MCS clients outperformed the dreadful stock and bond market results of 2022. Overall, client losses were minor with the potential to be easily recovered.
For the full year 2022 (if MCS clients’ investments were treated as one large portfolio including their cash), on average clients lost 2.67%, after fees. For comparison purposes, the S&P 500 Total Return Stock Index (S&P 500) lost 18.11%, and the Bloomberg Barclays Aggregate Bond Index lost 13.01%. The range of MCS individual client returns was from a gain of 2.86% to a loss of 11.86%.*
The clients with the lowest returns had higher exposure to investments that do poorly when interest rates rise (stocks and longer-term bonds). Clients with the highest returns held legacy oil stock positions that outperformed due to the war in Ukraine. MCS client returns were protected from the steep stock and bond market losses by our focus on short-term bonds, which had minimal price declines.
2022 Market Review
In 2022, the beating taken by many investors is not fully captured in the indexes. There were big losses in sectors that up until the recent past had enthralled investors. Here’s how some of the most popular exchange traded funds fared in 2022:
Crypto-related (BITQ, BITW, CRCW, etc.) down 60 to 87%
Cannabis -related (YOLO, ACB, POTX, etc.) down 70 to 75%
ARK Next Generation Internet (ARKW) down 69%
ARK Fintech Innovation (ARKF) down 66%
Source: Visual Capitalist.com
Stocks of well-known companies took a hit as well:
Higher interest rates, driven by unexpected inflation, pulled the rug out from under stock prices by decreasing the price-earnings ratio (PE). As shown in Figure 2, investors now pay roughly $18 for each dollar of earnings instead of the $22 they paid at the start of last year. In other words, a stock that sold for $22 a year ago now sells for $18. For a more detailed explanation of how the PE ratio works, see our 2021 Year-End Newsletter and Outlook2.
Source: Washington Post, Bloomberg3
Critical Questions:
Will inflation fall to the Fed’s 2% to 2.5% target, and if so, when?
If you have been reading my newsletters, you know that I was deeply skeptical of the expert consensus that inflation was transitory. I feel the same way about today’s Wall Street’s economic forecasts as a basis for investment positioning. Previously I quoted esteemed economists like Janet Yellen who, to their credit, admit that their understanding of inflation is still a work in progress:
“Ourtrackrecordat understanding inflation is really, really bad,” University of California, Berkeley, professor, David Romer said. “The range of plausible outcomes over the next year (2023) or two years is very, very wide,” including having inflation either fade or become embedded in the economy.
“The failure of most forecasters to see the persistent inflation coming out of the pandemic has led to much soul-searching and questioning of the assumptions in computer economic simulations that have guided policy for many years.”
Source: Comments from the Meeting of the American Economic Association in New Orleans, January 6-8, 2023, as reported by Bloomberg.
— OR —
Will inflation become sticky, say around 4% (which is too high), thus necessitating a prolonged period of higher rates?
I do not believe inflation will fall back and stabilize at the Fed’s target as quickly as market valuations indicate. I doubt that inflation is going to be as easy to tame as hoped. The Fed knows that inflation could decline only to rebound higher like it did in the 1970s. Mindful of the rebound risk, the Fed has indicated that it’s willing to keep short rates elevated for a ‘long enough’ period to make sure inflation is vanquished. No one knows how long ‘long enough’ is.
As an example of uncertainty faced by even professional investors, these headlines from leading industry experts appeared on my Bloomberg Terminal within two hours of each other:
Pimco Says ‘Bonds Are Back’ With Recession Likely This Year4, 2023-01-11 15:00:02.239 GMT
Yardeni Says (Stock) Bull Market Is Back as Recession Worries Fade5, 2023-01-11 16:33:17.631 GMT
Does anyone have a quarter? We’ll flip for it.
Creating a Stable, Growing Portfolio in Unstable Times
Traditional diversification works well in stable markets, but too-hot inflation is destabilizing. While instability is not unusual, the combination of instability and historically high stock and bond market valuations relative to inflation presents significant downside valuation risk to investors as shown in Table 2.
Yet, even in this uncertain environment, a stable portfolio earning about 4% can be created while limiting exposure to still overvalued stocks and bonds. I say overvalued because the 10-year Treasury bond only yields about 3.5%, while inflation is 6.7% (the bond yield is well below inflation). However, if inflation was 4% and the 10-year Treasury Bond yield was 5% or more, this would be a decent investment opportunity because the yield is above the inflation rate.
Of course, in any market, some assets will increase in value. However, successfully identifying and capitalizing on those situations is much harder when the tide is going out. Choppy markets tend to grind up investor portfolios.
Despite the challenges, Figure 2 illustrates that there are attractive returns available with limited risk.
The yield curve is a graph of fixed income interest rates and their maturities, with the shortest maturities to the left and the longest maturities on the right. A downward sloping (also called an ‘inverted’ or ‘negative’) yield curve is when short maturity rates are higher than longer maturity rates.
Historically, a downward sloping yield curve occurs before a recession, and a recession means that inflation will quickly decline as the Fed reduces short-term rates to reinvigorate the economy. A negative yield curve is often a signal to buy longer term bonds to lock in yields before the Fed responds to a recession by rapidly reducing short yields.
I’m ignoring this buy signal for now.
If inflation remains higher and more persistent than markets expect, interest rates are likely to rise further. Currently the 10-year Treasury yields about 3.5%, however, if inflation gets “sticky” at around 4%, it could easily drive those yields to 5% – 6%. This would mean another round of significant losses for stock and bond holders this year. Even a mild recession, which many expect, may not be enough to permanently bring inflation to the Fed’s 2% – 2.5% target.
Longer term, I expect to switch from US Treasury securities to municipal (muni) bonds or corporate bonds. Currently, those bonds don’t offer enough extra yield spread (the yield ‘spread’ is the difference between US Treasury yields and other bond yields) to offset the US Treasury Bill’s state tax exempt income and liquidity advantages. A recession should widen yield spreads, and that is a more opportune time to make the switch.
Short term, some market analysts are voicing concern after watching the US House of Representatives speaker confirmation process. They worry that members to the far right of Speaker McCarthy’s caucus may interfere with increasing the debt ceiling, thus threatening a US government debt crisis in the next six months.
This threat could make for a very bumpy ride in the financial markets.
To mitigate the low probability but high impact risk of delayed payment on US Treasury bonds, I am considering tax-exempt municipal money market funds as alternatives to US Treasury bills. Tax-exempt money market funds, although their yields are lower, are diversified over hundreds of high-quality municipalities that must balance their budgets. They are also exempt from Federal and sometimes state taxes.
What about stocks or commodities?
These will be on the table later in this cycle. A recession will likely take some air out of prices for both as the economy decelerates. The attractiveness of stocks and commodities is also tied to the level of interest rates. Higher interest rates mean lower prices for both.
The worst environment would be a recession combined with sticky inflation, forcing rates to remain high for a longer period than the market is prepared for. In this scenario, stocks could drop 20 to 25%.
Bottom Line
I believe that the stability of your finances is critical to accomplishing our mission of transforming money from a source of worry to a resource for fulfillment. In 2021, I protected client savings from rising interest rates by moving most investments into one- and two-year bonds and CD’s.
Despite last year’s poor performance of the stock and bond markets, I am excited about the investment landscape going forward (and how often do you hear me say that?). We can now potentially earn much better returns than were available over the last decade without taking more risk. We can achieve this while waiting for more compelling stock and longer-term bond valuations. That is good news.
Update on Succession Progress
In 2021 we started a significant effort to identify a potential merger partner with a good investment track record of downside protection – something similar to our investment performance6. After spending about $140,000 on a search, we found a firm with the performance we were seeking. However, over months of conversation, we also determined that we were not a best fit from a merger perspective.
While their track record is not long, we are impressed with their methodology, and one or more of their strategies remain an option. We continue to monitor their performance in real time by having them manage a portion of our personal funds. We believe in testing a recommendation like this before offering it to clients. Some of you may recall that we did the same thing many years ago with Auxier Investment Management.
If you would like to know more or are interested in having a portion of your funds in a separately managed account (SMA) under our supervision, please contact me at michael@mcsfwa.com or call me at 541-345- 7023. A separately managed account has management fees in addition to what we charge. Currently 62% of advisors use SMA’s to provide both strategic and tactical investment strategies for their clients7.
*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 accounts under management for at least one full month in 2022. These accounts represent 99% of MCS’s discretionary assets under management as of 12/31/2022 and were invested primarily in US stocks and bonds (5.6% of client assets on 12/31/2022 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 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.
Disclaimer
The information contained herein does not describe every aspect of our investment advisory services nor does it contain all of our performance records, and it is intended for residents of the United States. Information provided is obtained from sources we believe to be reliable but is not guaranteed. Nothing contained herein should be construed as investment, tax, or financial advice. MCS Family Wealth Advisors® is owned by MCS Financial Advisors, LLC (MCS), an investment adviser registered with the United States Securities and Exchange Commission. We only conduct business where properly registered or exempt from registration.
Categories
2022 Year-End Newsletter & Outlook
MCS clients outperformed the dreadful stock and bond market results of 2022. Overall, client losses were minor with the potential to be easily recovered.
For the full year 2022 (if MCS clients’ investments were treated as one large portfolio including their cash), on average clients lost 2.67%, after fees. For comparison purposes, the S&P 500 Total Return Stock Index (S&P 500) lost 18.11%, and the Bloomberg Barclays Aggregate Bond Index lost 13.01%. The range of MCS individual client returns was from a gain of 2.86% to a loss of 11.86%.*
The clients with the lowest returns had higher exposure to investments that do poorly when interest rates rise (stocks and longer-term bonds). Clients with the highest returns held legacy oil stock positions that outperformed due to the war in Ukraine. MCS client returns were protected from the steep stock and bond market losses by our focus on short-term bonds, which had minimal price declines.
2022 Market Review
In 2022, the beating taken by many investors is not fully captured in the indexes. There were big losses in sectors that up until the recent past had enthralled investors. Here’s how some of the most popular exchange traded funds fared in 2022:
Source: Visual Capitalist.com
Stocks of well-known companies took a hit as well:
Higher interest rates, driven by unexpected inflation, pulled the rug out from under stock prices by decreasing the price-earnings ratio (PE). As shown in Figure 2, investors now pay roughly $18 for each dollar of earnings instead of the $22 they paid at the start of last year. In other words, a stock that sold for $22 a year ago now sells for $18. For a more detailed explanation of how the PE ratio works, see our 2021 Year-End Newsletter and Outlook2.
Critical Questions:
Will inflation fall to the Fed’s 2% to 2.5% target, and if so, when?
If you have been reading my newsletters, you know that I was deeply skeptical of the expert consensus that inflation was transitory. I feel the same way about today’s Wall Street’s economic forecasts as a basis for investment positioning. Previously I quoted esteemed economists like Janet Yellen who, to their credit, admit that their understanding of inflation is still a work in progress:
Source: Comments from the Meeting of the American Economic Association in New Orleans, January 6-8, 2023, as reported by Bloomberg.
— OR —
Will inflation become sticky, say around 4% (which is too high), thus necessitating a prolonged period of higher rates?
I do not believe inflation will fall back and stabilize at the Fed’s target as quickly as market valuations indicate. I doubt that inflation is going to be as easy to tame as hoped. The Fed knows that inflation could decline only to rebound higher like it did in the 1970s. Mindful of the rebound risk, the Fed has indicated that it’s willing to keep short rates elevated for a ‘long enough’ period to make sure inflation is vanquished. No one knows how long ‘long enough’ is.
As an example of uncertainty faced by even professional investors, these headlines from leading industry experts appeared on my Bloomberg Terminal within two hours of each other:
Does anyone have a quarter? We’ll flip for it.
Creating a Stable, Growing Portfolio in Unstable Times
Traditional diversification works well in stable markets, but too-hot inflation is destabilizing. While instability is not unusual, the combination of instability and historically high stock and bond market valuations relative to inflation presents significant downside valuation risk to investors as shown in Table 2.
Yet, even in this uncertain environment, a stable portfolio earning about 4% can be created while limiting exposure to still overvalued stocks and bonds. I say overvalued because the 10-year Treasury bond only yields about 3.5%, while inflation is 6.7% (the bond yield is well below inflation). However, if inflation was 4% and the 10-year Treasury Bond yield was 5% or more, this would be a decent investment opportunity because the yield is above the inflation rate.
Of course, in any market, some assets will increase in value. However, successfully identifying and capitalizing on those situations is much harder when the tide is going out. Choppy markets tend to grind up investor portfolios.
Despite the challenges, Figure 2 illustrates that there are attractive returns available with limited risk.
The yield curve is a graph of fixed income interest rates and their maturities, with the shortest maturities to the left and the longest maturities on the right. A downward sloping (also called an ‘inverted’ or ‘negative’) yield curve is when short maturity rates are higher than longer maturity rates.
Historically, a downward sloping yield curve occurs before a recession, and a recession means that inflation will quickly decline as the Fed reduces short-term rates to reinvigorate the economy. A negative yield curve is often a signal to buy longer term bonds to lock in yields before the Fed responds to a recession by rapidly reducing short yields.
I’m ignoring this buy signal for now.
If inflation remains higher and more persistent than markets expect, interest rates are likely to rise further. Currently the 10-year Treasury yields about 3.5%, however, if inflation gets “sticky” at around 4%, it could easily drive those yields to 5% – 6%. This would mean another round of significant losses for stock and bond holders this year. Even a mild recession, which many expect, may not be enough to permanently bring inflation to the Fed’s 2% – 2.5% target.
Longer term, I expect to switch from US Treasury securities to municipal (muni) bonds or corporate bonds. Currently, those bonds don’t offer enough extra yield spread (the yield ‘spread’ is the difference between US Treasury yields and other bond yields) to offset the US Treasury Bill’s state tax exempt income and liquidity advantages. A recession should widen yield spreads, and that is a more opportune time to make the switch.
Short term, some market analysts are voicing concern after watching the US House of Representatives speaker confirmation process. They worry that members to the far right of Speaker McCarthy’s caucus may interfere with increasing the debt ceiling, thus threatening a US government debt crisis in the next six months.
This threat could make for a very bumpy ride in the financial markets.
To mitigate the low probability but high impact risk of delayed payment on US Treasury bonds, I am considering tax-exempt municipal money market funds as alternatives to US Treasury bills. Tax-exempt money market funds, although their yields are lower, are diversified over hundreds of high-quality municipalities that must balance their budgets. They are also exempt from Federal and sometimes state taxes.
What about stocks or commodities?
These will be on the table later in this cycle. A recession will likely take some air out of prices for both as the economy decelerates. The attractiveness of stocks and commodities is also tied to the level of interest rates. Higher interest rates mean lower prices for both.
The worst environment would be a recession combined with sticky inflation, forcing rates to remain high for a longer period than the market is prepared for. In this scenario, stocks could drop 20 to 25%.
Bottom Line
I believe that the stability of your finances is critical to accomplishing our mission of transforming money from a source of worry to a resource for fulfillment. In 2021, I protected client savings from rising interest rates by moving most investments into one- and two-year bonds and CD’s.
Despite last year’s poor performance of the stock and bond markets, I am excited about the investment landscape going forward (and how often do you hear me say that?). We can now potentially earn much better returns than were available over the last decade without taking more risk. We can achieve this while waiting for more compelling stock and longer-term bond valuations. That is good news.
Update on Succession Progress
In 2021 we started a significant effort to identify a potential merger partner with a good investment track record of downside protection – something similar to our investment performance6. After spending about $140,000 on a search, we found a firm with the performance we were seeking. However, over months of conversation, we also determined that we were not a best fit from a merger perspective.
While their track record is not long, we are impressed with their methodology, and one or more of their strategies remain an option. We continue to monitor their performance in real time by having them manage a portion of our personal funds. We believe in testing a recommendation like this before offering it to clients. Some of you may recall that we did the same thing many years ago with Auxier Investment Management.
If you would like to know more or are interested in having a portion of your funds in a separately managed account (SMA) under our supervision, please contact me at michael@mcsfwa.com or call me at 541-345- 7023. A separately managed account has management fees in addition to what we charge. Currently 62% of advisors use SMA’s to provide both strategic and tactical investment strategies for their clients7.
Endnotes
MCS 2021 Year-End Newsletter and Outlook https://mcsfa.com/2021-year-end-newsletter-and-outlook/
https://www.washingtonpost.com/business/wall-street-got-2022-half-right-the-other-half-still-hurt/2022/12/21/a0f74e26-8123-11ed-8738-ed7217de2775_story.html
https://www.bloomberg.com/news/articles/2023-01-11/pimco-says-bonds-are-back-with-recession-likely-this-year
https://www.yahoo.com/now/bull-market-back-recession-worries-163317409.html
https://mcsfa.com/wp-content/uploads/2022/09/MCS-Annual-Perf-5.jpg
https://www.nasdaq.com/articles/bringing-personalization-and-scale-to-advisors-through-managed-accounts-and-technology
*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 accounts under management for at least one full month in 2022. These accounts represent 99% of MCS’s discretionary assets under management as of 12/31/2022 and were invested primarily in US stocks and bonds (5.6% of client assets on 12/31/2022 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 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.
Disclaimer
The information contained herein does not describe every aspect of our investment advisory services nor does it contain all of our performance records, and it is intended for residents of the United States. Information provided is obtained from sources we believe to be reliable but is not guaranteed. Nothing contained herein should be construed as investment, tax, or financial advice. MCS Family Wealth Advisors® is owned by MCS Financial Advisors, LLC (MCS), an investment adviser registered with the United States Securities and Exchange Commission. We only conduct business where properly registered or exempt from registration.