Client Newsletter 3Q22
Dear Ambassador Family,
I hope you are enjoying a wonderful summer so far!
In my April newsletter, I shared my thoughts and predictions that 2022 would be a difficult year. Let’s jump in and see what’s changed since the second quarter.
Let’s Recap 2022 Thus Far
2022 has been a challenging year (and we are barely past the halfway mark).
But it could have been worse.
If you were only in stocks, you might have been down over -21%. This ranks as the worst start to a year in nearly 60 years. (If you were only in growth stocks, you might have seen even bigger declines.)
If you were in a 60/40 portfolio, your accounts might still be down -16%, the second worse performance for such a “diversified” portfolio since 2008.
Now imagine if you were in crypto? Bitcoin, the largest cryptocurrency by market cap, is down nearly -60% this year. (Disclosure: no client portfolios managed by AWM have any crypto exposure.)
The first half of this year seemed like a game of “keep away” or “hot potato”. We have spent the last six months really focusing on making sure your portfolios are not exposed to investments at risk from higher interest rates, inflation, and/or risk of recession.
Consequently, we pared down exposure in your growth bucket to equities, particularly in sector ETF’s and Japan.
Even though we entered the year quite cautious on fixed income, we don’t want to buy things because they are on sale. We want to buy quality. (Coincidentally, you might see a higher balance of cash than usual. You might expect to see some of it invested in the coming months, though we continue to be cautious with a lot of patience.)
What Are We Hoping to See in the Second Half of 2022?
One question that we wrestle with is this: what do we want to see for an “all clear” to buy risk assets?
Some observers allege that the Fed will “cry uncle” and stop raising rates soon. They hope that by doing that, inflation will have stopped, interest rates plunge, and risk assets will resume their bull market surge.
History of past 1H corrections in recent years might indicate this is a possibility. However, we are less optimistic near term.
What conditions would we like to see to become more optimistic? (It does not mean everything will line up.)
- Inflation is truly tamed (supplies in commodities grow and consumers are able to spend without borrowing)
- Stable interest rates (preferably with the 10-year Treasury yield starting at a 4% or 5% handle, thus returning to historically average rates and also providing a real positive return relative to potential future inflation of 3 or 4%)
- Economic growth and corporate earnings estimates reset downward once a recession is acknowledged (but be careful of what you wish for – that might also imply a lower price for stocks to begin with)
- Government policies less hostile to private enterprise (you might see a minor reprieve depending on outcome of midterm elections, real focus though comes in 2024)
- Geopolitical tensions stabilize or ease (détente with Russia, China does not commit incursion into Taiwan).
Addressing Risk in Your Investments
Let’s talk about one way we look at whether to add or reduce risk in your investments. (We cannot eliminate risk completely. Even cash has risk as do stocks.)
Over the long term, stocks in most time periods tend to provide the highest returns. However, there are moments when they don’t (and in fact can decline, such as now). The reason is that they are valued at a price which drives most of the return of a stock (in many cases, the dividend a stock pays can also be an important source of return). If the price of a stock is higher in the future than now, then you earn a positive return (and vice versa).
Think of this: a stock’s price can be considered as two components:
- The profits (or cash flow) that the underlying company can deliver, and
- The multiple (how many times one year’s worth of profits or cash flow) the market is willing to pay for that stock.
- Higher multiples tend to be associated with companies with strong growth prospects, market share, and/or stability.
- Lower multiples often come with lower confidence in those metrics.
One can consider a broad-based stock index (such as the S&P 500) as simply a group of many individual stocks. Thus, the same components that drive the price of a stock also drive the price of an index.
In a year such as 2021, confidence was high and earnings were expected to grow nicely. Consequently, investors were willing to pay a higher multiple on growing earnings, resulting in a strong price performance in 2021.
However, investors risk becoming complacent in bull markets. Multiples can (and did in 2021) surge to above normal levels, even though earnings prospects might not have changed nearly as much.
Switch to 2022, and we face a different environment. Indeed, the bulk of the correction in prices in 2022 resulted from the market assigning a lower multiple to a relatively flat level of earnings (for the broad stock market). However, changes in earnings prospects within sectors masked the earnings.
Reasons for investors paying a lower multiple for earnings might include:
- The Fed announcing it would raise rates and cease from buying more debt (ending “Quantitative Easing”) in order to try to lower inflation.
- Inflation starting with higher commodity prices (such as food and energy) has extended into other goods and services (airline prices, taxes). The war in Ukraine and China Covid lockdown policies have exacerbated a situation that began in 2020.
- Rising interest rates would dent future economic growth prospects. The Fed seeking to tighten interest rates might send the US into recession. Europe and emerging markets also are teetering on recession.
- Geopolitical volatility (Ukraine the latest example) also dampened investors’ willingness to pay a higher multiple for stocks.
If the US has truly entered into recession (which we believe is likely either in 2022 or 2023), then earning estimates likely go lower. In past recessions, earnings on the S&P 500 have been cut anywhere from -15% to -30% or more (such as in 2008).
A number of Wall Street banks estimate earnings on the S&P 500 to total around $240 per share in 2022. Taking even a mild -17% cut in a recession would drop them to $200.
In the good old days of last year, multiples reached as high as 21. Prior to 2021, multiples on market earnings have ranged between 13 to 18 times earnings.
In an environment of high confidence, fair value for the market might be around $3600 (18 times $200 in earnings). If confidence were to ebb somewhat (but not collapse), we could see the market sell down further to $3000 (15 times $200 earnings). As of June 30, the market closed roughly at $3800.
In a word, we believe the markets could still decline this year. It is possible to see near-term rallies (indeed, we have had 3 of them this year). However, at least thus far, the market has not gone to new highs.
We encourage all of our clients to have a financial plan in place. This will help with navigating uncertain times, preparing for retirement, understanding what income can be taken without depleting principal, strategizing tax implications, and help you avoid pitfalls.
My most successful clients always know where they are going and what their options are. Let us help to prepare you for retirement by properly adjusting risk in your portfolio, implementing strategies to save on taxes, and protecting your principal while not giving up your standard of living.
Please remember, it’s not about how much you make, but in the end, how much you keep that really matters.
Petr Burunov, CFP®
President / Wealth Strategist