The LTWM Insider – Market and Economic Commentary Q4 2022
Executive Summary
Stocks and bonds rebounded in the fourth quarter after three down quarters in 2022. Not enough to offset losses for the year, but the bullish trend has continued in January. The Fed, after botching the initial read of “transitory” inflation, had to catch-up with strong actions to slow the economy in its attempt to bring down inflation. The overnight lending rate has moved from 0% in the first quarter to 4.25% currently, a heavy brake on economic activity. Higher mortgage rates have successfully slowed the housing market and used car prices are down significantly.
The question every investor is asking, “will Fed actions lead to a hard or soft landing for the economy?” A soft landing will very likely mean the stock lows of mid-October will remain behind us. If inflation is more stubborn, the Fed will continue aggressive actions, which could send stocks down to new lows. It is not about the Fed, it is all about inflation. The next CPI report is expected to show no growth in month over month inflation.
We remain cautiously optimistic on the strength of the American consumer to make it through this period of higher inflation and believe better returns are in the future for globally diversified portfolios with a value and size bias. The last S&P 500 peak was on January 5th and the asset classes and stocks with the highest valuations are down the most, value stocks are down the least, which has helped LTWM portfolios during 2022 and so far in 2023. We expect the trend to continue.
We would like to remind everyone that you don’t own the highs and 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 to support your continued success 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 4th Quarter 2022 Index Returns
U.S., International Developed, Emerging Market and Global Real Estate stocks were all positive in the fourth quarter, a reversal of the down momentum from the previous three quarters of 2022. U.S. and Global Bonds were also positive as the level of interest rates decreased on short and longer maturities. For the broad U.S. Stock Market, the fourth quarter return of 7.18% was well above the average quarterly return of 2.1% since January 2001. International Developed Stocks returned 16.18%, which was significantly above the long-term average quarterly return of 1.5%. Global Real Estate Stocks returned 6.88%, above the asset class’s average quarterly return of 2.2%. Emerging Market Stocks returned 9.7%, above the average quarterly return of 2.5%. The global supply chains are still experiencing production issues, but it does appear the peak in inflation is behind us. The Federal Reserve reduced its rate hike to 50 bps at its last meeting, in response to lower inflation readings. With peak inflation behind us, stocks rallied during the quarter, but not enough to overcome the losses in the previous three quarters. It may be a while before stocks reach a new record high, but it is very probable they will. Here is a look at broad asset class returns over the past year and longer time periods (annualized):
For the full year, International Developed stocks led all broad categories by declining the least, down -14.29% in 2022, overtaking U.S. stocks due to a very strong fourth quarter return. U.S. stocks were down -19.21%, Emerging Markets stocks were down -20.09% and Global Real Estate stocks, down -24.36% during 2022. The U.S. Bond Market lost -13.01% and Global Bonds were down -9.76% for 2022, significant losses for bonds. LTWM fixed income decisions during 2022 resulted in much lower losses for client portfolios. Over the past five years, U.S. stocks were up 8.79% annually, while International Developed stocks were up 1.79% annually, Emerging Market stocks were down -1.4% annually, and Global Real Estate stocks were up 0.92% annually. The U.S. Bond Market was up only 0.02%, flat for the past five years, while Global Bonds were up 0.52%. Over the past 10 years, the U.S. stock market (up 12.13% annually) is well ahead of International Developed (up 4.59% annually) and Emerging Market (EM) stocks, which are up only 1.44% annually over the past 10 years. We continue to believe EM might be the place to be for the next 10 years. EM stocks did perform better than U.S. stocks during the fourth quarter of 2022 and are well ahead so far in January 2023.
Taking a closer look within U.S. stocks during the fourth quarter, we can see the significant outperformance of value stocks, with Large Value leading, up 12.42% and Small Value second, up 8.42%, both ahead of the Marketwide results of 7.18% and well ahead of Small Growth (up 6.23%) and Large Growth (up 2.2%). The large cap value factor premium was very large in the fourth quarter.
If we extend our analysis of U.S. stock over longer time periods, Large Value stocks have increased its lead for the past year. Large growth is the worst asset class over the past quarter and 1 year, but still leads over 3, 5 and 10 years. The trend of value outperformance is strong and is likely to continue for some time. The lofty valuations of growth stocks continue to decline. In fact, during 2022, historically high growth Meta (parent of Facebook) officially became a value stock. It is worth noting that Market wide results for the past 10 years are very strong, up 12.13% annually.
The U.S. business cycle still looks to be in the late stages of recovery from the global pandemic, and the strong belief that the Federal Reserve will land the economy in recession with its heavy-handed tools to fight inflation sent stocks and bonds down together for three quarters. However, the American consumer has weathered the inflation storm so far and holiday spending was respectable. We still believe it is difficult to see a heavy recession with the job market still so strong. The average wage earner is doing well; and jobs are still plentiful. The U.S. job market remains very tight; and until it breaks down, we are not likely to experience a hard landing from the Fed. However, it is difficult, if not impossible for the Fed to fight supply side inflation by using demand side destruction tools, which is all they have. A better process would be to increase the supply of all goods, which have been hampered by numerous covid era policies, including paying people not to work, vaccine mandates, and the zero-tolerance policy of China. Also, the work from home era has caused many in the working population to embrace quiet quitting, which is doing the minimum required work to keep your job. Many in the working class struggling with monthly cash flow are taking on a second job to make ends meet with the high inflation. U.S. inflation is expected to be flat to down in the coming months. China has just opened its borders and relaxed its zero covid policy. It is probable that just in time supply chains start working well again.
In a reversal from previous quarters when the dollar strengthened, International Developed Stocks were up in local currency, and up significantly more in US dollars, since the dollar depreciated against most foreign currencies. The Euro went from below parity with the U.S. dollar in the third quarter, $0.96, to its current value of $1.07. It is still down from $1.18 just over one year ago. Currencies normally don’t display this much volatility. The value premium (value-growth) was strong, while the size premium was negative (small cap international stocks underperformed large cap international stocks) during the 4th quarter. The currency effect served as a strong tailwind to international stock returns during the quarter, as US currency returns were much higher than local currency returns. Our investment funds are priced in U.S. dollars (unhedged):
Over longer time periods, the value premium (value-growth) is positive over the past 1 year and now 3-year period, but still negative for 5 and 10 years. The size factor premium (small cap-large cap) is negative in the past quarter 1-year, 3-year and 5-year periods but it is still positive over the past 10 years. We believe there is still plenty of room for the current trend of value outperforming growth to continue in the future.
Shifting the commentary to fixed income, bond market returns around the world were slightly positive during the fourth quarter, due to lower inflation expectations, higher overall yields, and a corresponding decline in interest rates in the middle of the curve. More overnight lending rate increases are expected in the first quarter of this year and the Fed’s QT (quantitative tightening) program is expected to continue for many years. The yield on the 5-year Treasury note decreased by 7 basis points, ending the quarter at a yield of 3.99%. The yield on the 10-year Treasury note increased by 5 basis points, ending the quarter at a yield of 3.88%. And the 30-year Treasury bond yield increased by 18 bps to 3.97%. Here is the U.S. yield curve, and you can see how yields jumped at the very short end so now the highest yield on the curve is at a maturity of 6 months and the yield curve is inverted from 6 months to 10 years and flat from 10 to 30 years (current yield curve in grey, one quarter ago in blue, and one year ago in green):
As a reminder, LTWM acted in response to the expected increase in rates. We made the decision on April 22nd to sell and limit the losses in our most conservative fixed income asset class, DFIHX, and replace it with the money market, since rising short term rates improves the yield on the money market and its par value of $1 does not lose money when short-term rates increase. Then on May 5th, we sold our highest duration fixed income holding, which had a duration of 6 and replaced it with zero duration USFR, an ETF that invests in floating rate U.S. Treasury Bills, which increase in value with higher interest rates. Both decisions were made to ensure we are following the LTWM philosophy of a stable reserve for fixed income. The stable reserve is used to rebalance out of when stocks decline. During the fourth quarter, the LTWM Investment Committee decided to sell the money market funds and move back into DFIHX, the DFA One Year Fixed Income Portfolio, which has more flexibility to invest in the highest yields around one year of maturity. We believe the risk of one-year yields increasing from current levels is low.
Notice below, the highest fourth quarter bond return is for the US High Yield Corporate Bonds Index (up 4.17%), while the US Government Bond Index Long was down -0.59% for the quarter and a whopping -29.19 for all of 2022. It is easy to lose lots of money with long term bonds in a rising rate environment and we have protected client portfolios from large bond losses. The best and only positive 1-year return was the U.S. 3-Month Treasury Bill Index, which is the benchmark index used for USFR. LTWM client portfolios still hold USFR as a replacement for our longest duration fixed income fund. Here are the period returns:
During the fourth quarter, the U.S. fixed income markets had elevated volatility but functioned well. The inflation and job market reports during the first quarter will heavily influence the Feds actions. The Fed has communicated they will focus on fighting inflation over maximizing employment. If inflation data comes in lower than expected and the stock market rises substantially, the Fed may still remain aggressive to combat the wealth affect that comes from higher portfolio values. Most importantly, a healthy supply chain will reduce inflation and the Fed has little to no effect on the supply of goods. The Fed will continue its $8.5 trillion balance sheet reduction (selling bonds) at a rate of $95 billion per month or $1.1 trillion annually. This action will keep rates at the long end of the yield curve elevated.
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
It is all about inflation. The entrenched inflation outlook is looking less entrenched, reducing the probability of a hard landing, which sent stocks up during the 4th quarter. The labor market remains strong, consumers continue to spend and so far, major companies are not responding to the slowdown by letting go of workers. Some technology companies that significantly increased employment over the past three years have announced job cuts. Tech workers are very likely to find new jobs quickly. The 4th quarter earnings season, which is just getting underway, will be closely monitored for job reductions and expected earnings.
Our recommendation, as always, is to tune out the news and focus on what you can control with your financial well-being. Please contact us with any questions or concerns. We are here to help you succeed. We very much enjoyed seeing so many of you in person during the last quarter and wish everyone an abundant new year.
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.
