Notes from a Bear Market
As always, thank you for your ongoing confidence and trust. It is during bear markets that these two things - confidence and trust - stand out as vital assets.
2022 has been, and continues to be, a difficult year for almost all markets and I want to offer this note with some general observations, which are numbered in no particular order of importance. If you have questions or comments about any of them, feel free to reference the item number so I can focus my attention where your questions or concerns are.
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The rapid rise in interest rates is, in my view, welcome. Things could not continue to go on with 10 year Treasury bonds yielding ½% and 30 year mortgages being available at under 3%. At some point, interest rates would normalize and that time arrived here in 2022. New Capital took early action, beginning well over a year ago, in its bond portfolios to significantly reduce exposure to potential interest rate increases. We created three different “silos” for our bonds: short term, inflation protected, and core, allocating 33% of the total to each of these silos. We further reduced the inflation protected silo to shorter term inflation protected bonds. Thus, 66% of our fixed income model was focused on high quality, shorter term bonds which are less susceptible to interest rate increases. The remaining 33% held investment grade diversified bonds of intermediate duration. Taken together, our bond portfolios had relatively low duration of about 3 going into 2022. We also reduced exposure to lower credit bonds, anticipating that a flight to quality would hurt those bonds. Despite all this preparation, even our bond portfolios have not been immune to losses from this year’s rapid rise in rates caused most clearly by unexpectedly persistent inflation.
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The sudden rise in interest rates this year has negatively impacted the price of almost all bonds including those of shorter duration (say 1-3 years). Duration is a measure of bond sensitivity to interest rates. The 10 year Treasury bond, for example, has a duration of 10, which implies that for every 1% change in interest rates, we may expect a corresponding 10% change in the value of the bond. And that is precisely what has happened this year, as investment grade intermediate duration bonds have lost 10-15% of their value. Still, bonds have helped lessen losses in 2022, as stocks have lost approximately 20% of their value.
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The rise in rates affects all assets: stocks, bonds, real estate, homes, businesses, inventories, everything. In general, higher rates lower the value of assets because interest rates correlate to the discount rates used to value all assets. Generally, a higher discount rate reduces the present value of future cash flows from an asset, and those future cash flows primarily underpin the current value of assets.
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All things equal, future returns rise as asset prices fall. In my view, this is also a welcome development, as stocks, bonds, real estate - everything - were recently priced toward upper bounds and lower returns. Lower prices should now translate into higher returns in the future. I am far more comfortable with prices at current levels than those that prevailed a year ago, and I am more willing to purchase both stocks and bonds at current levels.
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The Fed’s famous “dual mandate” - to manage for price stability and employment - now explicitly tilts heavily toward combating inflation, given the low unemployment rate but now persistently higher inflation. The Fed is now willing to tolerate a recession, including one that could result in job losses and asset price reductions, in order to combat inflation. Recessions occur regularly, and should not be feared. They offer a chance to “reset” the course of the economy for the future.
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The best gauge of inflation expectations is the breakeven rate - the difference between a regular Treasury bond and an inflation protected Treasury bond of the same duration. I regard the breakeven rate as the most reliable predictor of future inflation because it is based on global market participants trading in some of the most liquid securities (Treasury bonds) on the planet. Future inflation expectations as represented by breakeven rates continue to be under 3%, and have recently fallen from above 3%. In the nearer term, inflation may continue to run at higher levels, but market participants in the aggregate expect it to fall to more “normal” levels in the years ahead.
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The U.S. dollar has recently appreciated very rapidly against most foreign currencies. This effect may often go unnoticed by U.S. citizens, but it is important to recognize that this dynamic is having very dramatic effects in other parts of the world, as international investors seek to move money into dollar denominated assets, and loans priced in dollars become more difficult to repay for foreign debtors. It is also creating headwinds for U.S. companies that do business in other parts of the world, as they must repatriate their foreign earnings into dollars at higher prices.
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I want to caution all clients when looking at their Fidelity statements and apps. If you see a loss in a particular security, this does not represent the total return for the investment, because it does not include dividends. For example, STIP is a fund that holds shorter term inflation protected bonds. You may see a current loss of approximately 5%, because a 2% rise in interest rates correlates to a 5% change in the value of bonds with a duration of 2.5 (which is the duration of the STIP fund, so 2% times 2.5 equals 5%). However, this change in value does not take into account that STIP has also paid a dividend this year approaching 5%. When you add the loss on the fund with the dividend, the net loss is much smaller for 2022, perhaps 1%. So STIP has done its job fairly well this year to protect against both inflation and interest rate increases.
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Since the 1920’s, the US stock market has delivered negative returns every one out of four years on average, or 25% of the time. If 2022 ends with negative returns, as appears likely, it will be an entirely normal event.
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The investments you own are the very best that I know of, and I own them too. A collection of mutual funds from Dimensional, Vanguard, and Blackrock offers the least expensive, most diversified, most liquid, and best managed in the investment industry. Shareholders in these funds range from individual investors to the largest of institutions, and each of these companies maintains trading desks and analysts across the world. New Capital has representatives at each of these companies, and we are able to ask questions and receive answers at any time.
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It is important to remember that, even in a bear market, markets continue to function very well on a daily basis. Buyers and sellers, including New Capital, enter the market each day and clear trades without any trouble. For every seller in a completed transaction there is a buyer, and I assure you that there are many savvy investors all over the world who are now putting cash to work acquiring securities at lower prices and higher yields.
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In bear markets, my focus is always on diversification and avoiding bankruptcies or defaults in stock or bond portfolios. This is accomplished through the very broad and cost effective portfolio that we create for you, which contains tens of thousands of companies all over the world, and tens of thousands of high quality bonds spread over different credit sectors. New Capital’s investment approach involves two main “categories”: stocks (equities) and bonds (fixed income). The equity portion consists of US and non-US stocks in all industries, of all sizes, and of all valuations. The size of this allocation depends upon your risk tolerance and risk capacity. The bond portion consists mostly of US Treasuries (“regular” and inflation protected), investment grade corporate and mortgage bonds, and investment grade municipal bonds. This is a very basic, no-nonsense, tried-and-true approach whose benefits become apparent especially during bear markets.
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New Capital’s recent investments in new trading and reporting technology is paying off very well during this downturn, allowing us to quickly and efficiently make tax loss trades, re-balance portfolios, and raise cash where needed. Jaycee and I keep a spreadsheet of all of our clients, we make detailed notes on each client including actions that we are contemplating, and when we take action we are able to do it quickly and reliably across all of your accounts with our advanced software.
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We have spent, and continue to spend, a lot of time working to harvest tax losses for clients where advisable. We have additional work to do before the end of the year. We need your help to assist our analysis of your tax position: if you would please check your 2021 tax return and send Casey Moss the number found on Schedule D Line 16 it will help us tremendously in our work to put you in as advantageous a tax position as possible.
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Now that short term interest rates are paying meaningful rates (around 2-3%), we have built an Enhanced Cash portfolio that we can add to your existing portfolio. Enhanced Cash will yield significantly more than core account money market cash, albeit with more duration in the holdings. If you are interested in finding out more about our new Enhanced Cash portfolio please let me know.
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I encourage anyone who wishes to re-test their risk tolerance to do so with our quick evaluation. We can email it to you or conduct with you through Zoom.
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I want to remind all clients what we - you and I both - are invested in. We are invested in the ownership of companies all over the world, which, when their assets, employees, management, and shareholders are put together, likely represent the most accomplished, well-educated, and productive populations across the world. We are also invested in the U.S. Federal government and the people it governs - still, even after the most recent years of ugly and debased political turmoil, the most trusted around the world for stability and continuity. And we are invested in the states and municipalities of this country, helping to finance roads, schools, airports, and many other projects that benefit our cities and towns. Just as I have no interest in selling my ownership in New Capital Management just because interest rates have increased, inflation is high, or a recession looms, so I have no interest in selling my ownership in these other entities either for those reasons.
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I strongly encourage you to come, either in person or virtually, to our annual conference on October 27. We have assembled speakers from Fidelity, Blackrock, and Dimensional who will help me discuss the current market and investment environment against the backdrop of Fed actions, the upcoming elections, and other perspectives.
In the meantime, if we can be helpful to you in any way at all, please do not hesitate to ask. While we are extremely busy right now, we will make whatever time necessary to assist our clients. As always, thank you for your ongoing confidence and trust. It is during bear markets that these two things - confidence and trust - stand out as vital assets.
Sincerely,
Leonard M. Golub, CFA
