Investor Letter - 4th Quarter 2022

Dear Investors & Friends,

It is perhaps an understatement to say we find ourselves in choppy waters.?Elevated geopolitical and economic uncertainty has caused a significant repricing of worldwide assets thus far in 2022.?For equity investors, it has been a tough year, with the S&P 500 down more than 25% at the recent lows. But volatility in the stock market is well understood as the price of admission, and this bear market follows three consecutive years of well above-average positive returns.?In fact, over the past five years, the S&P 500 has annualized a 9.2% return, despite it taking quite the circuitous route to get there. (Morningstar, 09/30/22)

What has made this year particularly painful is the drawdown in the bond market and the impact on more conservative investors.?Through September, it has been the longest and deepest bond bear market on record, which has led to the worst year since 1931 for the classic “60 / 40” portfolio of stocks and bonds.?In terms of total market capitalization declines, 2022 has seen more than twice that of the 2008 financial crisis, because of the decline in global bond prices. And unlike stocks, which have paid investors back for enduring considerable volatility, US aggregate bonds have experienced a negative total annual return of -0.2% over that same five-year period.??

Stock markets generally discount uncertainty.?The more the uncertainty, the larger the discount.?And at the three-quarter mark in 2022, uncertainty and pessimism are at historic levels.?In fact, we recently saw lower sentiment numbers than were recorded during Covid, the Financial Crisis of ’08, the Tech Crash, the Savings and Loan Crisis of the early 90’s and even the inflationary recessions of the early 80’s.??

Consumer sentiment 1975-2022

In this type of market environment, you will see charts like this one floating around social media, analyzed on television, and passed along through email chains, the implication being that there is much more pain to come.?After all, fear sells and generates more clicks and more advertising revenue.?The prevailing narrative in the media and among the public reflects this extremely pessimistic attitude.

However, there are several indicators that run counter to this bearish narrative that are important to take into consideration.?The history of rate hiking cycles, presidential term cycles, price performance, sentiment, and valuations suggest that there are counteracting forces against the downward pressure of risk in today’s markets.

Rate Hiking Cycle

Below we see the last seven rate hiking cycles, the number of months the hiking cycle lasted, and the number of months from the beginning of the hiking cycle to the bottom of the S&P 500. In all but one instance, the bottom of the S&P 500 occurred well before the cycle ended, often by a year or more.?We are now seven months into this hiking cycle, and if the S&P 500 bottomed here, it would already be the 2nd longest of the series.?Markets tend to draw down in anticipation of the hiking cycles, bottoming as they get underway, and rebound long before they are completed.

Source: The All In Podcast

Presidential Cycle

Since 1928, the S&P 500 has demonstrated a clear and persistent trend of weaker performance in the first half of a presidential cycle vs. the second half.?In any given cycle this may or not hold, but the trend is strong enough and the difference in performance wide enough, that it bears consideration in our forecasts.?We are just weeks away from the mid-point of this presidential cycle.

Price Performance

Since 1950, the S&P 500 has drawn down by 25% or more nine times, including 2022.?In all but one of those instances, the market was higher one year later, by an average of 21.6%, and was higher three years later in all cases by an average of 36.9%.?Now, it is important to note that 25% was not typically the bottom, and the S&P did make lower lows in several of those drawdowns, sometimes significantly so.?But it suggests that for long-term investors, drawdowns of this magnitude are typically followed by strong rebounds.?

Source Michael Batnick Twitter

Sentiment

The Association of Individual Investors conducts a weekly survey that gauges how individuals are feeling about the prospects for the markets.?It is generally used as a contrarian indicator, in that when investors feel the most optimistic, markets tend to fall and vice versa.?The five most “fearful” readings in the survey history going back to 1987 are indicated below along with their forward 1-, 3-, 6-, and 12-month returns.?In the other most fearful periods, 100% of the time the market was higher 12 months later by an average of 33.2%.?Interestingly, the 3/5/2009 reading was the exact week of the stock market low.

Valuation

Finally, we can look to current valuations as a starting point for future forward returns.?The S&P 500 forward price to earnings estimate sits just above 15, solidly under the 25-year average of 16.84.?However, should earnings fall in a potential recession (the denominator in the ratio), this would push the estimate up.?Considering that, we don’t view the market as being undervalued with respect to this metric, but rather likely in a fair value range with an expectation of a modest decline in earnings for 2023.?While valuation does not tell you much about the next year’s return (it is not a good timing indicator), starting valuations do tell you something about the forward five-year return expectations as indicated in the dot chart below.?As you would expect, a lower starting valuation projects a higher forward 5-year return.

The risks to the downside are well-known but should not be dismissed.?It has been decades since a confluence of geopolitical and economic risks of this magnitude were present in the market at the same time.?

A too aggressive Fed could tip the economy in to a severe recession.?Inflation expectations could become entrenched and lead to a stagflation experience reminiscent of the 70s and 80s.?Or more concerning than anything else, we could see a further escalation of the war in Eastern Europe that draws NATO and Russia into a direct conflict, a prospect that only becomes more likely the longer the war drags on.?

These risks all remain present, but it is important to balance the prevailing narrative with other important pieces of context.?We expect further volatility as the market digests the evolution of these factors, but our base case is that we are closer to the bottom of this drawdown than the top of it and that long-term investors should be using these lows as an opportunity to put capital to work.?

Zachary S. Mineur, CFA

Chief Investment Officer