Quarterly Review and Outlook
"What a World, What a World"
A Look Back
The quote above comes from the Wicked Witch of the West in the 1939 classic movie The Wizard of Oz. The wicked witch starts melting when Dorothy douses her with a bucket of water meant to put out the burning Scarecrow that the witch had set on fire. Her full plea was “what a world, what a world. Who would have thought that some little girl like you would destroy my wickedness.” Like Dorothy, most investors are a little unsure of where this yellow brick road of an economy and markets is taking us. The last two years brought a global pandemic, which was then met with unprecedented government stimulus, followed by a stock market sell-off…which was followed by an ever steeper stock market run-up. We all felt the strain of supply chain disruptions born out of the global economic shut-downs, which led to increasing prices as demand soared and supply could not keep up. Sprinkle in some political divisiveness and the Russian invasion of the Ukraine, and you have more than enough to set the stage for what we have seen so far in the first half of 2022. The S&P 500 officially went into bear market territory (down 20% or more from a recent high) in June. Core bonds, which have historically acted as a balance to trouble stocks were -10.35% through June…less than stocks, but not the cushion we are used to. Further, bonds across the spectrum were negative as the Fed moved to increase the short-term Fed Funds rate to help fight inflation. Even Commodities, which had been the best-performing asset class YTD, and really over the last year got beaten down as the strong U.S. dollar and fear of recession took its toll.
The chart to the right shows just how negative fund managers have gotten as of end of June. The current levels of pessimism rivals the lows in October 2008 of the Great Recession timeframe. Of course, we went on to make a major low in March 2009 of 666 in the S&P 500, which paved the way to a 12-year bull run that saw the index reach 4800, or +730%!
The chart below looks at the year-over-year inflation numbers since the pre-pandemic time of January 2020. We had been averaging around 2 to 2.5% inflation for some time before Covid hit. You see the depressed inflation numbers throughout 2020 as economies were shuttered and people did little spending on anything except for necessities. As we saw inflation tick up in 2021, the Fed and many others believed it would be more transitory and would correct itself as the economy reset and supply chain constraints were resolved. We know now that it did not play out that way, and inflation has been much stickier and stubborn. Indeed, if we drilled further into the inflation numbers, we find that it is pervasive across almost all sectors to include food, energy, healthcare, leisure…and wages. The reason
that it is so problematic is that affects the average consumer at every turn and can drastically change spending habits.
I remember inflation as a particular problem as a teenager in the late 70’s into the early 80’s. Going back, inflation stood at 13-14% in 1981…much higher than current levels. However, the Fed Funds rate got as high as 20%. That’s right…twenty! It is hard to fathom in the current environment, but those were the numbers. So, even with a completely unhealthy level of inflation, consumers still had the ability to earn a real level of return (short term rates-inflation). Today we have the inverse as the Fed Funds rate is near 2% with the most recent inflation numbers above 9%. It becomes clear that the Fed is attempting to use the one main tool in its tool chest, the short-term Fed Funds rate to combat rising (and stubborn) inflation. The hope is that by increasing the cost of borrowing for goods, it can stem demand, and thus poke a hole in the rising price balloon. Further, the hope is that they can do all this without stemming demand so much that it pushes us into a recession. We used to call this the Goldilocks scenario…not too hot, and not too cold. We should point out that the track record of engineering just that is not great. There are so many components that affect overall economic activity, that expecting short-term rates alone to thread the needle just so…well, it’s asking quite a bit.
We show the asset class returns on the next page, and it isn’t pretty so far in 2022. Other than Commodities, most asset classes have shown negative performance. And then there is Cash. We have to remind ourselves sometimes that Cash, the stuff we keep in savings accounts or buried in our yards, is indeed an asset class. It is not the most exciting, but there are times when it is desirable to hold. Whether it is because of the actual level of return, or because it gives investors a hedge against uncertainty, it has a real place inside portfolios. Through the first half of the year, it was the second best performing asset class shown.
Although that white box, which represents a more balanced allocation is still negative by over 14% this year, it is still down less than stocks alone. More importantly, it has delivered investors over 6% annually from 2007 to present, which includes the Great Recession of 2008-09 through the pandemic to current times.
A Look Forward
If only those crystal balls really worked! We tend to be glass half-full kind of advisors and believe in the overall resiliency of our markets and our economy. That has not changed. We have also seen enough market cycles to know that the pendulum often swings too far…in either direction. We have enjoyed a remarkable bull run in the financial markets and the overall economy from 2009 through the first part of 2022. Was it reasonable to expect markets that were already stretched from a valuation standpoint at the end of 2019 to have a double digit return in the pandemic year of 2020…and then follow that up with a 28% return in 2021? Perhaps not, but that is what happened. Many argue that those two years of surprising performance were built on the backs of unprecedented government stimulus and easy Fed money. We believe that the Fed and the government acted quickly and decisively in the beginning stages of the pandemic, as we all were flying somewhat blindly. However, the additional rounds of stimulus and continued easy money throughout 2021 has/had its costs. Flush with “found” money, investors bid stocks higher and higher, and consumers bid prices higher and higher on homes, cars and other hard-to-find purchases as inventory and supply chain disruptions took their toll.
Perhaps it is just as reasonable to expect what we have seen in the first part of 2022. Stocks, and most other asset classes across the globe have been under pressure. We do believe that inflationary pressures will be reduced. The unknown is how much pain will be involved in getting there. That is why we end with the chart on the next page. Just as in life, patience has always been a key component in successfully navigating our markets. Emotion can be a strange thing. It is typically a good thing…we encourage our kids to not be afraid to show it. We want it from our partners. But, in investing…it can really get us into trouble. Left unchecked, it can make us too euphoric and complacent on the highs, and too nervous and afraid on the lows. Charged with managing client money, we have to look at every situation on its own merits, but we also must look to the long-term and use over 100 years of actual history as a guidepost. We have seen trying times before…most recently just two years ago. We have navigated World Wars and financial collapses of every shape and size. And yet, we persist.
The table below tells the story best…the importance of time and diversification, and how it relates to investment performance. The green bar represents stock performance and the blue bar shows bonds. The grey bar illustrates a balanced portfolio of the two. The data shown goes back to 1950, and if we went further back it would look very similar. In any one year, there can be volatility and a wider range of performance…both good and bad. However, over time, you see those ranges compress more and more. The numbers represent rolling 5, 10, and 20 year periods…so hundreds of data points. Just going out five years, we see that the worst that a 50/50 allocation has delivered is 1% and the best 5-year period was 16%. Further, through it all, the annualized performance of the balanced allocation has given investors 9%.
We certainly do not profess that it is always easy to be patient…in life, or when it pertains to the markets. We do believe it best though. It would be great if we knew those inflection points when things were about to turn. They just don’t normally stand up and announce themselves. With all that in mind, we remain a little conservative in our balanced allocation with a preference to value over growth stocks and a little extra cash to take advantage of opportunities when they present themselves. Importantly, we remain disciplined in approach and rely on the history and resiliency of markets that we have experienced over the last 100 plus years. It is not so different when things look great and when they look cloudy. It usually is much more about perspective and less about melting…