Date: November 2, 2022

***Q3 Client Update***

Many people like to read my very “brief” quarterly client update which I select excerpts. If you’re one of them, please read on. If not, feel free to stop now. Always happy to hear comments and questions.

In baseball, people sometimes refer to a homerun as a roundtripper, having started at home and ending at home. This season Aaron Judge of the 27-time world champion New York Yankees hit 62 roundtrippers, the most ever in the American League and really in all of baseball if you exclude those who egregiously cheated. In Q3 2022, the stock market did a sort of roundtripper of its own, beginning the quarter at 3785 on the S&P 500, hitting a high of 4305 and ending the period at 3585 for net loss of 5%. It was certainly frustrating that the market could not sustain its intra-quarter gain of almost 14% and then turned it into a loss. Of all the things I hate most in the markets, I think turning decent gains into losses ranks at the top of my list.

But we all know that we don’t get to choose the markets we want. We play the hands we are dealt. 2022 has certainly epitomized that and no one I know would openly root for a repeat of this year. And as disappointing as Q3 was in the end, we added a lot of value, both in terms of investment performance and financial planning. On the latter, we continue to harvest as many tax losses as possible which benefit taxable accounts. On the tax deferred side, we strongly recommend considering a ROTH IRA conversion for at least some of your IRA. While you will owe ordinary income taxes on that amount in April 2023, you would be converting dollars that have presumably declined in value, have full tax deferred potential for growth with withdrawals exempt from income taxes. Finally, with ROTH IRAs that are not inherited from a non-spouse, there is no requirement to withdraw funds at age 72. As always, please let us know if you would like to discuss further.

Getting back to the events of the quarter, there were plenty of geopolitical ones. Speaker Pelosi visited Taiwan which was pretty much guaranteed to cause controversy and anger the Chinese. For years and decades to come, I fully expect tensions to ebb and flow in that part of the world and markets to be impacted. However, as investors geopolitical risks are something we have to accept because they are always present. The longest serving monarch since Louis XIV and second longest in history, Queen Elizabeth, passed away on September 8th. The Queen is probably the single most recognized monarch of the modern era and one that most of us have known since we can remember. 70 years is literally a lifetime of rule.

The war in Ukraine raged on and I continue to believe that something doesn’t appear right. You all know me, and I am definitely not a conspiracy theorist, but a country with the military might of Russia has looked foolish and almost inept at times against a nation lacking resources. Months ago, I wondered why Russia stopped surrounding Kiev when the western military minds all thought Russia would choke it off from supplies and literally starve the population into submission. And then I realized this was well above my paygrade and I should stay in my lane.

In the end as I have said consistently all year, I do not believe the war in Ukraine is a market mover unless the unthinkable happens. For all the talk and worry about wheat, let’s remember that it peaked in early March and then did a roundtrip back to its pre-war levels. Crude oil also peaked in early March and returned to 2021 levels, things you don’t really hear in the media.

China continued to try to combat COVID spread by locking down various regions of the country. We now know this strategy is doomed to fail and they should be focusing on vaccines and therapeutics. With the 20th Congress of the Chinese Communist Party set to begin on October 16th, Xi and company have been desperately trying to juice the economy. It will be long-term instructive for the Chinese markets and global economy to see if any of Xi’s friends are replaced and with whom. This is an underreported story that needs to be watched.

Back at home, Congress and the Biden administration passed The CHIPS Act to help bring manufacturing and supply chains of the semiconductor industry to the U.S. Interestingly, that passage marked the peaked for the semis sector as the group declined 25% to quarter end. The Inflation Reduction Act was also passed in what has become a long string of legislative successes for the Democrats heading into the midterms. However, the name of the bill is a bit of a misnomer as the multi-strategy legislation does almost nothing to reduce inflation. And frankly, it’s unlikely that any piece of legislation could combat inflation without negatively impacting the economy.

Pivoting to the currency markets, the majority of investors do not realize that while the bond market is much larger than the stock market, the currency market is much larger than the bond market. Economies, markets and companies thrive on quiet and stable currencies which is not what we saw in Q3 nor throughout 2022. Single digit moves on an annual basis are the norm.

The British Pound has collapsed from 1.38 to the dollar to 1.04 at its Q3 low. That is historic and makes an import economy almost impossible to thrive as prices soar to unimaginable levels. In Europe the Euro currency has finally plunged to my first long-term target of parity or 1:1 with the dollar. Recall more than a decade ago when models, athletes and Hollywood types wanted to be paid in Euros when it was north of 1.5:1. Today, no one will touch it. Funny how sentiment works. My next target is all-time lows for the currency, under .80, last seen shortly after the currency launched in 1999. In the big picture, currency stability is probably the most important ingredient for sanguine markets.

The unusually strong U.S. dollar has certainly hindered the stock market as well as the economy as companies that export have pricing problems. On the flip side, the strength of our currency does raise our global standard of living as well as help curb inflation as we saw in the early 1980s, the last time the Fed was doing major battle with it. In short, the dollar absolutely must stop going up and then gently decline in the coming months and quarters.

And on the economy, we have now seen two straight quarters of negative GDP growth, what many refer to as a textbook recession. While that may have been conventional wisdom the data absolutely do not support the claim. Q3 should be plus or minus the 0% line when it is released in late October. I have spent the better part of a month arguing against calling a recession now and it’s not just because I forecast one would not happen in 2022. While there are definitely weak parts of the economy like housing and technology and job losses are likely to follow, other areas like travel and leisure, healthcare, retail and energy are all strong.

I have argued all year that the economy can’t create 300,000, 400,000 and 500,000 new jobs a month and be in recession. Unemployment cannot be trending lower to pre-pandemic levels in a recession. And while I know employment is a lagging indicator, the economy can’t have more job openings than people to fill them in a recession. Somehow the definition of recession became political in 2022 with the Democrats arguing against the classic definition and the Republicans crying foul that the goalposts were moved. The bottom line is that, like it or not, the National Bureau of Economic Research is the final arbiter of recessions. They may be late in declaring, but they are the verdict. The next recession is most certainly coming with a good chance in 2023, but it’s not here now.

Inflation has been the single biggest topic for the past 18 months. Jay Powell and the Fed made another generational mistake by labeling it “transitory” or temporary. The masses saw it coming and sustaining. The Fed screwed up, plain and simple. And now they are hellbent on returning inflation to pre-pandemic levels which will end up being another mistake.

In 2022, the FOMC has raised rates five times for a total of 3% with another 3/4% coming on November 2nd. Since we know it takes 6-9 months for Fed activity to impact the economy, most of the hikes this year are not even in the economy yet. This is what concerns me for 2023. Additionally, these sharp rate hikes have helped to create what’s called an inverted yield curve, meaning that short-term interest rates are above long-term interest rates. That creates a disincentive for banks to lend as they typically borrow short and lend long. Think about it. Why would a bank lend you money for less than they receive to borrow that money? They wouldn’t. And that’s why an inverted yield curve hinders economic growth. Credit is harder to come by which hurts the ability for businesses to grow and expand, exactly what the Fed is trying to do to control inflation.

As consumers we know that credit card rates, auto loan rates and HELOC rates are soaring. The 30-year mortgage has gone from 2.75% to 7%, essentially removing millions of buyers from properties they could previously afford. That all means more money goes to service your debt than spent in the economy, so Americans have to tap what has become $2.5 trillion in excess savings from the pandemic. And the whole thing leads to demand destruction, another goal of the Fed to bring inflation down.

With the Fed raising rates at a generational pace, the carnage in the bond market continued. Long-term treasury bonds fell another 10%+ after being down more than 20% through June 30th. The aggregate bond market declined another 5% on top of the 10% it fell during the first half of the year. While the stock market garners more attention, the bond market is double the size and the bear market in bonds is historic and precedent setting. There has never been a larger decline in bond prices nor one that has lasted this long. That is inarguable fact although let’s face it, when interest rates start at close to 0% and rise, the percentage move has to be jaw dropping by default.

To be clear and transparent, I did not see interest rates soaring as high as they have nor the levels to which the Fed has gone. Nonetheless, as I look at the bond market today, I see some of the best opportunities for both income and growth as I have seen in at least 14 years, if not 27 years. From 1981 through 2020, every time rates rose, investors could close their eyes and buy. They were always rewarded. 40 years of bond investors have basically seen a one-way street until 2021. Now they finally realize that bonds do in fact move like stocks, albeit with less volatility. I think this is the biggest story of the year and decade. Investors do not know how to react or what to do. And that will likely lead to more mistakes.

Stock market investors have seen two 50%+ declines in 9 years plus a few 20% declines and a 35% one this century. While no one enjoys that, that is always a risk of investing. For bond market investors, 2021-2022 is a whole new adventure that few, really none, have ever experienced. For years and years I have warned people against using those target date retirement funds in 401Ks and 403Bs which rely heavily on bonds the closer one gets to retirement or in retirement. Financial engineers never modeled the bond market for what is being seen today. Thankfully, none of our clients have those funds in their retirement plans. If you want a silver lining here, the good news is that most studies point to 2023 being a much, much better year and in the black.

Three months ago, I wrote about commodities rolling over, specifically energy and food. It usually takes a good three months or so for those declines to make their way to consumers and the inflation data. To date, oil’s peak was in March with a secondary peak in June. The same can said of wheat, corn and soybeans. Even used car prices finally let up. It is now the other ingredients in inflation that need to rollover, like wage growth and rents.

At this point in the report, I usually write about my barbell strategy to investing. If you picture a barbell from the gym, there is a long, thin bar with big weights on both ends. Think of those weights as our conservative strategies and aggressive ones, the exact proportions do not matter yet. In theory, your money would have higher weights to conservative and aggressive strategies, especially if you are in or very close to retirement, and lower allocations to the middle of the road strategies. This barbell approach has also worked very well with monies being transferred in from 401K and 403b plans as those pre-packaged plans rely heavily on bonds for the more conservative approach and do not account for interest rates rising. Additionally, their aggressive choices do not usually reward the risk taken. If you would like to learn more about the barbell approach, we can set up a meeting, call, Skype or Zoom.

Whether you are a stock or bond market investor, 2022 has been very challenging, but still full of opportunities. Similar to when Covid first decimated the markets and the masses ran for cover until the pandemic either turned or was over, investors have fled the markets in bigger droves this year, waiting for inflation to moderate and eventually go away and/or the Fed to stop raising rates. 33 years in the business has taught me that markets bottom long before the events confirm, or the fundamentals improve. In 2020 markets found their low very early in the pandemic as most scoffed and waited for the worst to be behind. The last time the Fed was this aggressive was 1994-1995 and the markets bottomed in 1994 with the Fed hiking rates into March 1995. More importantly, by the time the Fed stopped, the stock market was soaring well into new highs.

Looking ahead to Q4, there is a lot coming with two Fed meetings and the usual monthly releases of inflation and employment, both of which I see weakening along with the economy. We have the midterm elections on November 8th and it’s more than likely that we will not know which party controls what branch for several days. Unless there is a blue wave, I do not see the elections as being a market mover. A strong finish by the Democrats, however, could upset markets as the prospect for more massive government spending would likely lead to another run higher for inflation.

Midterm election years are notorious for major stock market bottoms as evidenced by 2018, 2010, 2002, 1998, 1994, 1990, 1982, 1978 and 1974. In almost every case, stocks flew at least 40% from the low to the high within 18 months. Moreover, October has well-deserved reputation as a bear market killer as we have seen in 2011, 2002, 1998, 1990 and 1974. So, the odds definitely favor a low in Q4.

From there, much depends on the Fed and the economy. If Jay Powell and the Fed are able to thread the needle and engineer that rare soft landing, we should see a major stock market bottom in Q4 with fresh all-time highs in 2023. If a mild recession is in the cards for 2023, I will argue that the market has already declined the average of mild recession bear markets, 25%. The ensuing rally may not be as strong as if there was no recession, but it should still be 20%+. And if I am totally wrong and there is a moderate recession, stocks should rally 10%+ and then rollover to new lows in Q1 2023, but next year is still up.

A few things are crystal clear. For a major stock market bottom, the 2-Year Treasury Note, 10-Year Treasury Note and U.S. dollar all need to stop rising, go sideways and then decline. All three should accommodate well before the Fed ends their rate hike cycle. Additionally, for the most bullish to win, I would also expect the Fed to at least taper, if not fully cease their quantitative tightening or selling assets from their balance sheet.

As life has returned to what has become the new normal with many clients meeting in the office, we will always offer Zoom, Skype and most other virtual meetings to suit our diverse and ever-growing client family. Please know that I am always interested in meeting, whether it is to create or update retirement projections on your financial situation, review the strategies in your portfolio, run social security analysis’ on when and how to file for the best benefit, discuss your estate or even smaller transactional-type issues like securing a mortgage or weighing insurance.

Please continue to share your feedback, positive and negative. Investing is a marathon not a sprint and the long-term future continues to look very, very bright, especially once we get past the next few quarters. We look forward to sharing that with you over the coming years. Again, here is the link to my calendar to schedule a meeting in the office, call, Zoom meeting or Skype.

Thank you for the privilege of serving as your investment adviser!


Heritage Capital, LLC


Paul Schatz AIF®

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Paul Schatz, President, Heritage Capital