Investors have been battered as market indexes retreated to levels last seen in 2020. As MCS client year-to-date performance demonstrates (below), clients have significantly outperformed both stock and bond indexes. As my previous newsletter discussed, an investor-friendly era has ended, and a very unfriendly era is taking its place.
My first objective is to keep your wealth intact.
Year to Date Review
For the first nine months of 2022 (if MCS clients’ assets were treated as one large portfolio), on average clients lost 3.6%, after fees. For comparison purposes, the S&P 500 Total Return Stock Index (S&P 500) lost 23.9%, and the Bloomberg Barclays Aggregate Bond Index lost 14.6%. The range of MCS individual client returns was from a loss of 0.6% to a loss of 14.7%.1
The clients with the lowest returns had large legacy stock exposure. Clients with the highest returns joined MCS in the last few years and have lower equity exposure. Overall, MCS client returns were shielded from the bond and stock market losses by the focus on safer short-term bonds, which did not materially decline in price.
“Proper preparation prevents poor performance.”-Stephen Keague
Over three years ago, I laid the groundwork for the strategy that is proving successful today.
Table 1 (on the following page) is from my fourth quarter 2018 newsletter and discusses various economic conditions and appropriate investment strategy responses. In it, I allowed for two outcomes that were not yet on the radar of most investors: ‘Chaotic/Unpredictable’ and ‘Too Hot Inflation/Stagflation.’ The ‘Chaotic/ Unpredictable’ outcome arrived as a pandemic a year later and as Russia’s invasion of Ukraine this year.
The investment allocation is similar in a ‘Chaotic/Unpredictable’ and ‘Too Hot inflation/Stagflation’: buy short term bonds and sell long term bonds and stocks. Both allocations are intended to reduce risk.
- In the ‘Chaotic’ outcome, risk reduction is an exercise in humility; if the situation is unstable and outcomes are difficult to confidently assess, the prudent course of action with someone’s life savings is to reduce exposure to higher risk investments.
- In the ‘Too Hot Inflation’ outcome, the central bank antidote is to raise interest rates high enough to shock financial markets and consumers into reducing consumption enough to cause a recession, which will then hopefully reduce inflation. I say hopefully because the last time inflation was a problem it took over a decade (1973 to 1983) for the Fed to get it under control. Rising interest rates are bad for long term investments like stocks and bonds.
As we entered the pandemic, my newsletters explained that, despite the stock market’s monstrous rally after the Fed intervened, we were in a ‘Chaotic/Unpredictable’ outcome. My first quarter 2020 newsletter concluded:
“Our situation is unprecedented on many levels. The government response to mitigate the economic damage is also unprecedented, and it will have significant side effects that can’t be easily determined. The world is not going back to what it was after this health crisis has passed…
There are times in economic history where the ‘winners’ are mostly those who lose the least. I am actively looking for investment opportunities on your behalf, while approaching current events with humility…
This is chaos: a period of great uncertainty when inputs, regardless of size, can have outsized effects.”
2021 to Present: ‘Too Hot Inflation’ or ‘Stagflation’
Unlike post-recession rate increases that recognize an improving economy and seek to normalize financial conditions, rate increases to combat inflation are designed to shock the economy into deceleration and cause financial markets to decline.
Under current conditions the general message to stock, bond, and real estate investors is very clear: Get Thee Out!
Long term asset values drop in two ways:
- A recession reduces expected future cashflows or earnings, making businesses less profitable
- A higher interest rate (also referred to as a discount rate) reduces the present value of future cash flows.
The investment allocation under a ‘Too Hot Inflation’ outcome is sell long term assets like stocks and buy short term assets like Treasury Bills. Ditto, but less aggressive sales for a chaotic environment.
Many commentators remark on how aggressive the Fed is with these big rate increases, yet they fail to appreciate that the starting point of the interest rate hikes vs. inflation was way below previous rate hiking episodes. Figure 1 (on the following page) shows a way to visualize it.
This graph shows the Fed funds rate (overnight interest rate) minus the Consumer Price Index (CPI). Negative numbers show inflation is higher than interest rates. Positive numbers show interest rates are higher than inflation. Gray bars are periods of recession.
In Figure 1 above, the circle on the upper left marks when the Fed raised rates to a record 20% in order to drive down inflation (the CPI was 10.8%). In March of this year, the circle on the lower right, inflation was running at 8.5% but the Fed Funds rate was only 0.33%.
It normally takes a recession to significantly reduce inflation. If you look at the periods just prior to recessions (gray bar), interest rates are higher than inflation in every period since 1960 until the 2020 pandemic micro- recession. Rates are far below inflation now. This implies interest rates must go higher, inflation must come down, or some combination of the two.
When is it time to buy and take advantage of lower prices?
This is not an easy question to answer.
A decade of success ‘buying the dips’ has conditioned investors to see downturns as immediate buying opportunities.
‘Buying the dips’ can become a Bear Trap; a situation where the recent low is not the lowest low by a long shot. Some downturns morph into a very long recovery period that grinds up investor portfolios, leaving them with very poor returns compared to the risk and uncertainty they endure. It can take decades to recover losses if the investor significantly overpays. For some investors buying near the top, the recovery never comes. Thirty-three years later, the Japanese stock market is still below its 1989 high, and the S&P 500 spent 30 years getting back to its 1929 level.
What would change my investment strategy?
Interest rates above the inflation rate is a strong indication that inflation will be brought under control. We are far from that situation. The investment watch words for now are: Remain Vigilant.
My goal is to recover our modest losses over the next year and take advantage of rising short-term rates. In addition, because your investment allocation includes short-term CDs which mature in 2023, this will further stabilize your portfolio.
I carefully monitor interest rates and inflation for signs that it is time to buy longer term assets to lock in higher returns for many years.
While stocks and bonds are taking a beating due to rising interest rates, there is not yet much stress in the real economy, despite the hand wringing from many pundits. This implies even higher rates. A recession accompanied by much lower asset prices would offer better long-term return prospects.
My career has now included three investment manias, Dotcom 2000, Real Estate 2008, and the Pandemic 2021. In all cases, I warned and positioned clients early for what was to come. In all cases, my early actions resulted in some clients leaving. Some of those clients came back after a year or two.
I appreciate your patience with my strategy. It’s not just about money, it’s about peace of mind.
- MCS Family Wealth Advisors (MCS) consolidated client returns are dollar-weighted, net of investment management fees unless stated otherwise, include reinvestment of dividends and capital gains and represent all clients with fully discretionary Income/Growth accounts under management for at least one full month in 2022. These accounts represent 99.6% of MCS’s discretionary assets under management as of 09/30/2022 and were invested primarily in US stocks and bonds (5.7% of client assets on 09/30/2022 were invested in tax-exempt municipal bonds). The Stock Index values are based on the S&P 500 Total Return Index, which measures the large-capitalization US equity market. The Bond Index values are based on the Bloomberg Barclays US Aggregate Bond Index, which measures the US investment-grade bond market. Index values are for comparison purposes only. The report is for information purposes only and does not consider the specific investment objective, financial situation, or particular needs of any recipient, nor is it to be construed as an offer to sell or solicit investment management or any other services. Past performance is not indicative of future results.
- Japan’s Nikkei 225 Stock Average, comprised of Japan’s top 225 blue-chip companies.