Fall Market Comments

I promised at the end of August that I would be back in touch sometime this fall.  This is my third attempt at writing this note. Events have moved so rapidly these past few months, that I’ve constantly been tearing up what I’ve already written and starting over!  Finally, I think there’s enough clarity to update you on the markets and my thinking going into 2023.   Stocks had rallied off their summer lows at the time of my last letter.  However, I warned then of the possibility of further weakness in the coming months.   Sure enough, markets fell an additional 8% through mid-October on inflationary concerns, higher interest rate hikes from the Federal Reserve and fears of a slowing economy as a result.  Markets seem to have found their footing around June’s price lows.  Even so, the average stock is currently trading about 18% lower than it was at the end of 2021.  Many individual securities have experienced declines significantly higher than that.   This will obviously affect the performance of Exchange Traded Funds as they are a basket of equities, comprising an index.  However, given the shake out we’ve experienced this year and given the current economic climate, I believe there is a higher probability of better investment conditions going forward.  This letter will explain why I think that and my thoughts regarding investing in this environment.   

I’ve previously written of the similarities between our current investment environment and what America experienced immediately after World War II.  The US economy of the late 1940s struggled as businesses needed to convert from a military to a civilian economy almost overnight.  Then as now the country experienced supply chain bottlenecks and inflation.  The reasons for this were that wartime price controls ended and people had money because there’d been little to spend it on during the war.  The results were soaring consumer demand which stoked an inflationary shock.   Inflation between 1946-48 topped 10% per year.  Markets struggled in that environment.  Eventually these issues were resolved, the economy began to grow again and equities began an advance that lasted until the 1960’s.   Similarly, we’re still dealing with the aftershocks of the economic disruptions caused by Covid.  The world economy’s been rocked by high inflation and shortages.  This stems largely from the supply chain mess, pent up demand and unprecedented levels of worldwide economic stimulus resulting from the virus. The war in Ukraine has magnified many of these problems.  

Our government’s response to inflationary pressures has been to significantly tighten credit and the money supply.  Both inflation and rising interest rates, plus the fear of an economy slowing more than the Federal Reserve would like to see has been a significant headwind for both stocks and bonds this year.  Cash has been one of the few places for investors to hide.  Even bonds have failed to perform their traditional stabilizing function in more conservative portfolios.  2022 through October is the 2^nd worst performance year so far for a traditional measure of a balanced investment portfolio where 60% is invested in equities while the other 40% is placed in fixed income.  That data goes back to the 1930s so you can see how rising rates have hurt even more conservative approaches to investing.    

 

That being said, I’m increasingly of the belief that much of this bad news has been discounted by investors.  Like earlier in the year, probability suggests equity prices are in a price zone where value’s being created in the markets, though the rally of the last week has likely taken some of the shine off of that assessment.   There’s a higher probability the economy will slow in 2023, but avoid a long-lasting and perhaps more significant downturn.  I think this is possible because our methods of measuring the economy, which largely go back to when we were more of a manufacturing nation, underreports our real growth.   While I believe interest rates will continue to rise going forward, there’s now a higher probability that future rate increases will slow and potentially be finished by the end of 2023.  This too I believe is largely discounted in stocks.  Besides, interest rates are high only relative to the investment environment we’ve seen since 2008. I spent the first twenty plus years in this business with rates higher than today and equities were able to advance then in the face of that headwind.  I believe now will be no different.  
   

Finally, we’re seeing evidence suggesting inflation is starting to subside and the supply chain issues that have bedeviled the economy are slowly straightening themselves out.  We also seeing declines in used car prices, construction, and home purchasing.   Add into that that when stocks have experienced significant declines such as we’ve seen this year, then historically one-, three- and five-year rates of return are almost uniformly higher and usually significantly better than the historical averages.  Another positive is it’s looking highly probable that the House of Representatives has flipped over to the Republicans.  This isn’t a political comment but a note that investors prefer divided government as it provides a guard against overzealous political tinkering with the economy by the Executive Branch.   Finally, stocks have also flipped over into the best six month seasonal period in terms of performance.   

My current strategy is no different than what I suggested was appropriate for long-term investors when the weather was warmer.  I am of the mind to strategically purchase ETFs where I can find value on market declines, depending on client mandates, cash levels and risk tolerance.   I am highly confident in the portfolio of ETFs that I hold in client accounts and still believe equities are compelling for those with a 12–18-month time horizon.  Similar to last summer, I still believe this is a period where money can be added to accounts if one is so inclined.  Nobody will ever know the exact date the market bottoms. However, probability suggests a higher degree of certainty for profit at these levels for those with a long-term investment horizon.  Also, since the investments we make for clients are only in Exchange Traded Funds, our risks are not necessarily tied to any individual stock’s performance within the indices these investments represent.  Finally, in taxable accounts I am employing tax loss harvesting strategies to minimize both current capital gains and to lower cost basis.  In the long-term investment equation what you keep is almost as important as what you make. Nobody likes losses, but these can sometimes be used in ways that potentially benefit a portfolio longer-term if implemented correctly by lowering the tax bill to Uncle Sam.
   

Finally a realistic note about war in the Ukraine.  Investors are discounting continued losses for the Russians and a likely settlement to the conflict at some point.  This assumption flies out the window if the war takes an unexpected twist, particularly if the Russians utilize a nuclear weapon or device.  Should that occur, then I’ll warn you that markets worldwide will likely have at least one, and possibly a series of very bad days.  Unfortunately, short of having all cash, there’s no realistic way to mitigate this risk in a manner that most investors are willing to assume.  This is similar to a natural disaster like an earthquake.  It may be occurring now as I’m writing this letter, or tomorrow or never in any of our investment lives.  I think the nuclear option is a very low probability. I would hope there are enough rational people in the Russian chain of command that would recognize the utter catastrophe of such an event and resist the order.  I also think the current direction of the war means the likelihood of this continues to decline.  However, while the odds are low, they are not zero and I think all of us should be aware of that risk.  I am happy to discuss this with  

you if you would like.  
   

I am still optimistic we’ll see higher stock prices over the coming 12-18 months.  Price action since October tells me that other investors also believe equity valuations are more attractive, although perhaps not as attractive as a week or so ago.  Information may change and we may not have seen the ultimate lows in stocks for this cycle, but probability suggests we’re close.  Further declines from here would only increase this argument.  Stocks may also take longer to recover than our last bear market from Covid in March of 2020.  But probability suggests that time and price are likely now on our side.