Date: November 17, 2023

***Q3 Client Update***

The third quarter of 2023 was another tale of two halves. The markets came off a strong first half of 2023 and kept on going in July. That’s where the fun ended. So many investors who sat on the sidelines for the first 6 months of 2023 couldn’t stand the gain regret and finally plowed into the stock market and other “risk on” assets in July. We know this factually by looking at money flows, sentiment surveys and the options market. I venture to guess that some, many or most of these investors were the same ones who panicked in June and September of 2022 and rushed to the exits.

Investing is difficult enough when you make the right decisions for the right reasons. It is next to impossible when you do so emotionally. When I look back on my 34-year career I have certainly been guilty of that at times, especially in my younger days although I still consider my self to be young in the industry. With each successive emotional failure, I know I have become a better and better investor and steward of capital. And I always try to help educate investors on the danger of making financial decisions based on emotions over data and facts.

When all was said and done in Q3, the stock, bond and precious metals markets all closed lower by single digits. Energy was strongly higher by more than 20%. GDP from the previous quarter was as expected, growing by just over 2% with higher growth anticipated in Q3. While inflation still increased, it did so with less acceleration, not exactly helpful to those who need to use heat, air conditioning, gas or want to feed their families. And as I wrote about on the blog, I see inflation finding at least a temporary floor from which a short-lived re-acceleration is likely.

Also during Q3 the Super 7 stocks quieted down dramatically and began to march with many other stocks in the market. The bloom of the rose of Artificial Intelligence (AI) was also reduced over the summer, but I strongly believe there is much, much more of this boom left. With so few companies having strong exposure to AI and no IPOs to speak of, AI has the feel of the Dotcom sector of the mid-1990s and nowhere near 2000.

Some would say that Q3 was characterized by strikes. There was the writers strike in Hollywood, followed by the actors strike. Neither of those were going to impact the economy. However, the auto strike has the potential to impact the economy, especially the labor market. The war in Ukraine raged on without an end anywhere in sight. And while presidential politics for 2024 was tame, former President Donald Trump’s indictments rose to roughly 91.

Probably the most important news that got the least amount of attention even in the financial media was the Bank of Japan’s (BoJ) shift in strategy to allow for more movement in Japanese Government Bonds (JGBs). I know you’re probably yawning right now or about to move quickly past this topic. It sounds like nothing, but it is far from that. For decades the Bank of Japan has purchased almost the entire Japanese bond market. I have heard estimates approaching 90%, so much that their bond market doesn’t have much activity day to day. They buy bonds to firmly control all interest rates to prevent them from rising. In turn, their currency, the Yen, has been used in a multi-trillion-dollar global trade known as the Yen carry trade. Investors borrow money from the Japanese at absurdly low or even negative interest rates in Yen and then convert that to dollars. With those dollars, they buy U.S. Treasury bills, notes and bonds along with some “risk on” assets.

Now imagine that the BoJ decides to let their interest rates fluctuate even a little as inflation has soared and their economy has greatly improved. The trillions of dollars in the Yen carry trade suddenly need to be repriced, causing market volatility and a number of market dislocations. While this is good news for the Japanese over the long-term, it is certainly going to add challenges to the global financial markets as the trade continues to unwind.

Since 2021, many pundits have been calling for recession. And many indicators have weakened sufficiently to add credence to their claim. However, the jobs market has stubbornly resisted weakening and rolling over. In Q3, more than 900,000 new jobs were ahead. At this stage in the recovery, that number should be half that historically. The fascinating part is that various sectors of the economy have seen earnings decline in what the wrong pundits now call an earnings recession to save face.

Real recession is more than just earnings declining in a few sectors. Real recession sees job losses, lower prices, lower revenue, lower earnings and higher inventories. It also means the Fed reverses course and cuts interest rates. Given the challenges and peculiarities in the economy since COVID began, the next recession will be a giant reset on the economy. Inflation should return to a more stable and lower level along with mortgage rates. The employment picture will normalize so there are no longer two job openings for every one person to fill. In fact, depending on the depth of the recession, that ratio could very well completely reverse.

I never root for recession. It is difficult on the majority of Americans, even though life is not easy right now for so many. Unemployment obviously rises, wages decline, and people struggle. The “risk on” financial markets are rarely a picnic either. But recession is a necessity of capitalism and the somewhat free market economy. The reset of recession sets the stage for the next economic boom and surge in innovation and productivity. And it also sets the course for unthinkable levels on the major stock market indices.

The Fed’s annual August symposium at Jackson Hole produced very little fireworks for the third straight year. Chair Powell again gave very brief remarks without much to draw from. The Federal Reserve continued to raise interest rates in Q3, however, only once in July by ¼%. From a peak of ¾% at every meeting to now ¼% at every other meeting, there is high likelihood that Jay Powell and the rest of FOMC are done raising rates for this cycle. Of course, it is possible but not probable that a single stray rate hike could be out there in reaction to some piece of hot data, but it’s not the most plausible path forward. Rather, the Fed is going back to a neutral stance and will jawbone the markets as it sees fit.

From the Q2 lows, oil rallied smartly in Q3 from the mid-$60s to the mid-$90s. That move came right on schedule with the prospects for more in the coming quarters. Similar to the U.S. economy, rumors of its demise were greatly exaggerated. After doubling during the first 7 months of the year Bitcoin peaked in Q3 above $31,000. It saw a very orderly pullback to $25,000 and it seems poised for another run above $31,000 in Q4. There has been tepid interest from clients in the crypto space and advisors still do not have the ability to invest on behalf of clients in the conventional sense. That day is coming in 2024 as the SEC will likely abandon its objection and try to heavily regulate.

At this point in the report, I usually write about my barbell strategy for 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.

The stock market continues to be in a pre-election year which is the most positive year during a president’s term. There hasn’t been a down pre-election year since Germany invaded Poland in 1939. With Q3 giving back some of the gains enjoyed during the first half of 2023, I expect a strong Q4 and a market bottom in October as I have been discussing in the blog for some time. There are a number of studies that point to November being an up month along with November and December being up. Additionally, November through January in a pre-election year is the best three-month period of the 48 months in a president’s term. Plainly put, stocks are supposed to rally from whatever low they see in October right into 2024.

To begin 2023, I thought bonds offered solid risk/reward. After all, the bond market had never been down back-to-back years until 2022. Surely, 2023 would not make it three straight. But the market has had other thoughts with bonds struggling throughout 2023. I have been dead wrong on that front. In Q3 the yield on the 10-Year Note went from just below 4% to almost 4.75% on its way to 5%. If my thesis on stocks is correct for Q4 then we should see bond yields fall and prices rally. I would not be surprised if the 10-Year fell below 4.5% and lower in early 2024 as the Fed concludes their rate hike cycle and economic growth begins to taper off.

When gold prices broke below what I viewed as the critically important area of $1900, I thought the bull market was in jeopardy. However, it looks more like a fake out to get rid of weak-handed bulls. I see gold marching to at least $2100 by early 2024 and conversations about a rate cut become more widespread. Crude oil continues to build a solid base for higher prices. Mid-$60s looks like a strong area where major buying will come in. Oil north of $100 is in the cards next year. Overall, commodities in general look like a potentially big winner for 2024 and a sector I think deserves a lot of investor attention.

The U.S. economy continues to defy gravity, even as Europe enters recession. It has been one enormous upside surprise. As I have discussed before, COVID has forced generational structural change to the economy, the enormity of which we are slowly beginning to grasp. Conventional economic research has continually failed post-2020, catching most economists off guard. With so much evidence pointing to a 2024 recession, this is really the last stand.With the vast majority of stocks lower on the year, tax loss selling should be a theme in Q4. In other words, the winners win more, and the losers lose more, especially in the widely held stocks. As always, we will do our best to harvest as many tax losses as possible and offer to inform you, in real time, where your taxable accounts stand. You can expect an email or two as we get closer to year-end.

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

Heritage Capital, LLC

Paul Schatz AIF

On Thursday we bought EEM and more levered NDX. We sold IVV and levered inverse NDX.


Paul Schatz, President, Heritage Capital