The LTWM Insider – Market and Economic Commentary Q1 2022

Executive Summary 

“Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.”

Warren Buffett, legendary investor

Have stocks peaked in January, marking the first quarter the start of a new bear market; or is this a pause prior to climbing to new record highs? We are all hearing plenty of forecasts of recession since more viewers tune into the news when they hear the word “recession”. We recommend you tune out the news.

Stocks peaked in early January and bottomed on March 14th, then rallied more than 6% during the last two weeks of the quarter. It was a volatile quarter for stocks and bonds. All indications suggest that the economic business cycle is still expanding, and as of this writing, all leading economic indicators point to continued growth. The World Bank recently reduced global growth forecasts, expecting growth to decelerate from 5.5% in 2021 to 4.1% in 2022 and 3.2% in 2023, but global growth is expected to be positive.

For the U.S. markets, the big question for the coming quarter is how well the Federal Reserve Board of Governors (the Fed) will navigate its monetary policy for a soft economic landing. The Fed is in a very difficult situation as it aims for slowing the economy by raising short-term interest rates to bring inflation in line with its target (2% long-term average), without disrupting the current projection of continued economic growth.

In March the Fed implemented a restrictive economic move by increasing a key rate, the overnight lending rate, up 25 basis points (or 0.25%) from zero.  Such a move typically effects short-term rates.  Later in March, when the minutes from the last board meeting were released, we learned that the Fed discussed reducing its balance sheet (selling bonds) at a rate of $95 billion per month or $1.1 trillion annually. This move is anticipated to affect the longer-term interest rates. Together, both moves have already shifted the entire yield curve up and are having a slowing effect on the US economy. While the more important goal is to bring inflation closer to the Fed’s long-term target of 2%, there is a large lag, so it will take time for the prices we pay for goods to decline. Crude oil and most commodity prices are already down from their highs. Higher mortgage rates are cooling the housing market.

Major central banks around the globe are moving much slower with raising interest rates to fight inflation. Europe and Japan have chosen to support growth in their local economies over fighting inflation. Both major economies are more directly affected by the trade disruptions due to economic sanctions against Russia.

War broke out in Ukraine and the past shows us that stock corrections from geo-political events are short-lived unless the event leads to a recession. Naturally, the correction that started out associated with Ukraine and worldwide sanctions against Russia has moved to a discussion about the probability of recession, which many place in the hands of the Fed. However, it will also be based on the decisions of hundreds of millions of consumers that currently have cash and jobs. Consumer spending represents 70% of Gross Domestic Product (GDP) and there is a reason for the famous phrase, “don’t bet against the American consumer.”

History tells us stocks can continue up in the face of increasing interest rates, if inflation is not too hot, or growth does not stall. Important economic indicators we monitor regularly include consumer spending, consumer confidence, productivity, unemployment, and corporate earnings. Despite the Fed’s restrictive economic stance, we remain cautiously optimistic on the strength of the American consumer to weather the more restrictive monetary policy and believe optimistic returns are in the future for globally diversified portfolios with a value and size bias. We also know the stock market is unpredictable in the short term and volatility should be expected.

You don’t own the highs, you don’t own the lows, you own the long-term performance of your portfolio. The best course of action is to focus on the decisions you can control to achieve the success of your financial plan. We are here in your support and would be happy to answer any questions or concerns.

For those who would like a deeper dive into the details, please continue reading…

World Asset Class 1st Quarter 2022 Index Returns

U.S., International Developed, and Global Real Estate stocks were all down in the first quarter. U.S. and Global Bonds were also down (worst quarter for US Bonds since 1980) as the level of interest rates increased on short and longer maturities due to stronger than expected inflation. For the broad U.S. Stock Market, the first quarter return of -5.28% was well below the average of 2.4% since January 2001. International Developed Stocks returned -4.81%, which was below the long-term average quarterly return of 1.6%. Global Real Estate Stocks returned -3.81%, well below the asset class’s average quarterly return of 2.6%.  Emerging Market Stocks returned -6.97%, below the average quarterly return of 2.8%. While supply chains have improved, production has not met demand and the resulting higher inflation, along with a late reacting Fed, created an environment with elevated recession risks. This increased economic uncertainty sent stocks down for the quarter. Here is a look at broad asset class returns over the past year and longer time periods (annualized):

Global Real Estate stocks (as defined by the S&P Global REIT Index) led all categories with a strong 18.97% return in the last year. The U.S stock market (as defined by the Russell 3000 Index) gained 11.92%, while International Developed stocks were up 3.04% over the past year. Emerging Market stocks lagged with a one-year return of -11.37%. Over the past five years, U.S. stocks were up 15.4% annually, while International Developed stocks were up 7.14% annually, Emerging Market stocks were up 5.98% annually, and Global Real Estate stocks were up 7.1% annually. Over the past 10 years, the U.S. stock market (up 14.28% annually) is well ahead of International Developed (up 6.25% annually) and Emerging Market (EM) stocks, which are up 3.36% annually over the past 10 years. We continue to believe EM might be the place to be for the next 10 years, due to much lower valuations and higher growth as the pandemic ends. We are seeing issues with supply chain disruptions as China continues large lockdowns and the war in Ukraine has created new supply chain issues.

Taking a closer look within U.S. stocks in the first quarter, we can see that market wide results were down -5.28%, value overwhelmingly outperformed growth across large cap stocks. Large Value stocks were ahead of Large Growth stocks by more than 8% and Small Value stocks beat Small Growth stocks by more than 10%. Overall, small cap stocks underperformed large cap stocks during the first quarter of 2022.

If we extend our analysis of U.S. stock over longer time periods, large growth is still the leading asset class over 1, 3, 5 and 10 years. However, the return of inflation and higher interest rates reduces the attractiveness of growth stocks, since their large future cash flows are discounted at higher rates, reducing the net present value. Growth stocks are having a challenging start to the second quarter of 2022.

International Developed Stocks were negative, except Large Value, which was up 3.5% in local currency, up 1.5% in US dollars, and a lone bright spot in the first quarter. The value premium (value-growth) was very large, while the size premium was negative (small cap stocks underperformed large cap stocks). The currency effect served as a headwind to international stock returns during the quarter, as US currency returns were lower than local currency returns. Our investment funds are priced in U.S. dollars and the dollar was strong during the first quarter.

Value was better than growth in the last quarter and the last year for International Developed Stocks. Over longer time periods, the value premium (value-growth) is negative for the past 3, 5 and 10 years. The size factor premium (small cap-large cap) is now negative in the past quarter and year, but it is positive over the past 3, 5 and 10 years. There is still plenty of room for value to catch growth over longer time periods in the future.

The U.S. economy is still moving forward in a new business cycle, but we are past the peak growth of the early stage, and now we have an increased probability of recession in the next 18 months with a Fed that may stall the economy in its fight to control inflation. It is a difficult task of balance, since acting to aggressively will slow the economy into a recession and not acting enough will cause high inflation to stall growth (stagflation). Higher prices is an extra burden on all households and hurts those living paycheck to paycheck the most.

The latest jobs report for March had employers adding 431,000 new jobs, which was below expectations of 490,000, however, unemployment dipped to 3.6%. The same jobs report had a positive revision for February, which initially reported 678,000 but was revised up to 750,000 on 4/1/22, much stronger than expectations of 440,000. In January, the U.S. added 467,000, well ahead of expectations of 150,000; and way better than 199,000 jobs added in December. Total employment is at 150.9 million workers, identical to levels in July of 2019 and very close to the pre-pandemic peak, which was just above 152 million workers. The U.S. job market is very tight; and remains supportive of the current business cycle expansion.

The Conference Board’s Economic Index of leading indicators has been positive for the past year, signaling expectations of continued strength in the business cycle. Consumer demand is so strong for long term purchases like residential homes, that many analysts hope the higher mortgage rates will slow the housing market and allow home supply to catch up with demand. It is very clear the Fed is behind the curve in addressing inflation, however, recent aggressive actions, including the potential of multiple 50 bps hikes at the short end and quantitative tightening (selling bonds), which raises rates at the long end, has steepened the yield curve to move it out of inversion. An inverted yield curve, with long rates lower than short rates, is a strong signal of a pending recession in the next 12-18 months.

The ECB and the Bank of Japan are nowhere near as aggressive as the Federal Reserve, instead choosing to keep monetary support accommodative. It may work to ignore inflation due to the strong restrictive effects of war in the region. The whole world continues to hope for a negotiated solution to end the physical war. Stock markets in South America are doing very well to offset weakness in stocks from Eastern Europe and China. In all regions, value stocks are performing better than growth stocks.

Shifting the commentary to fixed income, bond market returns around the world were negative during the first quarter, due to a significant jump in rates at the short end of the curve (1 to 5 year maturities). The yield on the 5-year Treasury note increased by 116 basis points, ending the quarter at a yield of 2.42%. The yield on the 10-year Treasury note increased by 80 basis points, ending the quarter at a yield of 2.32%. And the 30-year Treasury bond yield increased by 54 bps to 2.44%. Here is the U.S. yield curve, and you can see how yields jumped at the short end to make the curve flat from 2 years out to 30 years (current yield curve in grey, one quarter ago in blue, and one year ago in green):

Notice below, the highest first quarter and only positive bond return is for the US 3-Month Treasury Bill Index, while the US Government Bond Index Long was down over 10%. The most positive index over the last year is the Bloomberg U.S. TIPS Index (inflation protected treasuries), which was up 4.29% for the past year. Over longer periods, the best returns are within High Yield Corporate Bonds, due the strong performing U.S. economy in the past decade. Here are the period returns:

The Federal Reserve’s sudden pivot to a more aggressive/restrictive monetary policy created larger than normal losses for bonds, even the highest quality bonds. This is due to the bond pricing formula for the bond duration, which is the constant that determines how much bond prices decline with an increase in interest rates.

The Change in Bond Price = - Duration x the Change in Interest Rate

Bond duration is the same as maturity for a zero-coupon bond and is slightly less than the maturity of a coupon paying bond. So, if you own a bond fund with a duration of 4, then you would expect it to lose 4% of value for every 1% increase in interest rates. The longer the duration of the bond fund, the more it will lose as interest rates increase. This is the reason, LTWM targets a bond duration below 5, to remove the volatility associated with higher bond durations. As interest rates increase, it does reduce the value of the current bonds in the bond fund; but allows the bond fund portfolio manager to purchase new bonds at higher yields, as the lower yielding bonds mature. History is filled with examples of bond funds doing well during periods of increasing interest rates. As the production bottle necks resolve, the housing market cools, and aggregate supply can meet aggregate demand, inflation should decline as we get into the summer months.

One cannot time markets and typically the short term is just noise. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term). We encourage you to tune out the financial news, since major news sources have a bias toward negative headlines; and often the headlines of the day have very little to do with the direction of stocks.

CONCLUSION

We would also like to share a timely piece from our friends at Dimensional on why it is not a good idea to consider selling stocks as a tactical strategy:

Is It Time to Sell Stocks?

Weston Wellington, Vice President, Dimensional Fund Advisors (DFA)

After touching record highs in early January, US stocks1 have slumped, and investors have been confronted with worrisome headlines2 in the financial press:

“Inflation Hits Fastest Clip Since ’82”

—Gwynn Guilford, Wall Street Journal, January 13, 2022

“Economists Cut Back Growth Forecasts as Threats Pile Up”

—Harriett Torry and Anthony DeBarros, Wall Street Journal, January 18, 2022

“Giant Stock Swings Send Some Into Bear Territory”

—Gunjan Banerji and Peter Santilli, Wall Street Journal, January 18, 2022

“Markets Drop as Turbulent Trading Persists”

—Gunjan Banerji and Will Horner, Wall Street Journal,
January 26, 2022

“Fed Set to Start Increasing Rates by Mid-March”

—Nick Timiraos, Wall Street Journal, January 27, 2022

Some stocks that attracted intense interest last year have fallen sharply from their previous highs, as Exhibit 1 shows.3 

Is rising inflation a negative for equity investors? Do large losses in a handful of popular stocks signal a downturn ahead for the broad market?

Invariably, the question behind the question is, “Should I be doing something different in my portfolio?” This is just another version of the market timing question dressed in different clothes. Should I sell stocks and wait for a more favorable outlook to buy them back? More precisely, can we find clear trading rules that will tell us when to buy or hold stocks, when to sell, when to admit our mistakes, and so on?

The lure of successful trading strategies is seductive. If only we could find them, our portfolios would do so much better.

Consider Felicity Foresight. She is gifted with the ability to identify patterns in the champagne bubbles floating to the top of her glass on New Year’s Eve, enabling her to predict the best performer between S&P 500 stocks and US Treasury bills over the subsequent 12 months. How would her hypothetical portfolio have performed over the past 50 years following this simple annual readjustment strategy?

Rather well. Following a Perfect Timing strategy by investing in the best performer each year, she turned $1,000 into $1.8 million, nearly 10 times the wealth produced using a buy-and-hold strategy for the S&P 500 Index (see Exhibit 2).

But also consider Hapless Harry. He was never a fan of New Year’s and manages to get it wrong each and every year. His Perfectly Awful strategy winds up losing money over the same 50-year period.

Motivated by the substantial payoff associated with successful timing, researchers over the years have examined a wide range of strategies based on analysis of earnings, dividends, interest rates, economic growth, investor sentiment, stock price patterns, and so on.

One colorful example, known as the Hindenburg Omen, had a brief moment of fame in 2010. Developed by a blind mathematician and former physics teacher, this stock market indicator took its name from the German airship disaster of 1937. The Omen signaled a decline only when multiple measures of 52-week high/low prices and moving averages all turned negative. This indicator had correctly foreshadowed major downturns in 1987 and 2008. When it flashed a “sell” signal on Thursday, August 12, 2010, internet chat rooms and Wall Street trading desks were buzzing the next day, Friday the 13th, with talk of a looming crash, according to the Wall Street Journal.4 But no crash occurred, and the S&P 500 had its highest September return since 1939.5

The money management industry is highly competitive, with more stock mutual funds and ETFs available in the US than listed stocks.6 If someone could develop a profitable timing strategy, we would expect to see some funds employing it with successful results. But a recent Morningstar report suggests investors should be wary of those claiming to do so. The report examined the results of two types of funds7, each holding a mix of stocks and bonds:

• Balanced: Minimal change in allocation to stocks

• Tactical Asset Allocation: Periodic shifts in allocation to stocks

As a group, funds that sought to enhance results by opportunistically shifting assets between stocks and fixed income underperformed funds that simply held a relatively static mix (see Exhibit 3). Morningstar further pointed out that if the performance of non-surviving tactical funds were included, the numbers would be even worse. Its conclusion: “The failure of tactical asset allocation funds suggests investors should not only stay away from funds that follow tactical strategies, but they should also avoid making short-term shifts between asset classes in their own portfolios.”8

We should not be surprised by these results. Successful timing requires two correct decisions: when to pare back the allocation to stocks and when to increase it again. Watching a portfolio shrink in value during a market downturn can be discomforting. But investors seeking to avoid the pain by temporarily shifting away from their long-term strategy may wind up trading one source of anguish for another. The initial upsurge in prices from their lows often takes many investors by surprise, and they find it extraordinarily difficult to buy stocks that were available at sharply lower prices a few weeks earlier. The opportunity cost can be substantial: Over the 25-year period ending in 2021, a hypothetical $100,000 invested in the stocks that make up the Russell 3000 Index would have grown to $1,036,694.9 But during this quarter-century, missing just the best consecutive 90-trading-day period (which ended June 22, 2020) shaved the ending wealth figure by an alarming 33%.10

Add to this the likelihood of increased transaction costs and the potential tax consequences of a short-term trading strategy, and the odds of adding value through market timing grow even slimmer.

As a thoughtful financial advisor once observed, “A portfolio is like a bar of soap. The more you handle it, the less you have.”

Standardized Performance Data and Disclosures

Russell data © Russell Investment Group 1995-2020, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2020, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2020 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2020 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.

Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities.  Diversification does not guarantee investment returns and does not eliminate the risk of loss.  

Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Principal Risks:

The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.

Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.

The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.

Fixed Income Portfolios:

The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.

Risk of Banking Concentration:

Focus on the banking industry would link the performance of the short-term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.

The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities.  The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such.  The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information. 

Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements.  Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time.  Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.

Lake Tahoe Wealth Management, Inc.is a Registered Investment Advisory Firm with the Securities Exchange Commission.