The Generator - January 2023
As soon as my wife got pregnant, she lovingly inquired if there was something special or extraordinary I wanted for our son’s arrival (which is very soon).
Me, laughing, said: “A generator. Picture a Michigan winter with the little guy running around the house. Now picture it without power. Something may go awry with our electrical grid at some point, and I don’t want to think of our family without a backup plan.”
This thought process is not so different from the one we take to protect our clients. You must safeguard and have backup plans in place before things happen, not after they do. By that time, it may be too late. If I wait to get a generator after the power goes out, I may not be able to get one, and it’s likely to be as egregiously expensive as that Snoo bassinet thing. (If you don’t what this is, think of the price of a used car these days.)
We aren’t going to make predictions about markets and the Fed, but we can prepare. Over the past few years, people have been led to believe that simply diversifying and utilizing an index is a safe bet. This type of first-level thinking and planning is simple but dangerous, particularly when indexes don’t account for underlying valuations.
Growth markets had been increasing for years and many people have been led to believe this was a permanent trajectory. This is precisely the time when you should be questioning this hypothesis. We did, and having been in this industry for 24 years, it is my strong belief that each person needs a plan tailored to his or her specific situation with a value-oriented investment discipline versus simply indexing.
Overview of April 2020 – December 2022
Howard Marks said it best in a few of his old memos: “We worry so we don’t have to worry.”
Over a long period of time, markets tend to become too euphoric and then, too depressed. They become emotional. Every 8-12 years, the economic environment – coupled with severe dislocation in the equity markets – forces one to take a more thorough evaluation. The basic concept is an analysis of whether I should strategically do something different for clients with a portion of their portfolios.
During the COVID market comeback of 2020, due to easing monetary policy, I took a harder look at the economic landscape again from a macro perspective. I questioned if we should de-risk with equity markets surging due to artificial stimulus. The goal wasn’t upside or gain; it was simply to do our best to protect clients versus giving in to the simple first-level thinking of the general market.
Two very strong forces seemed generationally out of whack: interest rates coupled with growth stock valuations.
- Interest rates went to ZERO following a time when they were abnormally low pre-COVID.
- Growth stock valuations became historically high with only the tech bubble seemingly higher.
- This became inflamed with in-vogue, risky behavior in conjunction with easy monetary policy and stimulus (e.g., meme stocks, IPOs, crypto trading, FAANGs).
Something seemingly had to change, but one must approach investing with the humbleness to accept that you can be wrong for years. If you hear anyone say they know what’s going to happen next year, please take what they say with a grain of salt. If Buffett, McClennan and Marks don’t know, then I don’t either. Plus, the Federal Reserve has been permanently accommodative in recent years.
However, the change came to fruition in 2022, just when it became apparent to many that the growth euphoria would last forever. There is no free lunch in markets and in life. The growth market ended with war and serious inflation. And the Fed suddenly realized they were way behind the curve. Low rates were still encouraging more risk taking, amidst inflation. The Fed was even doing more Quantitative Easing into May of this past year. As the Fed looked for more relief, they realized they had to pivot – and drastically.
They were forced to aggressively raise rates to try to cool things off to prevent hyperinflation after 40 years of easy policy. And more rate hikes were going to be needed through the end of the year and even into 2023. Bonds and stocks fell precipitously, and the most negatively affected were those growth stocks, which were already over-valued to begin with, and we warned against.
Our last few newsletters (specifically 2020 and 2021) we pointed out the potential danger of the growth markets and longer bonds. Never in my wildest dreams did I think rates would head this far north this fast, but our overall thematic view was correct. When rates go up, both stock and bond valuations must come down.
And they both did. See below.
The average U.S. stock fund finished the year down roughly 17%, with the average large-value fund down about 6% versus the large-growth funds down an average of 30%. Perhaps even more damning was the bond market. See below.
Bond mutual fund and exchange-traded fund performance saw some of the largest losses in history. Thanks to the stubbornly high inflation, U.S. core bond funds (strategies generally used as the basic building blocks of portfolios) lost an average of roughly 12% in 2022, high-yield funds are down an average of about 9%, and inflation-protected bond funds have lost some 8%. (Source – Morningstar)
Our Strategic Allocations – Post Covid-19
Over the past few years prior to this year’s selloff, we reduced long-term bond exposure and moved even more to value-oriented investment theme for some. At times, this felt like watching paint dry. But this year, boring is suddenly sexy. Jim Cramer screams that cash flow and balance sheets are “now important again.” What an oxymoron.
I’m pleased with our equity manager lineup (Yacktman, FPA, First Eagle, and TRP Capital Appreciation). Collectively they have performed well this year vs their respective benchmarks, and more importantly, over multiple market cycles. (Source: Morningstar.)
Short-term performance when the market is down is much more important than when the market is up. If you are down 6-8-10-12% for the year with the market down 20% and bonds down 12%, this is good performance. Although I hate to see negative absolute numbers, overall, I’m very pleased with the performance of this past year, especially of our core holdings with First Eagle. More importantly, I’m proud we were proactive instead of reactive.
I’m continually focused on winning by not losing. We remain value-conscious with ballast and protection in your portfolio. The former manager of First Eagle, Jean Marie Eveillard, famously stated that he stayed up at night focused on how to protect vs how to profit. Investors ultimately profit long-term from protection.
The key is thinking about the generator. We are consistently aiming to protect, with the understanding that the future remains uncertain. If things get worse, our defensive, value-conscious strategies should serve us well. Your generator is a combination of liquidity, bond alternatives, fixed rate investments, income strategies, and gold.
Continue to think long term. Our investment managers and lineup have done some of their best work in tougher environments. Our portfolios are built to weather storms.
We value your business.
Happy New Year.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.
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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Asset allocation does not ensure a profit or protect against loss