Washtubs Not Teaspoons
Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.
We’ve made it to October! Right off the bat, we want to acknowledge it has been a hard year for investors. We know it’s tough to see your savings deteriorate in value, and it’s years like this that we truly appreciate the trust you place in our hands. All of our strategies are constructed for long-term growth and, while we expect, prepare, and plan for years like this to happen, it’s still never easy when it does. We ask for your patience through the storm and your trust that the sun will shine again. In the meantime, we think it’s important that we share some of the metrics we’re looking at, the insights gleaned from 25 quarterly earnings calls, and our joint conviction that now is one of the top three investment opportunities of our careers.
What inning are we in?
As the great philosopher of our time, Mike Tyson, once said “everyone has a plan until they get punched in the mouth,” and 2022 continues to deliver direct punches. After what we had hoped was a glimmer of a turnaround in July and August, September came in and dragged us back down to the June lows, with the broad S&P 500 down 25% YTD.
Investors have been navigating this challenging environment for the entirety of this year, and it still feels as if there is no end in sight to the volatility. Interestingly, the current bear market began in line with the calendar year 2022 – with the S&P 500 hitting its all-time high on the first trading day of the year. Thus, we are seeing the full peak to trough in performance as a YTD figure, which is both unusual and interesting.
Consider the chart below. Since 1980, the S&P 500 has been down over 20% intra-year eight other times. And every time, recovering to new highs. In three of these instances, the market recovered to finish positive on the year (1987, 2009, and 2020). In four other instances, the market went on to return over 20% in the year following (1991, 2003, 2009, and 2021).
For those on the edge of their seats in this environment, it’s worth stepping back to look at some different time periods for perspective. While S&P returns are down 25% year-to-date through the end of September, the index is still positive since the Covid-19 peak in January 2020 and up over 45% since the beginning of 2019 (inclusive of this year’s bear market). It’s natural for short-term performance to make us uncomfortable, but it’s important not to lose sight of our long-term goals.
So when will it turn around? We don’t know, but that doesn’t mean our investment staff, which includes two PhDs and two CFA Charterholders, are just bumbling around in the dark with your money. The markets (both stock and bond) are poised on a knife’s edge, trying to pinpoint exactly when the Fed will moderate its aggressive rate hikes. We believe this inflection point is fast approaching, within 1%.
The key data indicators to watch for are:
- lower core CPI – a key sign that Fed action is having its intended effect; and
- lower monthly non-farm payrolls.
You read that right. The market wants to see signs of a weakening labor market to begin its recovery. Why does the market want people to lose their jobs? Because the Fed has a dual mandate – to support conditions for stable prices (low inflation) and to maintain sustainable employment. Therefore, as long as the Fed can continue to impose rate hikes without causing broad unemployment, they will.
We broadly support this approach to interest rate normalization and inflation targeting; however, there is a breaking point which we believe the FOMC is very close to hitting. In support, the Bloomberg implied forward rates, derived from quoted swap markets, suggests that the terminal fed funds rate (i.e. “the breaking point”) is at 4.67%. As you can see from the graph below, we’re close. And as history has shown us time and time again, equity markets have the ability to recover very quickly.
Buying opportunity in equities!
Which brings us to our next point– bear markets create opportunities for long-term investors. We (the Directors of Radix Financial) believe in “putting our money where our mouth is.” And we have– being fully invested with our personal savings right alongside our clients. We are absolutely pushing equity mandates to the upper limit and sticking to our discipline. And while we do not expect for this recovery to be a straight line up, a market down 25% is a rare opportunity that has presented itself only a handful of times over our careers, and we strongly feel we’d be foolish to shy away from such an opportunity.
A key tenet of investing is that achieving long-term returns REQUIRES risk. A calculated risk, but our portfolios will always periodically experience downward volatility in line with the broad markets. This is true regardless of whether the “crisis of the day” impacting markets is economic, geopolitical, pandemic-related, or of any other nature we haven’t experienced yet, but no doubt, will. As Howard Marks is famously quoted as saying “the biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.” For those focused on the past, it’s easy to dwell on what has been “lost,” but for those focused on the future recovery and growth ahead, equity valuations look much closer to historical averages across almost any traditional metric.
Bonds are back baby!
While we believe that the equity markets are where the bulk of long-term growth will predominantly occur, bonds are now at levels that can begin to support portfolio income needs at levels we haven’t seen in a decade!
Even as recently as last year, (see chart below) a 10-year US Treasury note was offering only a meager 1.52% annual yield-to-maturity, and investors were gobbling them up. However, loaning the US government, or anyone else for that matter, any amount of cash for 10 years in exchange for a fully taxable 1.52% yield, was a non-starter. Between our fee, taxes, the liquidity risk from expected increases in interest rates, and inflation risk over a longer time period, it has been difficult to justify purchasing individual bonds for our clients.
But that tide is turning. Buying individual bonds allows us to “lock in” the rate of return we’re going to earn on the day of purchase, dutifully collecting coupon payments, and holding to maturity. No retail fund flows or further Fed action will affect it, which can greatly minimize risk to the overall portfolio while still rewarding our clients with low-risk, regular cash payments.
For those nearing retirement, rising rates are the best-case scenario. If we can all but guarantee that your day-to-day living expenses during retirement can be covered by the interest generated from an increased bond allocation, it makes the volatility of the equity portion of the portfolio much easier to sustain over short periods of time. We view this as a healthy dynamic and welcome the return to a “normalized” interest rate environment.
What have you done for me lately?
Especially in bear markets, it’s tempting to feel like you need us to “do something.” However, much like we wrote in January of 2019 right after a particularly ugly 4th quarter down 14%...
Long-term investing is like being a passenger on a ship crossing the ocean from one continent to the other. You can take a large cruise ship, knowing that if the weather turns bad, you can simply go under deck and trust that the captain (your advisor) knows what they’re doing. You may be seasick for a few days, but you’ll reach your destination safely.
Alternatively, you could try to time the market by joining the crew of a small sailboat. Some days you may be able to move much faster than the luxury cruise liner, nimbly navigating the smaller passageways finding short cuts and weaving in and out of trouble. It’s an exciting life with rarely a dull moment; however, a large storm could wipe you out, leaving your boat irreparably damaged.
By the way, the market returned 31.5% in 2019 immediately after the publishing of that article. So, while we make no guarantees, we offer a luxury cruise ride, built to withstand the storm and intentionally trading only to take advantage of cyclical opportunities as they present themselves. However, especially through rough waters, it’s important for us to communicate exactly what those navigational changes have been and our thinking behind it.
In August, we exited our publicly traded REIT exposure across all portfolios which has worked out well, as they have traded down 18% since then. REIT exposure has done incredibly well over the last decade with high yields and high growth driven by a very liquid, low-rate environment. But with rates rising so steeply, liquidity has dried up drastically and severely affected the distribution yield. We see a shift of “power” away from landlords and sellers and back into the hands of renters and buyers, so without that high dividend cash flow bonus, we don’t believe we’re being adequately rewarded for undertaking that risk. With the proceeds we’re taking the opportunity to reinvest in broad diversified equity exposure, which we believe provides a more direct route to recovery.
Secondly, and more significantly, we are beginning to rotate out of fixed income funds and into individual corporate bonds in larger accounts as we find high quality issues for purchase. If you’ll remember, last December we shifted into an interest rate hedged ETF strategy in anticipation of Fed action this year which has benefited us well. Over its holding period from December of last year until September 28th, the interest rate hedged ETF outperformed the corporate bond ETF it replaced, by 10.15%. However, as the Fed nears a ceiling on their ability to raise rates, we expect to see similar funds suffer from a mass outflow. At this stage, we view the risk of an exodus from this fund as greater than the risk of unexpected further upside in interest rates.
In its place, as you’ll see, we’ve begun to pick-up high-quality investment grade corporate bonds with maturities between 1-10 years. For the first time in a decade, we have the ability to lock in yields-to-maturity of over 5%. You may see cash a bit higher than usual in your accounts, as we hunt for individual bonds to fill the ladder.
Within our individual equity portfolios, we made the decision to sell Align Technology Inc. (ALGN), maker of Invisalign braces, just before reporting Q2 earnings. ALGN was originally added to the portfolio in July 2019, based on strong fundamentals and great net margins. We sold the stock due to concerns around supply issues from their manufacturing facilities in China, along with expected reduced consumer discretionary income for cosmetic dentistry. ALGN contributed a return to the portfolio of +26.8% over the holding period.
In its place, we have purchased CVS Health Corp (CVS) within the healthcare sector. CVS offers an attractively diversified conglomerate poised for high growth through strategic acquisitions that complement their core retail pharmacy business. CVS is the parent to Aetna insurance, is aggressively on the forefront of telemedicine, and expanding on-demand “minute clinics”, which we believe are well positioned to thrive. In the current environment, we see a lot of potential in bigger, more diversified companies with strong existing fundamentals.
Chevron Corp. (CVX) was also added to the portfolio, in the oil & gas sector. With mounting pressures in Europe and a relatively small energy allocation within the S&P 500, we believe that a bigger name with global exploration & production exposure will serve the portfolio best. Chevron, of the big four, is the best capitalized and we see potential to be a long-term portfolio holding.
To make room within the portfolio, we reluctantly said goodbye to Scotts Miracle Grow (SMG) at a loss. We have lost faith in management’s ability to navigate through the current supply chain difficulties and lack of a path to profitability in its Hawthorne business. SMG was originally added to the portfolio in 2016 for it’s potential in hydroponic farming through its Hawthorne subsidiary, but this business has failed to become profitable. While the company did well during the pandemic because of increased “stay at home gardening” interest, it has consistently failed to demonstrate the ability to successfully rebrand into the organic fertilizer market or effectively manage inventory levels due to decreased demand going forward.
As always, we appreciate your business, and welcome your feedback, comments, concerns, and questions.
Amy Hubble and Jessica Jablonowski