Q3 2022 Market Commentary
Asset Class Performance
US Small Cap was the relative outperformer in Q3 2022, but fell -2.2%. Commodities are still leading YTD even after posting a -4.1% return in Q3. Emerging Markets were hit the hardest in Q3 2022, -11.6% over the quarter for a YTD decline of -27%. Only two of the eleven S&P sectors posted a positive return during Q3. Consumer Discretionary and Energy were up 3.9% and 1.8%, respectively. The other nine sectors were all in the red with Communication Services and Real Estate falling the furthest, -11.6% and -11.1%, respectively. US Growth stocks broke their two-quarter streak of having the worst quarterly asset class performance, but during Q3, they were one of the top performers at -3.6%. The below visual comes from Q3 2022 Russell Investments Economic and Market Review, showing last quarter’s index returns and year-to-date index returns in 2022.
Extensive research has shown that, if you have a diversified portfolio, a whopping 88% of your experience (the volatility you encounter and the returns you earn) can be traced back to your asset allocation. - Vanguard.
Market Reflections and Outlook
The market has been a challenging environment across asset classes, leaving nearly no place to hide for investors. The stock market is down in the US and Internationally, and bonds are having the worst year on record. The combination of rising interest rates and a looming recession have created an environment where it is challenging to make money. While we have views on the health of the stock market and if interest rates will rise or fall, a core piece of our investing philosophy is recognizing that we don’t have a crystal ball. Our goal as investment managers is to invest in a diversified portfolio that can perform well in different market environments, but importantly, our foundation in risk management taught us to think about the risks from which even a diversified portfolio may suffer.
We recognize that the path of the Fed’s involvement with interest rates and inflation is going to drive the markets - from stocks, to bonds, real estate, currencies, and commodities. The Fed is continuing to raise the federal funds rate to combat inflation, but inflation remains high. The chart to the right shows the difference between the 10-year treasury rate, and US inflation; the pandemic created a gap (inflation over 4% higher than 10 year rates) that hasn’t existed since the mid-1970s. While we generally believe that the Fed will continue to raise rates between now and the start of next year, the path in 2023 onward is dependent on businesses’ ability to withstand a higher rate environment, a worldwide ability to handle a stronger US dollar, consumer health, and market sentiment.
A Shift to Dividends and Value
When investing in the US Stock Market, the most common investments are mutual funds and exchange traded funds that track the S&P 500. The S&P 500 represents the largest 500 companies in the US, and when we look under the hood, so much of the exposure is dominated by a small group of very large companies. These are names we all know: Apple, Google, Microsoft, Amazon, and Tesla, and they are concentrated in growth sectors: communications, consumer discretionary, and technology. Over the last decade, and the start of the pandemic, these companies were the strongest performers. JP Morgan writes: “The top 10 S&P 500 names accounted for nearly 2/3 of the 2021 return.” During the period of low interest rates, growth stocks greatly outperformed value stocks, and the valuation levels of growth stocks became extreme.
The chart below shows the factor performance for US stocks this year-to-date. While across the board, stocks are down, value and dividend stocks were better protected in this environment. Note, the below are index returns, and you cannot invest directly into an index. This chart is for illustrative purposes only.
If You’re Sitting on Cash
This time last year, we began writing about the opportunity in I-bonds (US Savings bonds designed to protect the value of your cash from inflation). Based on estimates on inflation figures between March and September this year the rate offered for I-bonds purchased after the end of October is expected to be 6.47%. At this point, because of the lower rate and the cap of $10k per individual, it makes sense to explore alternatives.
If you have more cash sitting in your checking or savings account and you intend to use the cash in the nearer term, here are a few options we think are worth talking about, especially because in this market short term bonds are actually paying a higher yield (or rate of interest) than longer term bonds.
Certificates of Deposit: If you’re willing to lock up your money temporarily, certificates of deposits can provide returns we haven’t seen in this space for decades.
Municipal Bonds: While municipal bonds are earning a 4% average yield, these yields are generally after-tax for federal taxes and can be after-tax for state taxes if you are invested in your state. Therefore if you’re a California resident invested in a California municipal bond earning 4% and you’re in the top tax brackets (37% federal and 13.3% state), your pre-tax return equivalent is actually closer to 8%.
T-Bills: Overall, T-bill yields are likely to respond faster to rate increases by the Federal Reserve compared to online savings accounts or CDs. You don’t need to pay state and local income tax on the interest you earn from T-bills, so this is a great option for high income earners in high income tax states like California and New York.
Corporate Bonds: Depending on the credit quality of the bond, corporates are generally earning a yield between 5-10%.
Investing in these asset classes can have greater risk than sitting in cash, however, with inflation continuing to persist, staying in cash can result in your dollars today being worth less tomorrow.
The table on the left shows the current yields for asset classes within the bond universe, and the chart on the right shows the impact of a rise or fall of 1% in interest rates. This is the first time in over a decade where bond yields provide protection against rising rates. For example, if you were to invest in 2 year treasury bonds at a 4.22% yield, you would earn 4.22% if rates go unchanged, and between 2.4% and 6.2% if rates rise or fall by 1%.
Time in the Market (Not Timing the Market)
We started our careers as Wall Street careened into the Great Recession of 2008. Every market around the world went down at the same time, and every 24/7 news channel at some point proclaimed that stock markets would never make a comeback. Sound familiar?
It may seem like a lot of the news is filled with doom and gloom right now, which is why we think it’s important to perform a little mental time travel while referencing the picture to the left.
On the left you’ll see the visualization of the cost of missing the best week, month, three months and six months in the broad US stock market.
What was the best week? The week ending November 28, 2008. Lehman Brothers had failed two months prior. The financial crisis was unfolding.
What was the best month? The month ending April 22, 2020. The Covid-19 virus had spread throughout the world.
The best three months? June 22, 2020. We finally realized that Covid was a global pandemic.
The best six months? September 4, 2009. Six months before, the S&P 500 hit its lowest point in the financial crisis, closing at 676.53.
Nobody likes losing money, but exercising disciplined buying during times of market dislocation presents investors with the opportunity to experience much higher expected returns in the future.
Investor Ben Carlson recently wrote about opportunities for every generation of investor during bear markets. It’s well worth the read, but if you don’t have time, take a look at the chart above. After the S&P 500 has fallen 25% from all-time highs, the average 1-year return is 16.7%, the average 5-year return is 83.3%, and the average 10-year return is 213.7%!
The dislocation we’ve seen in 2022 has certainly shifted future expectations for just about every asset class. As we finish out the year, our best recommendation is to review the job descriptions and timeframes you’ve assigned to your portfolios. If you’re feeling like the timeline has shifted for your goals, reach out to your financial advisor and work with them to update the investment policies for your portfolios
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Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.