***Q4 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.
With the clock striking midnight on December 31st, the single worst year in diversified investing of the modern era ended. While it was a very challenging year for stocks with most of the larger indices down -20% to -30%, it was not a precedent setter. Twice this century, the stock market lost more than 50%, 2007-2009 and 2000-2002. And I have repeatedly stated with high conviction that 2022 is not part of a larger, more secular bear market with losses in the 50% area.
Although the stock market gets the salacious headlines, 2022 was about the bond market and the continuation of the single largest and longest decline in history. For more than a decade, I have pointed to a coming wealth decimation at some point that would do more damage to retirees than any stock market collapse. That would be in the bond market because once you hit the 0% boundary and accepted that negative interest rates would not be happening in the U.S., it was only a matter of time before rates would rise due to inflation.
Let’s not forget that the bond market is much larger than the stock market and investors have spent decades loading up on total return and index bond funds as they have acted like ATM machines for 40 years. Several times I thought the party ended, in 2012 and again in 2016. We now know that it took a global pandemic and catastrophic mistakes by the Federal Reserve to end the greatest bull market in history in March 2020. That is bonds not stocks.
Turning to the quarter at hand and the time period of this report, the markets began Q4 on shaky ground as the final bottom I had been looking for in Q4 was hammered in by mid-October. Stocks and bonds rallied smartly for a solid 6 weeks and besides a mild to modest pullback, I thought that trend would continue into January. To my surprise, the stock market fell almost 10% into its December low and barely got off the mat before the quarter ended. While that decline did not damage the markets’ underpinnings nor my still positive outlook, it certainly impacted returns for Q4 and left investors with coal in their stockings.
Q4 was a busy one around the globe. After resigning from office in July, UK Prime Minister Boris Johnson watched his successor, Liz Truss, last less time in office than some of our vacations. The war in Ukraine waged on with no end in sight, yet the commodity market saw little to no impact for the second straight quarter. Argentina won the World Cup and the Houston Astros won the World Series.
In what has become a complete and utter soap opera, Elon Mush of Paypal, Tesla and SpaceX fame agreed to close his deal to buy Twitter in what will likely end up rivaling AOL’s purchase of Time Warner as the overpayment of the decade. While I have always thought of Musk as an unhinged lunatic without regard for consequences, you simply cannot argue with his string of corporate successes. He’s a visionary who transcends corporate America.
Elsewhere, the U.S. had its midterm elections in November and the outcome was very much in line with what I wrote on the blog. The House went red by a slim margin and the Senate a little bluer. I did not see this as a market moving nor economic event in real-time and the only impact for investors is that gridlock returns to Washington. That is a good thing, historically, as neither party gets what they want and additional spending is unlikely to pass.
As the cryptocurrency market continued to implode, it became obvious who was skinny dipping when the tide went out. The incredible rise and lightning-fast collapse of Sam Bankman-Fried and his FTX empire was the biggest market story of Q4. He literally went from attempting to rescue companies on the brink to needing a rescue himself. As his $10+ billion empire quickly evaporated to dust, Twitter reminded us of all the rich and famous who backed SBF, the media who couldn’t stop gushing about him and even those who labeled him the JP Morgan of Crypto. In the end, big institutional money who fancies themselves as the smartest investing minds on earth with the most arduous and stringent due diligence processes were completely embarrassed in what has been labeled Madoff 2.0.
Speaking of 2.0, as 2022 ended, Congress finally passed The SECURE Act 2.0 which has wide-reaching implications for retirees, inheritances and RMDs. While there is lots to chew on that we will cover in our private update meetings, the timeliest piece impacts those turning 72 in 2023 as the rules on RMDs have changed. Overall, it’s a big winner for those who have planned properly and will plan their retirement futures going forward.
Turning to events that did impact the markets, China’s zero policy had wide-reaching consequences for their economy as well as the western world. However, it seems as though Xi has quietly abandoned his stance and China’s reopening 2.0 is well underway. Of note, Chinese stocks which also bottomed in October soared in Q4 and that will likely continue well into 2023 where easier monetary policy will become a theme. As you know, it’s not what the news is, but how markets react.
Economically, the U.S. grew by 3.2% in Q3 and I fully expect a moderately positive number when Q4 is released this month. It wasn’t long ago when I was wasting time fighting with folks on Twitter who insisted the U.S. was in recession after Q2 because there were back to back negative quarters of GDP growth. Economic data somehow became political. Inflation continued to decline from generationally high levels to what should be a new normal between 3% and 4%, which will force the Fed to reassess their 2% goal or just change the formula for how it is calculated.
The job market remained very strong, much to my surprise as well as economists. The economy created more than 200,000 new jobs in all three months of Q4. There have clearly been major structural changes here caused by or as a result of Covid that have been difficult to quantify. Employment data is the most lagging of all and that’s what the Fed continues to target with their interest rates hikes. While I do not envision massive job losses like we saw in 2008-2009, the economy started to see and should continue to see major layoffs in the technology sector and beyond.
In Q4 the Federal Reserve hiked rates twice, 0.75% in November and 0.50% in December, bringing the total for 2022 to 4.25%. At the same time, the various yield curves which are simply the difference between a long-term and a short-term interest rate became more negative or inverted. Yield curve inversion is a classic sign of impending recession. It is beyond a sign of resilience that more economic damage wasn’t done although it does take 3-9 months before the Fed’s moves are seen in the numbers and yield curve inversions can often take a year to be fully felt.
The Fed continues to fight yesterday’s battle as they have done for decades at the expense of Americans and the economy. They should be fighting today’s battle. Although the Fed heads seem unified in their theme of higher rates for longer, I fully doubt they will be resolute if and when the economy is shedding 50,000+ jobs a month and unemployment is over 4%. I do not believe Jay Powell is strong enough to face a bipartisan skewering from Congress. But by then, it will be too late.
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.
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.
2022 was challenging for almost all investors to some degree, but especially those who focus on bonds, seeing unprecedented losses. While I am not minimizing the pain growth and technology investors felt, it was not their first rodeo and with the potential reward comes the risk. On October 14th, I wrote that the markets just put in a significant low, if not the bear market bottom. It was too early to decipher which one, but I had high conviction at that time. While the December decline threw a monkey wrench in what was to be a very strong quarter, it did not shake from conviction going forward.
If you have read the myriad of blogs or watched my videos or media segments, much of what I am about to write has already been shared. In my 2023 Fearless Forecast I called 2023 The Year of the Bull as most markets should end higher 12 months from now. The masses and pundits mostly scoff at the idea that better times are ahead so soon with the backdrop of lower but still elevated inflation, an overly zealous Federal Reserve and a weakening economy.
Since Germany invaded Poland in 1939 we have not seen the third year of a president’s term close down for stocks. 2019, 2015, 2011, 2007, 2003, 1999, 1995 and 1991 in recent memory. Weak midterm election years like we saw in 2022 are almost always followed by outsized years, averaging 30%. 2019, 2003, 1999, 1995, 1991 were all strong years. Since WWII, back to back down years in the stock market have only been seen in 1974, 2001 and 2002. The odds heavily favor 2023 rewarding the bulls with returns well above 10% and possibly a lot higher.
On the fixed income side, interest rates soared from their 2020 historic lows to their highest levels since 2007. In recorded history there has never been a move like we saw last year. My thesis is that all rates not associated with what the Fed controls have already peaked and the Fed’s rates will be peaking during the first half of 2023. With that, I see 2023 as a good year to own bonds with my most likely scenario seeing 10%+ returns.
The U.S. economy should continue to weaken and dip into a mild recession. Housing is already very weak from the surge in mortgage rates. Manufacturing has rolled over to recessionary levels. The Conference Board’s Leading Economic Indicators have rolled over. Layoffs in tech land continue. Perhaps most importantly, the various yield curves have been inverted for a long time and to a deep level. They have a 100% accuracy rate. However, if I am wrong and the Fed does engineer the elusive “soft landing” like 1995, I will point to the resilience in the very lagging employment market as the key while stocks soar 30%+.
Fed Chair Jay Powell & Co. are close to ending one of the most vicious rate hike cycles in history. While I do not think they will fully pivot and cut rates anytime soon, a move to neutral is warranted already. In 1995 by the time the Fed stopped in February the stock market was already at all-time highs. I said that 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. That has happened.
In Q1, I look for stocks to rally and may surprise to the upside. If I am wrong we will know in January when dozens of companies lower Q1 earnings guidance and fall more than 5%. That would tell me that not enough bad news is priced in like I think it is. Remember, the average decline for stocks is 25% when a mild recession happens. At the 2022 lows, the S&P 500 was down 25% which is why I keep saying that much or all is priced in. Bonds and gold should also rally in Q1.
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. We look forward to sharing that with you over the coming years. And 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. Again, here is the link to my calendar to schedule a meeting in the office, call, Zoom meeting or Skype. https://schedulewithpaul.as.me/
Thank you for the privilege of serving as your investment adviser!
Sincerely,
Heritage Capital, LLC
Paul Schatz AIF®
President
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