4th Quarter 2022
Happy New Year. As I sat and wrote this, I had the TV tuned to CNBC. Yes had. Instead of talking about the media lets really start at the beginning. Today being the first business day of the year, I headed into work all set to make 2023 better than 2022. Frankly 2022 was a pretty bad year. And CNBC was doing nothing but reminding me of that. From a personal standpoint we lost both friends and family members in 2022. From a wealth standpoint last year is now recorded as the 4th worst market since WW2 with the largest equity indexes falling double digits and the ‘safe’ bond market registering its worst year in history. Yes history. (the 30 year US Treasury fell over 32% in price last year…) The S&P500 growth index dropped almost 30% and the Mega Caps, as measured by the Vanguard Mega Cap Growth Index were down about 34%. The TV is blaring words like ‘disaster’, ‘loser’, ‘dysfunction’, ‘recession’, ‘inflation’, ‘war’, ‘trade war’, ‘supply chain disruption’, ‘crisis’, ‘battle’, ‘China lockdowns', 'China and Taiwan’… doom…gloom… This negativity is all reflected in the fact only one sector of the S&P500 registered positive returns in 2022. Energy, up over 65%. Utilities were second best, up just under 2% when you add the dividend into its performance. Yes, 2022 was not good for wealth creation. I know all this, so I turned the TV off.
Honestly, it’s easy to see why there is pessimism. Bad news sells and there has been plenty of it to capitalize on. After almost three years of being told by the supposed experts that we were all going to die of a disease called COVID, lockdowns and policies that have done incalculable damage to the economic stability and mental health of so many, an invasion of a sovereign state by a nuclear power with no clear end or even true goal in mind, inflation rates that have not been seen since the 1970s, energy and food prices that have sky rocketed, new ESG policies in the boardroom that places gender and appearance ahead of qualification, unfettered mass migration from third world countries over our southern border bringing with it new and more powerful drugs that are designed to addict and harm our children, complete disfunction in Washington amongst our elected officials and little belief that they know what they are doing anyway, now substantiated information about what we ‘knew but didn’t want to admit to’ that we are lied to by the media and that the government has intentionally suppressed dissenting views on a variety of subjects including our healthcare, riots and our elections all while some are rewriting the history we grew up with through the removal of stories in the classroom, statues in our parks and museums and the ‘cancelation’ of people who have differing opinions and /or were once our heroes, it’s no wonder people are depressed. Yet as I said, I came in this morning with my head up and a sense of optimism.
So why the optimism? It’s really because yesterday I was reminded what is important. You see, I receive a morning affirmation in a text from one of you every day. Yesterday the message was simple but impactful. ‘Let us approach the New Year with resolve to find the opportunities hidden in each day’. To find the opportunities HIDDEN in each day…. hmmm. Opportunities.
In business school, students are typically taught about the efficient frontier, that is the benefit of diversifying and adjusting one’s portfolio to achieve the maximum return with the least amount of risk. Rarely taught is the fact that frontiers or goal posts shift depending on the economic climate. We are in such a period now with many individuals and managers attempting to “de-risk” their portfolios at perhaps the worst time. They are moving goal posts. An example is that the real estate private equity investment manager Blackstone recently received substantial redemption requests. In fact, they were so great that Blackstone put a hold on redemptions so that they could efficiently (re: slowly) dispose of assets to cover the requests without disrupting the businesses and properties they had invested in. Depending on one’s view of inflation, interest rates and cap rates, these redemption request might be viewed as ill-timed. One might look at this as the proverbial ‘selling at the bottom’.
We have seen this before. 2001 and 2008 come to mind. As a matter of fact, those of you who used to read my morning missive at UBS may remember the story of a client that stopped me outside of my office on a Monday morning in 2008 to talk before the market opened. He needed to do ‘something’. He was concerned that the market could drop another 10%. He had read Barron’s over the weekend and the paper was filled with doom and gloom…btw, the market was already down ~30% for the year at that point. He was nervous and he had a bad case of ‘fight or flight’. SO influenced by the media, he came up to my office and on that Monday morning he sold his entire portfolio of securities. (The story ended on a positive note when the next day our client called and reversed course buying everything back…but he had acted originally, not out of logic but out of fear influenced by the media...but luckily realized he had given up his opportunity to recover and made the hard yet correct move to reinvest.)
Opportunity shows up in different places. Some savvy investors have made a habit of seeking and benefiting from fear and the ensuing market disruptions. The billionaire Tisch family purchased tankers at $5M each in early 1982 when the scrap value was near $5M. Soon, the same tankers were trading at $50M. Likewise, the head of a major trading firm generated the seed capital for his firm by visiting the various betting venues, assessing odds, and placing bets based on statistics rather than emotions, thereby locking in dependable gains. Sophisticated investors anticipate real value and reactions of fellow investors. Warren Buffett is known for taking advantage of others who panic at the wrong time and buying good companies' stock with a long-term investment horizon during those periods. It was Buffett who effectively gave Goldman Sachs a loan in 2008 and in return got his money paid back and a hefty piece of equity in the investment bank just a few short years after making the loan. Sam Zell, the Chicago financier who built his fortune on the cycles that shape different industries from real estate to rail cars, noted in a 2007 lecture to the students at Wharton that the economic turmoil of that time was "not really a credit crunch" but a "confidence crunch". Zell blamed the problems on excess liquidity and on people who “bought anything they wanted and were proud that they didn't do due diligence. I think they have all been chagrined and are scared out of their minds." Perhaps this quote again applies to today. And there...there is an opportunity.
The question today isn’t what will happen to the markets over the next week, the next day, or the next month. Does Warren Buffett worry about the short term or the long-term opportunity? Investing is about returns over years not minutes. With a solid plan in place and realistic expectations one can weather the short-term storms that are thrown at us as investors. (Investing and trading are different pursuits. Ill note that I can name quite of few successful investors yet not one successful trader. Why is that??…)
2022's asset price decline came amid rising inflation that prompted the Federal Reserve's Federal Open Market Committee to boost its benchmark lending rate several times, sparking fears that the rising rates may lead to a recession. Stock market participants are predicting a recession either in 2023 or early 2024. The severity of their predictions run the gambit...shallow to horrific. The market seems to be pricing in worse case scenarios. But the economy seems to remain resilient regardless of what the stock market says. And now bond rates on the longer side have begun to drop. The bond market is signaling that inflation has peaked. Unfortunately, the Federal Reserve is having to fight the ridiculous spending spree that Washington has been on by raising interest rates and penalizing the average American. They have said they will stop only when inflation is tamed...which means more Americans are out of work and housing prices are where many cannot afford to buy.
So where is the opportunity today? Well Market participants had been hoping the rate increases would slow, and perhaps end. There certainly is a possibility that this happens. The Fed has already raised rates more aggressively than ever before. Prices are not rising at the rate they were, and the employment picture isn't as rosy as it was a year ago. Rising rates are impacting the economy. The housing market also may surprise us and remain a strong source of support. A major beneficiary of loose money in 2020-21, the housing market is nothing like it was during the Great Recession of 08-09. Prices have already retreated to what could be called fair value (roughly replacement value) and if rates tick down there is pent up demand as we are 'under housed' in this country.
There is also the possibility that there is some resolution to the conflict in the Ukraine. Considering the costs both in terms of money and life, peace cannot come quickly enough. Should Russia and the Ukraine enter peace negotiations then energy prices will drop, alleviating some of the inflation pressures caused by the conflict. An added benefit will be increased global grain and fertilizer availability which should lead to lower overall global food prices. With any ending of the war, inflation is likely to ease, the slow rebuilding will begin, interest rates might moderate, and the dollar might lose some of its recent strength.
China is finally addressing the certainty of COVID and opening up. Although this will draw more energy from an already tight supply system the offset is the foul up in supply chains will decrease leading to lower goods prices. There is little doubt that XI Jinping has made significant policy mistakes upsetting China's trading partners, but it will take years to move significant manufacturing back to North America. Opening and the return of manufacturing on shore will lead to years of growth.
There is additional optimism when one considers that the equity market looks ahead versus behind. We know what has happened in 2022 and we know that CEOs, economists and pundits were not optimistic about the economy but the S&P500 is now trading at roughly 15 times expected 2023 earnings. Back out the top 5 holdings in the S&P and that number is closer to 12. This is historically a good entry point to equities. The drop in equity prices in 2022 may already take into account a slower economy with a worse job outlook. Valuations have adjusted and if you are an investor the historic 15-year rate of return of almost 9% per year is certainly worth considering. (the last 10 years have averaged almost 13% per year)
Finally, it seems that everyone that you see on TV or read in the paper or listen to on the radio has a negative bias. It's easy in light of all the problems I described above to have this take. It puts you in a comfortable lot with many others. You are not the outlier. Unfortunately, it also goes against what has always happened. You see Sam Zell was right. What we have today is a confidence crunch. He told those students at the University of Pennsylvania a simple truth that people seem to forget over and over again. What he knew, and what he shared was that business and markets are cyclical. Warren Buffett takes advantage of these business cycles and of all that negativity and invests for the long term. Perhaps that is what we all should be doing.
Information contained herein does not involve the rendering of personalized investment advice but is limited to the dissemination of general information.
A professional adviser should be consulted before implementing any of the strategies or options presented.