Summer Letter 2022

 There’s been no place for investors to hide in 2022 as the bear market that actually began in late 2021 has seen stocks tumble.  The S&P 500 lost nearly 21% in the first six months of this year.  The NASDAQ as well as the average growth-oriented investment index was down nearly 30%.  The average stock lost nearly 24% of its value in the first six month of 2022. It is the worst first half performance for stocks since 1970 and is the worst ever performance for a more balanced portfolio as bonds have been in their own bear market since the Federal Reserve signaled last winter that they were going to start raising interest rates.  I’ve previously covered why this has happened, so I don’t think it’s worth wasting the ink on that.  Instead, I’m going to discuss how I’m thinking about this and what we might see going forward.  First though I want to address the longer-term picture.  

 

Markets and investment cycles don’t operate on our seasonal calendar of day’s weeks, months and years. Markets will rise and fall based on investor’s gauge of future economic growth.  Thus, while seasonal characteristics and investor sentiment play an important role in the daily movement of stock prices these will be trumped by investors longer views about the state of the economy.  Right now, the many longer-term positives in our economy, are being trumped by inflation concerns as well as the corresponding rise in interest rates and the war in Ukraine.  Data is emerging that inflation may be peaking, but investors worry about a slowing economy and are sitting on their hands.

However, stocks are long duration assets and their returns should be measured over longer time periods.  Here then are some numbers to keep in mind.  From its lows in March 2009 through the end of June this year, the S&P 500 is up 462% without dividends.  The Nasdaq Composite, an index of growth-oriented investment names, is up 771%, again without dividends.  By our work each of these indices has seen ten corrective periods equal to or greater than 10% during this period.  The Covid related crash in March of 2020 lopped 35% off both indices in about six weeks, yet each of these indices was still considerably higher at their lowest levels in 2020 than their 2009 market lows.  Both the S&P 500 and the NASDAQ are still up better than 60% from those Covid lows even after this year’s decline.  Let’s think about that.  Given everything that’s happened since the beginning of 2020, after all the pandemic trauma and economic dislocation, after all the rioting and violence stocks are still higher than in March of 2020.  Even given the largest war fought on European soil since 1945, ruinous inflationary numbers and after a hard decline since last fall, stocks are still offering a return that’s likely better than anyplace else most investors could have put their money since the 2020 market lows.  You could lop another 20% off the market averages and this would still likely be true.  Each correction at their worst felt like the end of the world and the investment punditry came out each time proclaiming the end of the bull market.  They were wrong then and I believe they will be wrong again for reasons I’ve discussed with you many times in the past few years.

Mankind has yet to invent an investment that is riskless. Volatility-the decline in market prices or their daily price gyrations is the ticket you punch when you invest in equities.  It is the markets’ reset mechanism. Investors should expect some volatility and should accept that sometimes prices will correct.  Equities are never a one-way ticket higher.    Volatility, while most often associated with declines, can work both ways. Presumably though, investors don’t mind when there are sharp gains in their investments. Investors mostly hate volatility as prices head lower. There are strategies in our playbook that deal with more volatile periods that we use in our game plan for client accounts. One of the easiest methods is to have some cash on hand.  However, since it is unlikely that your portfolios will ever be 100% in cash when invested with me this is not complete protection against declines.  Put it this way, if Warren Buffett knows of no way to completely hedge a portfolio, then it is probably impossible to do.  The goal when investing is to be aware when the markets are in a lower probability environment, and have enough cash that fits into your risk/reward parameters.  Hopefully you will be able to deploy that cash as markets begin their next advance. 

In a period like this, we must recognize how things have changed and then adapt that change to portfolios.  I have been using this period to reorganize portfolios as necessary while selectively adding to positions that I believe are attractive, given my usual 12–18-month investment horizon. I believe the current environment is well suited towards my ETF process.  This is especially true where I believe investors have likely priced in much of the bad news and mounting evidence that inflation is peaking.   In the short-term this may not play out but I believe there is value being created in this current decline as long as the economy continues to grow.  I am always attracted to ETFs where the current market dislocation has brought the fund down to levels where the dividend is attractive.   Dividends can provide some support in market declines.  Markets will rise and fall in value, but the cash earned from dividends is yours to keep.

There are also enormous advantages to ETFs, especially during volatile times.  However, ETFs are not immune from market declines.  They will also lose value by something that mirrors the decline in the underlying index when the bear growls.  However, we can invest knowing we own a diversified portfolio of assets, backed by the value of the securities in an underlying index while removing single stock risk from the portfolio.  The history of equities tells us they can be wracked by fraud, can trade to zero due to a catastrophic loss or be rendered obsolete by unforeseen technological change.  But it is an extremely low probability event that a plain vanilla ETF, especially one with a long trading history and based on a well-established index, will suffer such a catastrophic event causing it to lose all its value.  I say this is a low probability event because 36 years of investing has taught me there are no guarantees.  However, the inherent value of the underlying assets and the unique creation and redemption process of ETFs make this unlikely.  Frankly it’s likely the only events that would cause the majority of ETFs to trade to zero would be ones where we think most of us would have more things on our minds then the value of our investment portfolios.  Because the underlying assets supporting ETFs have value, we can use our systematic approach to creating portfolios and strategies from this asset class.

I believe much of the bad news has now likely been priced into stocks.  I also think investors will need some time to rebuild trust and that it will take longer for us to recover from this decline than 2020’s Covid related rout.  Declines like what we’ve recently experienced usually take time to heal.  Probability suggests it could take anywhere from six months to a year for stocks to approach our most recent highs.  These would be nice returns going forward if I’m correct. However, I’ll also warn you of the possibility we haven’t seen the final lows for this bear market cycle.  That would just make equities more compelling in my opinion.  Here’s why.  Historically declines of this nature tend to be excellent places for long-term investors to find value.  This decline ranks as the 11^th worst six months period using the Wilshire 5000 Index.  Near-term results can be mixed but going out a year shows the average return is 26%, the average three-year return is 56%, the average five-year return is 115% and the average ten-year return is 281%.  That is why I’ve suggested that if you have extra cash lying around, now might be a good time to let me start dribbling it in the market for you as long as you can stomach some short-term volatility.   

Irrespective of the near-term, I am unchanged in my optimism about the future, the economy and the markets.  The reason I’m so positive has to do with the pace of technological advancement, which is still increasing exponentially and is unlikely to slow down in the foreseeable future.  I’ll invite you to go back and read on my blog, lumencapital.blogspot.com, what I’ve said before on this subject. Just know that many of these previously discussed trends are advancing more rapidly than ever.Behind these ideas are new businesses, jobs, and economic advancement. But markets are never a one-way ticket higher and corrections will happen.  Even our previous bull market had periods where it paused to catch its breath. Then as now there were also periods where stocks did not advance.  I think we’ll review this period in the coming years as one of these pauses.

Fortunae rota volvitur or Fortune’s wheel is always turning.  It always looks the worst near bottoms and while perhaps we’re not completely there yet, the resounding negativity and the weight of the evidence suggests we might be close.  Commentators who have constantly called for the end of the world have been wrong and have cost both themselves and others many opportunities over the years.  To that end I will again leave you with comments from Warren Buffett about stocks and volatility.  They are as relevant today as when they were first uttered.

 

“The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities — Treasuries, for example — whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskierinvestments — far riskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”

*Long ETFs related to the S&P 500 and NASDAQ in personal and client accounts.

Christopher R. English is the President and founder of Lumen Capital Management, LLC.-a Registered Investment Advisor regulated by the State of Illinois. A copy of our ADV Part II is available upon request. We manage portfolios for investors and also manage a private investment partnership. The information contained here is taken from sources deemed reliable but cannot be guaranteed. Mr. English may, from time to time, write about stocks or other assets in which he or other family members has an investment. In such cases appropriate discloser is made. Lumen Capital Management, LLC provides investment advice or recommendations only for its clients. As such the information contained herein is designed solely for the clients or contacts of Lumen Capital Management, LLC and is not meant to be considered general investment advice.  Mr. English may be reached at Lumencapital@hotmail.com.