2022 Market Commentary
Fourth Quarter and 2022 Market Recap
An extremely difficult year in the financial markets ended with a thud for US stocks. After a 14% rally in October and November, the S&P 500 Index dropped 5.8% in December to close out the year with an 18.1% loss, its largest annual decline since 2008.
Foreign stock markets held up much better in the fourth quarter. Developed international stocks (MSCI EAFE Index) gained 17.3% -- one of their best quarters ever -- and Emerging Market stocks (MSCI EM Index) were up 9.7 %. For the full year, developed international stocks outperformed the US market by nearly four percentage points, dropping 14.5% (in US dollar terms). EM stocks were down 20.1%, slightly worse than the S&P 500.
A major headwind for non-US stocks was the strength of the US dollar (DXY Index), which appreciated 8.3% for the year, reducing dollar-based foreign equity returns one-for-one. However, in the fourth quarter, the dollar dropped 7.7%, providing a boost to EM and international equity returns for US investors to end the year.
Turning to the bond markets, core investment-grade bonds (Bloomberg US Aggregate Bond Index, aka the “Agg”) had a solid fourth quarter, gaining 1.9%. But this was still the worst year for core bonds in at least 95 years, with the Agg dropping 13.0%. The key driver, of course, was the sharp rise in bond yields; the 10-year Treasury yield ended the year at 3.9%, up from just 1.5% a year prior. High-yield bonds (ICE BofA Merrill Lynch US High Yield Index) had a strong fourth quarter, up 4.0%, but were down 11.2% for the year. Floating rate loans (Morningstar LSTA Leveraged Loan index) were the best segment within the bond markets, down less than 1% for the year. Municipal Bonds were down 8% (Morningstar National Muni Bond Category).
Alternative strategies generally outperformed traditional stock and bond indexes. The standout was trend-following managed futures strategies, which gained roughly 28% (SG Trend Index) for the year, despite fourth-quarter losses. Flexible/nontraditional bond funds (Morningstar Nontraditional Bond category) were down roughly half as much as core bonds.
Source: Morningstar Direct and Yahoo! Finance. Data as of 12/31/2022.
As shown in the chart below, 2022 was only the third year since 1926 that both US stocks and core bonds declined, and the only year that both asset classes lost more than 10%.
Portfolio Performance and Key Performance Drivers
For 2022, our portfolios materially outperformed their benchmarks.
In stocks, the primary contributors to our outperformance were geography, style, sector, and volatility differences. Specifically, our overweights to North America, value, energy, and shorting stock volatility respectively. This resulted in our managed stocks declining much less than the world stock index (MSCI World Index).
In bonds, the primary contributor to our outperformance was duration. Specifically, over overweight to shorter maturity bonds which meant our managed bonds declined much less than the bond index (Bloomberg US Aggregate Bond Index).
In alternatives, the primary contributors to our outperformance were interest rates, currencies, and commodities. Specifically, our material allocations to trend following managed futures meant strong double digit positive returns were achieved by short positions in Bonds and Japanese Yen and long positions in Crude Oil. As a reminder, a long position means you make money when prices rise and a short position means you make money when prices fall.
Not since 1926 has market conditions been this painful and yet our managed portfolios incurred a fraction of the pain compared to long only stock and bond allocations which is the most common allocation for most investors.
Macro Outlook for 2023: High Risk of US and Global Recession, Small Chance of a Fed Soft Landing
We look at the macroeconomic ocean across two dimensions: inflation and growth.
US inflation data have improved, suggesting we’ve seen the peak in inflation for this cycle, absent an exogenous shock. But core inflation remains far above the Federal Reserve’s 2% target, and the Fed’s message is that it intends to maintain restrictive (tight) monetary policy throughout 2023.
On the economic growth front, key leading indicators deteriorated further in the fourth quarter, which along with tight monetary policy, point to a likely recession in the year ahead. There are good reasons to think the recession will be a relatively mild one. We also don’t rule out a scenario where the economy slows but doesn’t contract next year — the fabled “soft landing.”
For investors (not economists), the difference between a flat economy and a mild recession next year is a distinction without much difference. What we care about is the impact on corporate earnings and valuation multiples — the latter being a function of earnings, interest rates, and market sentiment (investor herd psychology).
In the sections below, we provide a more detailed update on the macroeconomic ocean, followed by our assessment and outlook for the financial markets (stocks, bonds, currencies, etc).
Inflation
Inflation and Federal Reserve monetary policy remain the financial markets’ key macro focus. In the fourth quarter, major central banks across the globe — except for China and Japan — continued raising short-term interest rates. Tighter monetary policy curtails “aggregate demand” — consumer and business spending – which in turn reduces inflationary price pressures (again, absent exogenous shocks (like wars or pandemics) to the supply side of the economy).
The good news is that the October and November US inflation reports showed a sharp fall in headline consumer price inflation (including food and energy prices). Various measures of core inflation (excluding food and energy) have flattened on a year-over-year basis, but at around 5% to 6% are still far above the Fed’s 2% target.
On a more granular level, we see that core consumer goods inflation, which drove much of the high inflation over the past year, has dropped sharply — albeit from extremely high levels to still-too-high levels. But the trend is clearly down as the transitory, COVID-related, supply-chain dislocations continue to normalize, and consumers’ spending preferences (the demand-side) also normalize from goods back towards services.
The less-good news is that consumer services prices are generally stickier (that’s an official economic term) than goods prices. And as the chart below shows, core services inflation is still rising. Fed Chair Jerome Powell has recently cited this as a particular focus of the Fed.
Speaking of the Fed, as expected, at its December 14 meeting, the Federal Open Market Committee (FOMC) raised the fed funds rate by 50 bps to a target range of 4.25% to 4.50%. It also forecasted 75 bps of additional rate hikes in 2023. This is more than the markets expect.
Trying to reset market expectations, Powell struck a hawkish tone in his press conference, stressing that the Fed does not expect to cut rates in 2023. The fed funds futures market is currently pricing in Fed rate cuts later in the year.
While we know that the ability for anyone to predict what the Fed will do next year -- including the Fed itself -- is nothing more than a guess, we think the following quotes from Jerome Powell are worth highlighting as they at least reflect his/the Fed’s current outlook:
“The inflation data received so far in October and November show a welcome reduction in the monthly pace of price increases. But it will take substantially more evidence to have confidence that inflation is on a sustained downward path.”
“I would say it’s our judgment today that we’re not in a sufficiently restrictive policy stance yet, which is why we say that we would expect that ongoing hikes will be appropriate.”
“The historical record cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”
“The labor market remains extremely tight.”
Each quarter the FOMC publishes its forecasts for inflation, GDP growth, unemployment and the fed funds rate. Continuing the negative trend for the year, the December revisions were for lower GDP growth, and higher unemployment, core inflation and interest rates in 2023. While we’d never expect the Fed to actually forecast a recession – because to do so would all but ensure one ensued – their latest forecast of 0.5% GDP growth in 2023 is about as close as it gets.
Source: Federal Open Market Committee (FOMC). Data as of 11/30/22.
In addition to higher rates and lower growth, the FOMC also increased its unemployment rate forecast, to 4.6% next year. If that plays out, history suggests a recession is likely. Since 1950, there has never been an instance where the US unemployment rate increased by a half percentage point or more from its cycle low without an accompanying recession. The unemployment rate bottomed at 3.5% in July.
Wages
The largest input cost for most businesses, and services businesses in particular, is wages. Wages in turn are a partly a function of inflation expectations, which can feed into a self-reinforcing wage-price spiral — the Fed’s biggest fear.
The data on wage inflation and inflation expectations continue to be mixed. Current year-over-year wage inflation at around 6% is inconsistent with the Fed’s 2% inflation target. Wage inflation would probably need to fall into the 3% to 4% annual range for the Fed to be comfortable (assuming labor productivity growth of 1% to 2%). Historically, declines in US wage inflation of that magnitude have only happened during recessions, accompanied by the aforementioned increases in unemployment.
Wages are a function of the supply and demand for labor. As Jerome Powell said, the U.S labor market remains very tight. The 3.7% unemployment rate in November is still near all-time lows. The ratio of Job Openings to Unemployed workers – one measure of labor supply vs. demand – is still near all-time highs, at 1.7 job openings per unemployed worker. As shown in the chart below, there is a strong positive relationship between this ratio and wage growth (wage inflation). As with other inflation metrics, we may have seen the peak in wage inflation but still have a long way to go to get to the Fed’s targets.
More broadly, rising wages correspond to higher overall unit labor costs (defined as compensation per unit of output). And rising unit labor costs are highly correlated with rising core inflation, as the following NDR chart shows.
The latest monthly wage data suggest a deceleration of wage inflation. But the Fed will want to see a material and sustained downward trend before declaring victory. The Fed’s hope is that tighter monetary policy will reduce the number of job openings (demand), relieving the pressure on wages without causing a big increase in layoffs and unemployment. That’s a possibility given the unprecedented number of job openings relative to unemployment, but it’s not our base case.
Inflation Expectations
A significant bright spot in the otherwise awful inflation picture this year has been the stability of medium- and longer-term inflation expectations. (Shorter-term inflation expectations, which are highly sensitive to gasoline prices, have also recently been dropping.)
Inflation expectations are crucial, because if they become unmoored they can feed into a self-reinforcing, inflationary wage-price spiral - where wage and price hikes feed back into higher inflationary expectations which feed into further wage and price hikes, etc. This was the inflationary regime that Fed Chair Paul Volcker had to break in the early 1980s. One stark difference (among many) between now and then is that medium-to-longer term inflation expectations reached double-digits in Volcker’s time, requiring a near 20% fed funds rate to ultimately crush the inflationary mindset. In contrast, as shown in the chart below, 5-to-10-year inflation expectations this year have remained in a 2-3% range.
Inflation is not just a US problem. Nearly all the other major global central banks (except Japan and China) are also continuing to hike interest rates to fight inflation in their countries. For example, both the European Central Bank (ECB) and the Bank of England hiked their policy rates another 50 basis points (0.5%) in December. The ECB hawkishly stated, “We decided to raise interest rates today, and expect to raise them significantly further, because inflation remains far too high and is projected to stay above our target for too long.”
These synchronized global rate hikes will further depress global aggregate demand and economic growth over the shorter term. It’s also typically a headwind for equity markets.
Economic Growth
Along with persistent core inflation, the 2023 growth outlook has worsened for the US and most of the globe. In our recent commentaries we’ve highlighted two widely followed economic indicators that are published monthly: the Purchasing Manager Indexes (PMI) and the Conference Board’s US Leading Economic Index (LEI). Both measures continued to deteriorate in the fourth quarter, signaling a recession is increasingly likely in 2023.
We put particular weight on the LEI, which has a long track record of “calling” recessions. In addition to the magnitude of its recent decline, it has fallen for nine consecutive months (and likely will again in December). This has never happened without an ensuing recession. Having said that, our caveat, as always, is that no economic indicator is 100% foolproof and there is a first time for everything. But in terms of recession probabilities, based on the evidence, we believe the odds are tilted strongly in that direction.
A third time-tested recession indicator is an inverted Treasury yield curve – meaning short-term yields are above longer-term bond yields. An inverted yield curve is unusual and usually (but not always) a leading indicator of recession. The timing from inversion to onset of recession has been highly variable. But as with the LEI, the current degree of inversion has never occurred without a subsequent recession in the US, adding to the weight of the evidence.
Finally, as we’ve noted before, more important than whether the Fed is raising or cutting the fed funds rate is whether the policy rate is at a “restrictive” or “accommodative” level. This year has been the Fed’s most aggressive rate hiking cycle since 1980. At the current fed funds target rate of 4.25%-4.50% compared to inflation expectations of around 2.5% and the Fed inflation target of 2%, one can argue the rate is now in restrictive territory, with the full negative impact on the real economy still to come in 2023 due to monetary policy’s well-known lagged effects.
A counter argument is that with current inflation readings still well above 4.5%, the after-inflation (real) fed funds rate is still negative and therefore not yet restrictive. After the December rate hike, Fed Chair Powell said, “We’re not in a sufficiently restrictive policy stance yet.” If that’s the Fed’s view, it reinforces the likelihood they will continue to raise rates in 2023, albeit at a much-reduced pace than in 2022.
Putting all the macro pieces together, our view from three months ago remains. We see a US and global recession as the most likely scenario over the next 12 months.
Bottom line
A US recession next year is not a certainty. But based on the evidence, we think it is highly likely.
A Fed-engineered soft landing is a possibility, but the historical odds aren’t good. The Fed typically tightens until “something breaks.” If the economy defies the leading indicators and remains strong with sustained high core inflation and wage growth, the Fed will likely raise rates “even higher for longer” than the markets currently expect. That scenario would not be good for financial asset prices either. As one market strategist recently put it, one way or other “the Fed and the US market are on a collision course.”
This circumstance would be challenging for basic stock and bond investors who are limited to long only positions. Fortunately, we are multi asset long/short asset allocators which materially increases the odds of successfully fishing for opportunity in such difficult macro waters.
Financial Markets Outlook for 2023 and Beyond
Despite their ubiquity, short-term stock market forecasts are a fool’s errand - as seen by how wrong they usually are - and not a sound basis for a successful long-term investment strategy. Instead, our portfolios are built on the foundation of a long-term “strategic” asset allocation that aligns with the client’s risk profile, financial objectives, and investment temperament. (Regarding the latter, Warren Buffett famously said, “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”)
We will tactically adjust our strategic portfolio allocations based on our analysis of expected risk and return over a medium-term (five-to-10 year) horizon. This medium-term time horizon incorporates a typical “market cycle,” where short-term market dislocations and asset mis-pricings should resolve (or revert) towards their underlying economic fundamentals.
We also incorporate shorter-term (12-month) downside risk assessments for asset markets in our portfolio construction and management. We want to understand the “reasonable worst-case” shorter-term outcomes and weigh the likelihood of them playing out. Our assessments are based on a weight-of-the-evidence and multi-scenario approach that incorporates both historical market analysis and forward-looking judgement. This is very different from forecasting a 12-month market return and then investing based on that forecast.
As such, and given the inherent uncertainty about the future, our portfolios are structured to be balanced, diversified, and resilient across a wide range of scenarios, but also with the flexibility to be opportunistic when markets get out of whack (i.e., when current prices do not reflect underlying longer-term fundamentals) due to excessive fear or greed. In such cases, we act contrary to the current market mood – trying to be “greedy when others are fearful” (Buffett again) and vice versa.
Stock Markets
Our assessment of the US stock market (S&P 500 index) has not materially changed from the end of the third quarter. In sum: We do not believe the S&P 500 is adequately discounting the likelihood and severity of an oncoming earnings recession.
In our third quarter investment commentary we walked through the details of our US stock analysis. The key elements remain in place; if anything, the outlook has deteriorated over the past three months with the economic data worsening but the US stock market several percent higher than it was then.
Shorter-term S&P 500 Downside Risk
The average peak-to-trough decline for the S&P 500 in post-WWII “recessionary bear markets” has been 35%. That would imply the S&P 500 falls to 3,100, from its peak of 4,800 in January 2022. The median decline has been 32%, which would be 3,260 on the S&P 500.
We’ve often said, “The economy isn’t the market,” meaning that financial markets often move in unintuitive ways relative to the current economic news. For example, a recessionary economy with a high unemployment rate is usually associated with strong stock market returns going forward (because most investors are fearful). Conversely, when the economy is very strong and earnings growth very high, forward equity returns are usually poor (as overly optimistic investors have priced in unrealistically high growth expectations).
So, the fact that we (and the consensus of economists) expect a recession next year doesn’t necessarily mean equities will do poorly, if the market has already discounted a recessionary outcome in current prices. However, looking at consensus corporate earnings forecasts for 2023 that isn’t the case.
Specifically, our analysis (and that of other strategists we follow) shows that S&P 500 index earnings typically decline around 15% to 20% during economic recessions as both sales growth and profit margins compress. In a mild recession, the earnings decline might be closer to 10%-15%.
Whether earnings fall 10% or 20%, that is a far cry from the current market forecast that S&P 500 earnings will grow by roughly 5-10% in 2023. We take that consensus growth number with a large grain of salt and note that 2023 earnings estimates have been coming down for several months now. But we still view the gap between a 10-20% earnings decline in 2023 and current market expectations as too wide and not adequately discounting the likelihood and magnitude of an earnings recession.
Assuming a 10-20% earnings decline for the S&P 500 across a range of reasonable valuation multiples, we derive the following matrix of potential peak-to-trough S&P 500 index declines for this cycle.
Within this matrix, we believe the most likely outcome range is -33% to -44%, corresponding to an S&P 500 level of 2,700 to 3,200 at the bear market bottom. This is also consistent with the 3,100 to 3,200 range based on the simple historical average and median recessionary bear market declines cited above.
With the S&P 500 ending the year at 3840, we could see a 15-25% market drop at some point in 2023, before the market then starts rebounding on expectations of Fed easing and a new economic and earnings growth cycle.
Relative Attractiveness of US Stocks versus Bonds
The above analysis looks at the absolute shorter-term risk/return for US stocks. But equities don’t exist in a vacuum. Multi-asset long/short asset allocators (such as ourselves) also evaluate the relative attractiveness of asset classes versus each other. At the highest level, this is a comparison of stocks versus bonds, also referred to as the equity risk premium (ERP) — the extra return an investor should expect to earn (or historically has earned) from owning stocks versus low-risk Treasury bonds.
Given the sharp rise in core bond yields this year, stocks no longer look cheap relative to bonds, as shown in the chart below. To revert to a more normal ERP will require a decline in equity valuations, lower bond yields, or some combination of both.
Five-year Expected Returns for Global Equities
The next piece of our weight-of-the evidence stock market assessment is our estimate of five-year (medium-term, tactical) expected returns. The expected return is essentially the sum of three components: (1) the market’s dividend yield; (2) the annualized percentage change in the P/E valuation multiple between now and five years from now; and (3) the implied earnings-per-share (EPS) growth rate over the next five years, which we derive from our sales growth and profit margin assumptions. (We described our methodology and key assumptions for each major geographic market in our Q3 commentary and asset class reviews.)
The following table shows our five-year expected returns for the US, Europe, and EM equity market indexes across a range of scenarios, as of 12/31/22. For US stocks our Base Case return estimate ranges from 3.1% to 9.3%, with a central tendency of roughly 6%.
Estimated returns are annualized and generated by iMGPFM. This table shows our five-year, annualized asset class return estimates across several broad macroeconomic scenarios we believe are possible. Collectively, the scenarios encompass the range of outcomes we believe are reasonably possible and therefore worth considering in creating our portfolio allocations. We make assumptions for various fundamental and valuation metrics we believe are consistent for each asset class within each macro scenario then incorporate current prices to generate an estimated return. The macroeconomic scenarios and estimated returns can change. When this happens, we will clearly note it and give guidance on new estimates. See “Estimated Returns Disclosure” at the end of this commentary for more information on macro scenarios and fundamental/valuation metrics used in the analysis.
That would be at the low end of a reasonable expected return range in an environment with average or normal US equity risk. But it’s too low an expected return given our conviction that an earnings recession is likely in the next year with significant downside for stocks, and considering relatively attractive bond returns, thanks to their now-higher yields plus core bonds’ superior downside protection.
As such, our medium-term analysis is consistent with our shorter-term risk analysis and our relative-return/equity risk premium analysis, which all point to US stocks not (yet) adequately pricing in the risks we see.
This is why we are maintaining our long positions and short positions in stocks, bonds, currencies, and commodities.
A few more reasons why we don’t think US stocks have yet bottomed
Several other historical market facts support our view that we have not yet seen the market low for this cycle, i.e., that the S&P 500 will drop below its October 2022 low of 3,577.
US equity bear markets have never ended before the start of a recession. If this holds true again, a recession in 2023 would imply we haven’t yet seen the cyclical market low. Again, anything can happen, but it would be unprecedented.
The stock market has typically bottomed several months after the last Fed rate hike. Given the Fed just hiked again in December, this also supports the view that the market has further downside ahead.
Inverted yield curves typically un-invert before the stock market bottoms. US yield curves remain deeply inverted.
To repeat what we wrote last quarter: “In sum, as we weigh the trade-off between short-term downside risk management (playing defense) and medium-term upside return potential (playing offense) we want to shift our portfolios towards more defense right now, and we do not believe we are giving up return in doing so. When the equity market declines to levels that offer compelling medium-term returns — which typically happens during a recession when investor pessimism and fear are rampant — we will look to play more offense.”
The US Dollar Should be An Additional Tailwind for Foreign Stock Returns
The US Dollar index was up 8% for 2022, but that includes an 8% decline in the last three months. We would expect the dollar to strengthen again in the short-term as the global economy slows — because the dollar is a counter-cyclical, safe-haven currency that typically appreciates when global growth is declining — and/or if the Fed hikes rates higher for longer. But we believe the medium-term direction for the dollar is lower for several reasons — large US twin deficits, rebounding ex-US growth relative to US growth, shrinking interest rate gap between US and ex-US, reversal in bullish dollar sentiment and momentum — as we’ve discussed in previous commentaries.
Should the dollar’s recent negative momentum versus EM currencies continue that would be very positive for EM stocks. As shown in the chart below from Ned Davis Research, over the past 20 years the MSCI EM stock index has risen at a rate of more than 20% per annum when the relative strength of EM currencies versus the dollar is in an uptrend (defined as above its 50-day moving average). This is consistent with other historical evidence that a declining dollar is a big tailwind for international and EM equity returns for dollar-based investors.
In addition to the points above, the dollar also still looks very overvalued on a fundamental (purchasing power parity) basis. As with equity market valuations, currency valuations don’t matter in the short run, i.e., they are not predictive of near-term currency returns because other factors dominate. But over the longer-run, fundamentals and valuations ultimately win out and are reflected in asset (and currency) prices and returns.
Bonds
The past year has been one of the most difficult investment environments ever for the bond markets. The traditionally defensive Bloomberg US Aggregate Index (“the Agg”) lost 13% in 2022 as high inflation led to a spike in interest rates. While losses have been painful, the good news is that current yields will likely translate into positive returns that bond investors have not seen in years.
When evaluating bonds, we start by defining a range of economic scenarios which includes estimating end-of-period Treasury rates, inflation levels, and real rates. The objective of this exercise is to understand the potential range of outcomes and consider those outputs when constructing portfolios. In addition to our five-year return estimates, we also evaluate shorter-term scenarios when considering allocations to bond sectors as the range of potential outcomes for most bond assets is much narrower and the degree of certainty higher than for stocks.
Core Bonds
When estimating returns for core bonds (the Agg) over longer periods of time, the starting yield is a good approximation of subsequent returns. The chart below illustrates the strong relationship between starting yields and subsequent 5-year returns.
At year-end, the Agg was yielding 4.7%. Our base-case return assumption for core bonds over a five-year investment horizon is now slightly above 5.0%. This assumes a slightly lower Agg bond yield from today’s level, implying some capital appreciation in addition to the current yield. In our bearish macro scenario, where Treasury and Aggregate bond yields move lower, we estimate that core bonds will generate a 5.6% annualized return. (This bearish scenario for stocks is a bullish scenario for core bonds.) Lastly, in our bullish macro scenario, core bonds return approximately 5.25%. We also consider an environment where inflation remains stubbornly high and/or the Fed increases rates higher than consensus expectations. In this scenario, we would still expect core bonds to generate a return in the high 4% range.
While these five-year expected returns fall within a narrow range, our shorter-term (12-month) return estimates have much wider variance. In a base-case scenario, we think core bond returns could be in the 4.5% range, plus or minus 50 basis points, while our bearish and optimistic scenario returns range from 1% to 8%.
We expect core bonds to deliver a positive return if a recession plays out, providing valuable portfolio ballast while riskier assets such as stocks get hit. For example, if the 10-year Treasury yield were to decline 75 bps (to 3.10%) over the next 12 months, we estimate the core bond index would return close to 9% (from yield plus price gains).
Our core bond allocation also acts as “dry powder” that we can tactically allocate into stocks and other higher-returning assets at much more attractive (lower) prices.
Portfolio Positioning
Weighing the macro and market evidence we are maintaining our underweights to stocks and bonds as well as our overweights to alternatives relative to our strategic benchmarks.
In our stock allocation, we are maintaining our overweights to the North American geography. Moreover, our stocks must pass thru a stringent filter of being undervalued, profitable, and growing quality. As a reminder, undervalued means buying a $1 for $0.50. Profitable means generating profits materially above costs. Growing quality means a business selling a widget for $1 that costs $0.50 to make and is looking to sell more widgets. This approach results in rejecting over 94% of stocks available for purchase. We also are maintaining a tactical short position in hedged equity volatility which is in essence selling fire insurance to collect insurance premiums (i.e. collecting $10) and then buying reinsurance just in case (i.e. spending 2$) while keeping the difference (i.e. $8).
In our bond allocation, we are maintaining exposure to US Treasuries given that risk free rates are finally material after years of being suppressed. Moreover, we are overlaying an option premium harvesting strategy by selling short dated put or call spreads on stock indexes (similar approach to the fire insurance example previously aforementioned). By combining US Treasuries with selling short dated put or call spreads, we expect to earn superior downside risk adjusted returns compared to basic long only bond portfolios of treasuries, corporates, mortgages, etc.
In our alternatives allocation, we are maintaining positions in trend-following managed futures. As a reminder, managed futures means a strategy that can have long or short positions in stocks, bonds, currencies, and commodities. Managed futures returns were strongly positive in 2022 as traditional stock and bond funds plunged. These alternative funds, with their alternative sources of return and risk, should continue to provide tactical and longer-term strategic benefits to our portfolios. They are much less dependent than traditional investments on the type of macro regime that unfolds over the coming years (e.g., deflation, stagflation, inflation, or growth). Today, we are positioned with short positions in US stocks, EM stocks, Bonds, Euro, and Gold with long positions in International Developed Stocks, Japanese Yen, and Crude Oil.
Closing Thoughts
As 2022 has (painfully) reminded investors, a narrowly defined opportunity set of asset classes (stocks and bonds) that are limited to long only positions results in a painful vitamin D deficiency: diversification.
We believe 2023 will present us with some excellent long-term investment opportunities. Unfortunately, in our base case we also expect we’ll first have to go through a recessionary bear market with a significant drop in global stock prices.
While challenging, it is critical for long-term investors to stay the course through these rough periods in the markets. The shorter-term turbulence and discomfort is the price one pays to earn the long-term “equity risk premium” – the additional return from owning riskier “growth assets” (such as stocks) that most investors need to build long-term wealth and achieve their financial objectives.
Bonds are also now reasonably priced with mid-single digit or better expected returns. US Treasury bonds will also provide valuable portfolio ballast in the event of a 2023 recession. Our investments in alternative strategies should provide further resilience to our portfolios no matter how the next year (and years) play out.
From all of us at TYME Advisors, we wish you and yours a healthy, happy, and prosperous New Year.
TYME Advisors subscribes to AdvisorIntelligence, a leading research service for investment professionals that is published by Litman Gregory Asset Management, an independent, fee-only wealth management firm based in the San Francisco Bay Area. AdvisorIntelligence provides our firm with asset class research, manager due diligence, and risk-managed portfolio construction guidance with a 27-year proven track record. Utilizing the resources of Litman Gregory as an outsourced investment strategist and research arm provides significant benefits to our clients, and is a complement to our own work. It allows us to cover more investment opportunities in greater depth than we could on our own, and helps us make decisions on how to allocate your assets to achieve your long-term goals.The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations.Estimated Returns Disclosure
Scenario Definitions:
Downside: The economy falls into a deep and sustained recession for any of various reasons, such as deleveraging/deflation, unexpected systemic shock, geopolitical conflict, Fed or fiscal policy error, etc. At the end of our five-year tactical horizon, S&P 500 earnings are below their normalized trend and valuation multiples are below-average reflecting investor risk aversion. Inflation and 10-year Treasury nominal and real yields are very depressed.
Base: Consistent with long-term economic and market history, reflecting economic and earnings growth cycles that are interspersed with recessions around an upward sloping normalized growth trendline. Inflation is at or moderately higher than the Fed’s 2% target level and 10-year Treasury real yields are around zero percent to slightly positive. For the S&P 500, we now bookend our base case with a lower-end and upper-end estimate:
At the lower end of our base-case fair-value range, reflation efforts are successful and nominal economic growth is higher than the average. However, the economy overheats, and valuation multiple and some margin compression largely offset the favorable macro backdrop.
At the upper end, reflation efforts are also successful, nominal economic growth is higher than observed since the 2008 financial crisis on average, profit margins move slightly higher, and valuation multiples are also slightly higher than the recent historical average.
Upside: S&P 500 earnings end the period well above their long-term (base case) normalized trendline. Valuation multiples are well above average and higher than the upper end of our base case. The Fed exits its accommodative policy without major economic or market disruptions, although a normal recession within the five-year period is still possible. Inflation is around or moderately higher than the Fed’s 2% average target. Real 10-year Treasury yields are around zero percent to negative as the Fed succeeds in keeping rates from materially rising.
What the Table Shows: Our five-year, annualized asset class return estimates under several broad economic scenarios. Collectively, the scenarios we use encompass the range of outcomes we believe are reasonably possible and therefore worth considering in creating our portfolio allocations.
Why We Use Scenarios: Considering how each asset class might react under a consistent set of scenarios allows us to calibrate our return expectations across asset classes. We believe this helps us make better asset allocation decisions.
These Scenarios Can Change: As the overall economic environment changes it will at some point necessitate changes to the scenarios we consider. Therefore, there could be times when we are reassessing scenarios and temporarily suspend providing updates for one or more scenarios. When this happens, we will clearly note it and give guidance on when we expect to complete this process.
Any projections provided regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Investing involves risk, including the potential loss of principal, and investors should be guided accordingly.
