement Planning: When Should I Plan & How Much Should I Save?
As we have focused more on financial planning over the years, we have sometimes run into situations where a client is wondering why they should start planning for retirement at a given age. The assumption of many is that planning is not necessary until a year or two away from retirement. However, this is not advisable. If someone waits until this point, the options available to change their trajectory (if they are off track) become more limited. Should the projection be unsuccessful, those individuals can now only reduce retirement spending or delay retirement. If a plan is completed at an earlier date, it may be possible to modestly reduce current spending, save more, and not need to either delay retirement or spend significantly less in retirement than desired. 
The issue that many have with this is that they will say to us that their life is not stable. We understand this thought process. After all, the further we are from retirement the more that can change on the way. However, the point in planning is not to get the plan perfect the first time – we understand that it will change many times between when we first prepare a projection and the retirement date. The point of the plan is to have something to make sure that someone is going in the correct direction and that their expectations match reality. Even after you retire, we recommend that the financial plan be updated on an annual basis to make sure that it is still on track. This reduces the need to make drastic changes later in life if something needs to be adjusted.
Related to the discussion of why a financial plan should be done is how much to save. Ideally, a financial plan will be completed to set an adequate savings level to reach a desired goal. However, there are rules of thumb that are based on age. These start at a 10% savings rate for someone that is in their 20s and goes up from there depending on how much they have already saved. Consider the example to the left. Elyse needs to save considerably more the closer she is to retirement. In order to meet her goal, at age 40, her total savings need to equal 1-2 times her current salary, while at age 60, her savings needs to equal 15-20 times her current salary.
We are here to help you in this effort. Remember that we also offer standalone planning if you have a family member or friend that possibly manages their own assets but who could use the services of an advisor for this important topic.
Investment Outlook & Portfolio Positioning
The current macroeconomic data continue to send mixed signals. On the one hand, the U.S. economy has been more resilient than we (and many others) expected through the first half of the year. The economy has grown, albeit at a subpar rate. The labor market has remained very strong, supporting consumer spending; and headline inflation has dropped meaningfully, thanks to a sharp decline in energy prices. On the other hand, key leading indicators of an impending recession are still flashing red, including a deeply inverted yield curve and tightening credit conditions, among others. Moreover, although the Federal Reserve paused its aggressive interest rate hiking campaign in June, core inflation (excluding food and energy) remains stubbornly high, with the Fed signaling it will resume rate hikes later this year, further raising the likelihood of a recession. 
As we read the muddy economic tea leaves through our cloudy crystal ball, we maintain our view that a recession is the most likely outcome over the next few quarters. Historically, the odds are unfavorable for the economy avoiding a recession after the Fed has been aggressively tightening. And we have yet to see the full (lagged) impact of this cycle’s monetary tightening on the real economy.
However, a near-term recession is not a certainty. Each cycle is somewhat different and this one is considerably so due to the pandemic dislocations, and there have been three instances (out of 13) where the Fed tightening cycle ended without a recession. So, a more benign near-term outcome is certainly possible, and the current growth and inflation trajectory is not inconsistent with that.
Just as the U.S. economy has been more resilient than expected in the face of aggressive Fed tightening this year, the U.S. stock market (S&P 500) has been as well — and then some — gaining nearly 17%. There are always multiple factors driving the markets, but we think the key drivers of this year’s strength include the fact that the economy and corporate earnings have held up better than many expected, the markets are optimistic that the Fed will soon end it’s tightening cycle, and most importantly, investor euphoria around Artificial Intelligence (AI).
Specific to the last point, we would argue that while it is likely AI will have a huge impact on society and the global economy, that does not necessarily mean the current AI stock frenzy is justified by these companies’ underlying earnings fundamentals. It may be in some cases. But we can also remember the technology/internet stock bubble in 1998-2000. The internet obviously has had huge economic impact over the past 25 years, but very few tech stocks were priced appropriately in early 2000.
As an example, a poster child for the current AI exuberance is Nvidia, a graphics chip maker used in AI applications. The stock is up over 200% this year (as of June 30, 2023), pushing its market cap over $1 trillion and into the top-10 largest constituents of the S&P 500. Nvidia has strong fundamental earnings growth potential, but its stock is currently trading at a price-to-earnings (P/E) ratio of more than 220x! (The overall S&P 500 index has a P/E around 20x, currently.)
While our portfolios maintain significant exposure to U.S. stocks overall and many of the mega cap tech stocks mentioned previously, we remain slightly underweight U.S. stocks in favor of foreign stock markets. Put simply – our analysis continues to suggest U.S. stocks are trading at expensive valuations and are not adequately reflecting the economic and earnings recession we expect to unfold over the next year or so. And 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 that the U.S. setting them up for attractive medium-to-longer term expected returns.
Unlike U.S. stocks, our view of the U.S. fixed-income markets is more positive. With rising yields over the past year, most bond market sectors now offer attractive expected returns relative to their risk.
For example, the yield on the core U.S. Aggregate Bond Index is currently around 4.7%. With inflation very likely to drop below 4%, core bonds are finally providing a positive real (after-inflation) yield. With a duration of around 6 years, the core bond index will also generate strong price gains if interest rates fall during a recession, as we would expect. We added to core bonds within the quarter for all portfolios that contain bonds by reducing our weighting to flexible bond managers. We believe that this will be helpful to portfolios if a recession is stronger then expected.
In addition to our core bond exposure, we continue to have a meaningful allocation to higher yielding, actively managed, flexible bond funds run by experienced teams with broad investment opportunity sets. There are many fixed-income sectors outside of traditional core bonds that offer attractive risk-return potential, and we want to access them via our active managers. These funds are currently yielding in the high single-digits. While the higher yield indicates they carry more credit risk than core bonds, all our active bond managers are very attuned to risk management, especially heading into a late cycle/recessionary period. And they have the flexibility to tactically vary their portfolio exposures in response to market risks and return opportunities.
We continue to review opportunities within the private markets and have added funds in this area for investors that meet minimum qualification levels. With public market stocks trading at high valuation levels, we believe that adding private companies and private debt is attractive. Yield potential on private debt is around 10% annualized currently with floating rate loans. In an environment where we think that U.S. equities might earn 7% annualized over the next three to five years this is very good. Also, the historical loan losses have been minimal on private debt. Private real estate also can serve as a good diversification tool for portfolios and can earn a similar 8%-10% annualized return over the long term with less variability than equities.
Firm News
River Capital Advisors is pleased to announce that Dana Carney, an Associate Wealth Manager at our firm, has earned her CERTIFIED FINANCIAL PROFESSIONAL™ designation as of this past quarter. Dana already has a Bachelors and Masters degree in financial planning as well as holding an Accredited Financial Counselor® designation. The CFP® designation is considered one of the highest marks of our industry and will only further Dana’s ability to help clients achieve their financial goals.
We have implemented new systems to engage more with clients and prospects through social media. Be sure to follow us on LinkedIn for the latest blog postings. We will be trying to communicate on a more frequent basis through this channel on various subjects including planning and investment related matters. We believe that this will allow us to share more information than could fit into a quarterly newsletter on a timely basis. We will be rolling out a Facebook page soon as well for this purpose.
We are looking into additional investment opportunities that could make private offerings available to those that do not meet qualifications for accredited investors. These so called “interval funds” can provide access to the private markets while not being as complex as accredited investments. We are hoping to complete our research in this area over the next few months. It has been something that we have already spent a substantial time on and our research to this point has been encouraging. Interval funds are a relatively recent innovation and something that large private firms are launching to allow access to strategies that were once reserved for the very wealthy.
Let us know if there are any items within our process that you think could be improved or if you have any feedback on recent changes that we have made. We appreciate feedback of any kind and strive to make it as easy and rewarding to work with us as possible.
Closing Thoughts
While we believe a recessionary bear market is the most likely outcome over the next 12-months, there are reasons to believe it could be relatively moderate given the strength of the labor market, ample household savings, and solid corporate balance sheets. As we extend our time horizon over the next five to ten years, we see reason for optimism. Within the U.S. stock market there are companies and sectors that are reasonably priced and offer attractive return potential. The fixed-income landscape is also attractive, thanks to higher yields and inefficiencies that can be exploited by skilled active managers.
We also see strong total return potential from international and emerging market stock markets, which have been out of favor and underperforming for more than a decade. These markets are not “priced for perfection” as the U.S. market seems to be. Instead, they are susceptible to “upside risk” – better-than-expected earnings growth and valuation expansion. While foreign markets will get hurt in a near-term recession, we don’t want to try to time “getting out and getting back in” given their attractive five-year return outlook.
We are investors, not short-term market traders. Strong short-term market trends can trigger our emotions and make us want to act – either chasing (buying into) a rising market or fleeing from (selling) a falling one. That is not the path to successful long-term investment outcomes. Successful investing requires a balance between offense and defense. Earning superior long-term returns does require one to take calculated risks when opportunities present themselves, but to also exercise caution during periods of market exuberance. By maintaining a disciplined and balanced investment approach, we are well-positioned to weather the inevitable market storms and capitalize on the opportunities that are also sure to arise.
Thank you for your continued trust and confidence.
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.
