A second bite at the apple

A second bite at the apple -Originally written January 8th, 2023
 

"I know now, after fifty years, that the finding/losing, forgetting/remembering, leaving/returning, never stops. The whole of life is about another chance, and while we are alive, till the very end, there is always another chance."

-Jeanette Winterson

 
2022 In numbers
 
During the past year we experienced violent tumult in financial markets not seen since the financial crisis of 2008-09.  Here are a few of the most important markets and indicators that impacted clients.
 
Bonds:  The iShares Core U.S. Aggregate Bond ETF: AGG faced a price decline of -14.38% in 2022 which was eclipsed in downside magnitude by the Vanguard Long-Term Bond Index Fund ETF: BLV with its -28.37% decline. I believe that the indices these funds represent have an unparalleled influence on all other risk assets.  Given these historic declines, the interesting change entering 2023 will be the four-plus and nearly five percent yield of each fund respectively. 
 
Money now having a price above zero, editorializing, will have continued impact on all global financial markets.  Does this price of money increase or decrease will be one of the most important catalysts for the general stock market to answer in the year ahead. 

All data sourced from Schwab Advisor Center, Research.  Charles Schwab and Co., Inc.

 
Inflation: According to the BLS survey data, November 2022 being the last reading as of this writing, inflation ended the year at a 7.1% YoY increase.  While 0.3% higher than the November 2021 reading, this reading represents a 2% decline from CPI’s zenith in June of 2022 at 9.1%.  Furthermore, if you were to annualize the last three months average inflation, you would find the current rate of inflation is annualizing at 3.6%.  
 
The Fed erred in calling inflation “transitory”.  While the word implies short-term that “short-term” isn’t defined to delineate three months from three years.  Close watchers of the sources of inflation could make the argument that certain drivers of inflation have been transitory; however, the drivers of inflation have moved from goods to services keeping overall numbers high.  The continued decline or stagnation of inflation will be another factor driving risk markets in the year ahead as it looks like inflation could cool rapidly.  
All data sourced from CPI Home : U.S. Bureau of Labor Statistics (bls.gov)
 
Equity markets: The S&P 500 suffered it’s fourth worst calendar performance since the 1957 inception of the index at -19.4% with the Nasdaq declining a painful -33.1%.  Stocks did not suffer equally as equites in the Vanguard High Dividend Yield Index ETF: VYM decline only   -3.48% which was nearly mitigated by it’s almost three percent dividend yield.  Emerging markets fell just around -29% depending on the index you choose. 
 
A rebound or lack thereof within the equity markets will dominate the coming year.  According to Twain “Prediction is difficult particularly when it involves the future” thus you will not find me gazing into my crystal ball to make predictions.  An important point to remember is that bear markets can and have persisted for more than one calendar year.  Diversification in asset class and equity type can help mitigate this potential continued bear market. This could be the year that international markets finally outperform given their previous streak of multi-year under performance.  

  
 
“The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!,’ ignore them.”

-Warren Buffett
 

The most interesting story in risk assets
 
Since I started investing in 2007-08 until the beginning of 2022 interest rates have generally moved in one direction, down.  In 2022 the long-term downward trend in rates, which you could easily argue began in the early 80’s, reversed its course.  The Fed raised rates at each meeting in 2022 including several, aggressive 0.75% rate increases later in the year.  This decisive rate-raising regime led to carnage in the bond market especially on the long-end of the yield curve (see BLV above!).  I especially like the Austrian 100-year bond offering maturing in 2117 that lost roughly 54% of its value in 2022. But, where there is carnage so is there opportunity… 
 
While my favorite ETF for long-term bonds, BLV, declined nearly 30% in 2022, it bottomed in late October and has since rallying nearly 9%.  In fact, not to be pedantic, BLV rallied nearly 17% off the lows of October into early December before retreating to end the year; thus, giving us a second bite at the apple. 
 
This rally was powered by the expectation, still yet to be fulfilled, that the Fed will end its tightening spree.  Perhaps, and a theory I find most plausible, entails the anticipation that Fed over tightening leads to a Fed induced slowdown.  The slowdown then is the tail that wags the dog by forcing the Fed to lower rates in response to recessionary pressures. In this scenario you would not expect downside price pressure on long-term bonds. The question becomes, can long-bonds rally higher in 2023? 
 
What makes long-term bonds (municipal, investment grade corporates, and treasuries, excluding high yield) most interesting is the balance of the risks in differing scenarios.  Let’s examine three of the many such scenarios that could unfold.
 
First, if the economy experiences a “soft landing”, that is no recession with an end to Fed rate raises, the price of long-bonds will be difficult to anticipate.  I would very much doubt the bonds fall in price as in this scenario, the Fed would have “vanquished” inflation which, quite clearly, is their stated goal.  More than likely this would leave us with the current yield of these bonds intact. This representing a relatively decent, diversifying return for the average portfolio at higher yields not seen in many years.  
 
Two other scenarios result in yield of these securities plus a duration trade.  That “duration trade” is the increase in price of these bonds because interest rates decline which adds to an already generous yield.  These two scenarios involve either inflation refusing to subdue easily thus forcing the Fed to continue tightening the economy into a recession or a recession that has already taken root due to the lag in the already steep interest rate increases. 
 
In either scenario we could assume that the long bonds would give the opportunity, while not guarantee, to outperform stocks that might struggle during recessionary pressure or continued inflation. While unknown, this seems most likely as investors would seek to move up the capital structure in times of recession. Moving up the capital structure means increasing the likelihood of recovering your investments if the company you invested in experienced insolvency.  Often this simply means becoming a bond holder versus equity holder especially in a year that equities may struggle. The overriding point is that return may be possible outside of the equity market given our current conditions.  
 
This circles all the way back to the earlier point that bear markets can exist for multiple years and require outside the box thinking to overcome.  Utilizing differing asset classes and imagining a multitude of outcomes while pursuing the highest probability opportunities remains our stance at Fiduciary Financial Advisors especially, when you have previewed the upside scenario. Never hesitate to take that second bite at the apple!
 
As always reach out with questions, commentary, or just to say hello!
 
Be well and invest for the long-term,
rob
 
Disclosure: The opinions expressed above are my own and do not constitute investment advice.  When investing in securities, there is always a potential for loss including principal loss.