Taking Advantage of Time

July 5, 2022 – After six months and a 20% loss, we are well into a bear market for the S&P 500. Bear markets are part of investing, and greater returns do not come without acceptance of risk. In last quarter’s letter, we discussed the causes underlying the current market weakness. While each new economic headline you see in the news affects the markets to some extent, short-term economic predictions are not reliable or particularly useful.

Chairman Powell has said the Fed will remain data dependent: relying on various upcoming data points including inflation to determine how fast and how far the Federal Reserve will have to raise rates. The past few weeks there have been positive signs such as commodity prices easing, demand slowing, and long-term interest rates declining. Whether the U.S. economy will post a second straight quarter of negative Gross Domestic Product growth, the textbook definition of a recession, is still yet to be seen. Throughout the month of July, we will see the regular monthly numbers such as inflation and employment. We will also see quarterly numbers including GDP and corporate earnings and guidance.

Fortunately, we don’t have to make short-term predictions. We have the advantage of time. We can consider market prices and form an opinion about what influences are already factored into those prices. The markets and the economy are related but not the same. Market prices and economic data don’t move in sync. In past business cycles, the market has bottomed and started a lasting recovery several months prior to the economy reaching a low. Given recent negative consumer sentiment and the disposition of this market, a mild recession is likely already priced in. This minimizes downside risk to some extent and offers more upside. Historically, markets look ahead, anticipating changes and factoring in the potential that lies six to nine months in the future. That outlook is priced into investments well ahead of the results later reflected in short-term economic data.

The seeds of wealth creation are sown during bear markets. We look for opportunities to add quality assets at very reasonable prices. We will look back at this summer and see we had the opportunity to buy great companies at bargain prices: Apple down 29%, Microsoft down 31%, JPMorgan down 36%, Starbucks and Amazon down 46%, and NVIDIA Corp down 57%.Market declines additionally offer opportunities to rebalance assets and make sales with an eye toward future tax benefits. In October, we discussed how we construct portfolios with sufficient low-risk assets, such as cash and short-term fixed income, to provide the cash flow needed to last several years. This prevents investors from being forced to sell risk assets during a period a price decline.

Due to the market pull back, U.S. stocks are, in our view, the most preferred of the major asset categories. Former pandemic beneficiaries such as new digital technologies, biotech, real estate, and communications services have given back much of the outsized gains of the last two years. Sectors such as energy, utilities and health care have held up better in this time of rising prices. Year-to-date, the growth segment of the US market is down 34%, while value stocks are on average off 7%. We are emphasizing quality – strong corporate balance sheets and profitability – over fast revenue growth.

Global growth is expected to slow, driven by sanctions on Russia and rate hikes by major central banks around the world. This could help ease the relentless rise of the U.S. Dollar and, in turn, benefit foreign investments. Emerging markets may face a headwind, with higher borrowing costs and a slowdown in China. We intend to maintain our target allocations in foreign stocks, while considering geographic region exposure and economic sector weighting.

Fixed income, strategically managed, offers opportunities with bond yields now higher than dividend yields on stocks. We are taking advantage of higher interest rates to make a partial move from defensive short-term and floating-rate positions to longer-term, high-quality bonds. With a slowing economy, we are cautious regarding credit quality, favoring higher quality with longer duration. We “ladder” portfolios of individual bonds with two through six-year maturities. We use tax-exempt municipal bonds in taxable accounts, which are increasingly attractive on a tax-adjusted basis. Corporate, taxable municipals, CD’s, government, and agency fixed income are the choice for IRA accounts. Since we hold bonds to maturity, market price changes during their term do not affect portfolio results. Laddering gives us the opportunity to reinvest maturing bond proceeds in longer maturity bonds at the new, higher yields.

Although we provide an overview of many areas of the market, our focus when managing your portfolio is on your personal goal and an individualized strategy to reach that goal. We welcome your feedback and questions.