Welcome back readers. We hope you are enjoying the spring and have made plans for a summer break. Let’s get to it. Yes, the first five months of 2022 have been a very challenging time for the equity and the bond markets. By now, we are all aware of the obvious keydrivers weighing on the markets: (1) Inflation running hot with an 8.3% April CPI print (2) the Federal Reserve’s plan to aggressively raise interest rates, (3) slowing corporate earnings (4) war in the Ukraine (5) ongoing COVID lockdowns in China and the impact on supply chains.
As of this print, year to date (YTD) the S&P 500 is down -17.9%, the NASDAQ down -26.9% and the DOW is down -13.8%. The carnage has been much worse under the main market averages. Over 50% of the stocks in the NASDAQ are down over -50%. The aggregate bond market has not been spared. Rising rates have had the expected negative impact on the bond market, as interest rates rise, the prices of bonds with fixed coupons fall. The AGG (iShares Core U.S. Aggregate Bond ETF) is down -9.86% YTD. As we will cover below in “Yields on The Rise”, those bond investors that hold to maturity can still effectively capture a steady stream of income and be repaid at par value if positions are held to maturity.
On a positive note, two main points to make, 80% of the companies that reported first quarter earnings beat analyst expectations. Secondly, the U.S consumer continued to show strength in spending though major retailers are beginning to report slower sales and providing lower guidance. While we are confronted with high inflation and Fed balance sheet reduction, we are not in a 2008/2009 scenario in which we saw global fundamental structural issues in the housing, banking, capital markets etc. If we are in a “Bear” market, which is TBD, it is always important to understand that Bear markets are generally short-lived, and recovery can be swift. See chart below.
The markets are, and always have been, a forward-looking mechanism on the economic outlook and are considerably impacted by investor sentiment. The stomach-churning volatility is present this year as bankers, financiers, private equity firms, portfolio managers and investment advisors have been adjusting, hedging, and speculating as they consider whether the Fed rate increase(s) over the next year or two will push the economy into a recession or if we will be able to achieve a “soft landing”?
Below we will cover in more detail how we are working to best address portfolio holdings in this uncertainty, and some ways to keep risk at bay if conditions deteriorate.
Investor Sentiment Matters
The recent downturn in stocks and bonds have left money managers with few places to hide, and data has shown that individual investors are becoming increasingly pessimistic. The share of investors who believe the stock market will fall over the next six months ended April is at its highest level since 2009. However, widespread pessimism isn’t necessarily bad news. Some view this as contrarian indicator, betting that when sentiment appears to have soured to an extreme level, markets are poised for a rebound. Given the downdraft in nearly all asset classes YTD (with some exceptions we talk about below) one can make the argument that the damage has been done, even if we enter a light recession in late 22 or 23.
For asset allocation specialists and tactical portfolio managers, these roiled markets are often a good time to put money to work and, depending on the investor and their individual portfolio strategy, is why we like to hold 10-25% cash at any one time. The Oracle of Omaha, Warren Buffett, a longtime adherent of value investing, has long advised that investors “be greedy when others are fearful.” That philosophy was difficult to practice for much of the past two years, during which investors’ mood largely seemed ecstatic and without fear. It should also be noted that Berkshire Hathaway is one of the few stocks, with the exception of those in the commodities sector, that is up year to date.
In summary, one should see sentiment as an important part of what moves the market. As the Fed and economic picture becomes a bit clearer, we see sentiment improving and see a tremendous opportunity to buy targeted holdings.
Bond Yields on the Rise
As global interest rates were relatively low for nearly a decade, dividend stocks didn’t have a lot of competition for income investors’ attention. But now, as the Federal Reserve continues to raise interest rates, and tighten monetary policy to fight inflation, the landscape has changed dramatically and swiftly. The Fed’s rate hikes have started to take hold, and this is reflected in yields. For fixed income investors, new issuances with higher yields/coupons are a welcome sight. For those retired and/or those having a more conservative risk profile, the prospect of higher bond yields and the steady income stream they provide is increasingly attractive.
Where to Invest
For the past two years rising tides have lifted nearly all market asset classes. 2022 is a different market, and while volatility is here to stay for at least the short term, there are sectors, industries and asset classes that are working this year. We will highlight these below:
Sectors: The industry sector picks that we highlighted in our January newsletter that are working this year include Energy, Agriculture, Metals & Mining, Industrials and High Dividend Producers. These sectors, particularly Energy (XLE +48.8% YTD), Metals & Mining (XME +15.8% YTD), and Agriculture (DBA +13.4%) performed particularly well and should continue to perform well due to macro conditions pushing them forward. In terms of technology, we remain focused on quality technology companies that have strong business models, material market share, strong cash flows and billions of cash at hand. While big tech has not been immune to recent sell-off, one can make the case that Apple, Amazon, Google, and Microsoft are strong, extremely profitable companies with excellent prospects and should be held thru nearly any market cycle.
Value: Relative to growth stocks, value stocks have performed better this year as rising rates weighed on growth stocks. Growth stocks are considered long duration because their cash flows are realized further into the future, and higher rates reduce the present value of these future cash flows. Value stocks are shorter duration with cash flows returned to shareholders earlier in the investment cycle. While value has performed better than the market is should be noted is still down -4% on one year basis.
Bonds: Our client’s bond positions are held in individual investment grade corporate bonds that are laddered in terms of maturity date. An individual bond position, held to maturity in a bond ladder, will be paid full face value upon maturity, absent default. Defaults in high grade corporate market are .002% over past 25 years. Higher yielding bonds, with higher interest income streams, are making bonds more attractive than they were less than two years ago. As mentioned previously, one needs to consider the impact that rising yields will have on a fixed income portfolio. This impact is magnified with longer duration portfolios.
Private Equity (PE): A traditional 60/40 weighted portfolio has not performed well in 2022. Coming into 2022, with storm clouds building, we looked to be proactive and overweight certain specific industry sectors, as well as add to alternatives and build up cash cushions. For our Accredited and Qualified Purchaser clients we have directed a significant percentage of their asset allocation into alternative investments. For a Qualified Investor an appropriate asset allocation should look different as we go through these market corrections. What this means is that an asset allocation of 25% Equity, 25% Bonds, 25% Alternatives and 25% Cash may be a more appropriate holding now than it had been in the past.
Private Equity has a lower correlation to equity market price movements and can add value and diversification. Our January 2022 newsletter provided some detail on this asset class and included two recommendations.
BREIT (Blackstone Real Estate Income Trust) which for the first four months of 2022 reported a total return of +6.0%.
BCRED (Blackstone Private Credit Fund through 3/31/22 had an annualized distribution yield of 7.8% and its ITD (Inception to Date Total Return) was 9.1%.
Each investor is different and adjusting one’s asset allocation is a detailed and private conversation that takes place between the investor and the advisor.
Please contact us if you would like to discuss, in more detail, these PE funds and or any of the other PE holdings the firm works with and to determine if this asset class is appropriate for your portfolio.