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Quarterly Review and Outlook: September 2023

"Life Moves Pretty Fast"

Loyd Johnson Photo

By Loyd Johnson, Chief Investment Officer
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A Look Back

The full line from the movie, Ferris Bueller’s Day Off, is “Life moves pretty fast. If you don’t stop and look around once in a while, you could miss it.” The comedy classic was released in 1986 and grossed over $70 million on a $5 million budget…and that was when $70 million really meant something. In 2014 the film was selected for preservation in the United States National Film Registry. Those selected are deemed “culturally, historically, or aesthetically significant.” Played by Matthew Broderick, I believe Ferris really hit on something fairly important. The demands, pressures, and obligations of everyday life can be engulfing if we let them…if we don’t take the time to look around and appreciate all that is around us. The same can be true as we think about the financial markets. It is difficult to believe that we are over three and a half years removed from the beginnings of Covid in 2020, and yet we are. We are still feeling and dealing with the ramifications resulting from that troubling time. In the U.S. we lowered interest rates to zero and various government programs emerged that gave families and businesses direct money to help cope with the economic shutdown. The Fed balance sheet more than doubled. The long list of reactions here and abroad can be debated in the history books, but the impact…both good and bad cannot. The higher inflation we have experienced from the artificially low interest rates and consumers awash with money has been the fight of the Fed for the last two years. Their swift move to now raise interest rates and hopefully curb consumer spending has been a bumpy road, and a fight that is still not finished. It is in this backdrop that we examine the third quarter returns of this year. In short, it was not so great for stocks and bonds. The S&P 500 was down 3.27% and Small-Cap and International stocks were down even more. Core bonds, as shown by the Bloomberg Aggregate in the table above, were down over 3% as well, making the YTD return negative by 1.21%. It has been the most difficult time talking about bond returns in my 37-year career. People generally understand that stocks can go lower. They have seen it play out numerous times…like last year, for example. The Great Recession in the late 2000s saw the S&P 500 deliver a -38% return in 2008. The ”Dot Com” bubble just seven years earlier saw the tech-heavy Nasdaq trade down over 80% from its high. Bonds are a little different. They are the “safer” asset class. They are not supposed to give investors double-digit negative calendar year returns like they did in 2022. Historically, Core bonds have averaged around a 5.50% return on a yearly basis…and that includes last year. The chart of a typical 60% stock/ 40% bond portfolio on the next page tells the story best.

The table above shows the returns of a 60/40 portfolio in dark green. The bond, or fixed income portion of the return is in grey, while the stock, or equity portion is light green. You can see that the YTD return in 2023 as of September 30th was 7%. However, notice that the contribution from bonds is not only slightly negative this year, but was decidedly negative in 2022 and a bit negative in 2021 as well. As you look back over the last 75 years, that just has not happened. Traditionally, bonds have acted as cushion when stocks have underperformed…like in both the ”Dot Com” and Great Recession timeframes. We will talk about our outlook for bonds going forward in a bit.

We show the next chart mostly to highlight the fact that there really hasn’t been any strong correlation between stock performance and inflation levels over the last three decades. We’ve seen stocks do just fine in higher inflation periods like 2021 and struggle in periods of low inflation. It is certainly one of many factors that can influence stock prices and risk appetite in general…and one that the Fed is determined to get under control.

We like including the asset class returns in our quarterly update. The chart below is a consistent reminder of the big-picture nature of what it is we do. It is always our goal to construct client portfolios that generate the best risk-adjusted returns. I suppose that is just a fancy way of saying that we are always looking to deliver the most amount of return with the least amount of risk. One way to do that is to have a diversified portfolio, as shown in the white asset allocation box below. So far this year, it returned nearly 5% in nine months. By definition, it will never be the best…but it will also never be the worst, and will typically be somewhere in the middle. It has averaged around 8.5% over the last nearly 100 years

A Look Forward

The look forward is littered with many unknowns. A new geopolitical risk has emerged in the Middle East with the Israeli-Hamas war. It threatens not only peace in that region, but has the potential to have farther-reaching impacts. But the road to long-term returns has always been bumpy. The chart below shows just how bumpy the ride can be.

The long-term annualized return from stocks over the last 96 years has been around 10%. But, as illustrated by the darker green lines, it has only been within 2% of that 10% average in six calendar years. Only six! That means that 90 other years were significantly better or worse that the 10% average. (It is mostly better) That 96 year period certainly includes many events that can affect overall stock performance…from World Wars to Recessions and a recent global pandemic. As we have often said, markets are extremely resilient. In the end, people buy shares of a company because they believe they are at least fairly valued and have a probability of delivering longer-term returns that are better than the risk-free rate. And they have. It sure would be much easier if it was just linear, but it hasn’t been, and will never be. People tend to get too optimistic on the highs and too afraid on the lows. We’ve seen how that plays out…creating bubbles on the highs and great buying opportunities on the lows. Regardless, the risk has been worth it. Stocks have outperformed bonds by nearly 5% a year and Cash by nearly 7%. Bumpy but productive.

We show the chart above because there has been much talk about the possibility of an economic recession in the U.S. over the last couple of years. I asked a colleague what they thought the probability of a recession was, and they rightly said, “100%.” I didn’t specify a timeframe, so of course that was the right answer. A little snarky, but correct. Unfortunately, recessions are part of the economic boom/bust cycle. The hope is that they are shallow in nature and short in time…just like the very brief one we had in 2020. Importantly, what the above chart shows is that not only are recessions hard to predict, but if you are waiting for one to start or end, you kind of miss the boat…either way. The example is from the Great Recession period from January 2007 to December 2010. If you waited for a recession to be officially announced, stocks already dropped 40%, and likewise if you waited for the official announcement of the recession ending in September of 2010, you would have missed a strong rebound in stocks.

We end with our promised take on bonds currently. We like them. It may not come immediately, but we do believe that core bonds have a real chance to deliver a double-digit return over a 12-month period in the not-too-distant future. As rates normalize, and even potentially head lower, that should be a good environment for bonds…and even if they just stay unchanged, bonds should get back to their long-term average. And we like stocks too. It just may a bit more of a bumpy road over the next few quarters. As Ferris reminds us, life does come at us fast, but taking a breath and looking around is well worth it...

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