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Ugh!

Posted: Jared Jameson

The first half of 2022 is over, thankfully. It was, for some investments, the worst start to a year on record. Not only did stock and bond markets suffer, but the economy also did. Inflation accelerated to its highest level in 40 years. Oil prices skyrocketed. And many other commodities hit multi-year highs. The Federal Reserve also embarked on a very aggressive tightening cycle. On the positive side, unemployment remains low, and some investments, especially alternatives, made money. In this WJNotes, we give more detail on first-half performance, discuss the benefits of diversification, highlight some recent trades, and comment on what we expect over the remainder of the year.

The following chart shows primary asset class performance for the first half of 2022.

All core asset classes which comprise our benchmarks were down. The stock market declines were typical for a bear market and unsurprising after three strong years. On the other hand, the bond market decline was historic. When was the last time the bond market declined 10% or more to start a year? It was 1788, according to Deutsche Bank, when the president was…George Washington!

Why did bonds perform so poorly? Simply, interest rates rose significantly and from a very low base. Remember, bond prices move opposite interest rates as existing bonds reprice to remain competitive with newly issued bonds. Add the negative returns of stocks and bonds together, and our benchmarks were down 13% to 18% (all returns are year-to-date through 6/30/2022). Fortunately, your portfolio was down materially less, discussed later.

The stock market decline was not monolithic. Energy stocks were up 31.6% as oil prices soared because of limited supply and recovering demand. Profitless technology and “cool idea” companies were decimated. Our poster child for this investing style, Cathie Wood’s ARK fund, was down 57.7% and is now down 71.6% from its peak over 18 months ago. Even the once impenetrable mega-cap technology stocks were down substantially (Apple -23%, Microsoft -27%, Amazon -36%, Facebook -52%, Nvidia -56%, Netflix -71%). Bitcoin was down 60%, and many other cryptocurrencies no longer exist after declining 100%.

What was the cause of this disaster? In short, historically high inflation. A mismatch between supply and demand creates inflation. COVID severely disrupted supply chains leading to supply issues across many industries. While, demand, stimulated by “stay at home” and Government handouts, spiked for certain goods. The result was an inflation reading in July of over 9%.

But, inflation alone shouldn’t get all the blame. The US Federal Reserve (“Fed”) was another primary influencer. In addition to maximum employment, the Fed’s other mandate is to maintain price stability. Clearly, they are not meeting this goal, and they finally recognized it this year. To combat inflation, the Fed has raised short-term rates from 0% at the beginning of the year to 1.75% in a series of three interest rate hikes. The last hike in June was 0.75%, the largest since 1994. And they’ve signaled many more increases to come. Throughout history, a Fed increasing interest rates to fight inflation has almost always led to a recession. The grey bars in the following chart represent recessions.

As the chart shows, most recessions were preceded by the Fed increasing rates. Investors recognize this pattern and sold stocks in anticipation of a potential recession later this year or in 2023. We discuss inflation and recession risk in the last section of this WJNotes.

2022 WJ Performance

Recently, we met with a fund representative from a large well-known investment firm in our office. We have these meetings frequently, as fund companies try to get their best products out in front of us. Typically, the meeting starts with the fund rep asking us questions about how we’re managing money so that they can tailor their pitch to our current situation.

As we’re describing our investment approach and the asset classes we’re invested in, it becomes evident to the rep that we’re likely outperforming the typical advisor he meets with. To which we respond to the rep, “Yeah, we probably are.” The next thing he said took us by surprise. He said, “well, have you told anybody?”

The answer was a simple “no.”

It’s likely a combination of reasons why we’re hesitant to talk performance. First, it’s just not our personality. Second, no one wants to hear about outperformance when their portfolio is down. Most of all, it’s the fact that we know performance can be fleeting and depends on numerous factors that aren’t always in our control.

Thinking back, we have talked about performance quite a bit…when we were trailing. Unfortunately, most of that time gets spent trying to defend our approach, educate on why we diversify, discuss “risk-adjusted returns, ” and establish a long-term focus. But fair is fair, so we’re going to take a short victory lap as an opportunity to demonstrate why we’ve invested the way we have over the years.

Our portfolios generally have beaten their benchmarks by around 3-4% this year. And we’ve more than doubled the performance of our benchmarks over the last two years, and the solid performance continues going several years past that.

Like we said earlier, we don’t love the idea of touting outperformance when the overall portfolios are down. Saying “we’ve lost less” isn’t the most satisfying conversation with a client…but is crucial. When markets are volatile and fear and uncertainty are high, it’s times like these that make-or-break financial plans. When markets are roaring and everyone’s making money and happy, those are the times where temptation creeps in. Temptation to take a little more risk. To sell “losers” in the portfolio that we own for diversification. No one wants diversification in a bull market.

This is where we excel. We’re happy to ride the wave of a bull market like anyone else, but we know it can’t last forever. For that reason, we put a lot of work into trying to diversify portfolios to a level we believe is beyond the typical investor. Below is a description of some of those concepts.

Managed Futures

Managed Futures is one of our favorite strategies. It just has a knack for showing up when you need it most. In 2022, while both stocks and bonds are crashing, our pure managed futures funds (ASFYX and PQTIX) have returned 37.1% and 19.9%, respectively.

These funds work by looking for trends in various markets including stocks, bonds, currencies and (especially helpful this year) commodities. They ride the trade for as long as it’s working, and get out once that trade reverses.

This is typically a great strategy when markets are stressed, such as in 2008 or during the pandemic crash in 2020, or this year. Managed futures can also do well when markets are calm, which makes the strategy a great long-term hold.

Reinsurance

Our primary reinsurance fund is up 6.3% through the end of June, beating stocks and bonds by about 20%. Recall that reinsurance makes money by collecting premiums to insure various properties from catastrophic weather damage.

In 2017, after a tough year dealing with Hurricane Harvey, Irma, and Maria as well as California fires, we decided to purchase the fund while it was down. Buying reinsurance after bad years is typically a good strategy as insurance companies raise premiums to recover losses. Unfortunately, we were a bit unlucky as there were continued disasters in 2018 and 2020.

On the bright side, those difficult years have led to some of the highest premiums the industry has seen in a long time. In addition, the premiums are often quoted as a spread to interest rates. So as those have gone up, our baseline expected return continues to go up for this fund.

We buy reinsurance for two reasons. It has a positive expected return, and importantly it has no correlation with what stocks and bonds are doing. This year is a perfect case for why that’s so important.

TAA Funds

TAA stands for tactical asset allocation, which is just a fancy way of saying adjusting the asset mix for a changing environment. Within this category we have two funds, one that adjusts based on momentum (what has done well), and one that adjusts based on value (what is cheap now).

Both have performed well this year, collectively outperforming their benchmark by about 5%. The momentum driven fund (ticker: ROMO) started reducing its stock exposure at the end of last year in favor of short-term bonds. The other fund (WABIX) had a very low amount of stock to start with as it viewed stocks as expensive.

These funds will continue to adapt as the market changes. As stocks cheapen and begin to recover, you should expect these funds to transition their positioning to take advantage. Until that time, they remain defensive.

Stocks

Within the stock portion of the portfolio, we’ve outperformed by about 1%. We limit active bets in this part of the portfolio, but it does have an overall value bias, which has helped this year as growth has suffered disproportionately.

Bonds

Bonds have had one of their worst years in history so far in 2022. The pain has come from two sources. First, longer maturity bonds have been hit the hardest as interest rates have soared. Second, credit spreads have gone up substantially, as company’s ability to service their debt has come into question.

Fortunately, we’ve owned mostly short-term bonds that are less affected by interest rates, and nearly no corporate bonds at all. As a result, our typical bond portfolio has beaten its benchmark by about 5%.

Alternatives

Lastly, we’ll discuss alternatives. We’ve already talked about managed futures and reinsurance, which represents most of the alternative portfolio. We also owned SVOL earlier in the year which gets return by shorting volatility (a complicated topic for another post), which CYA later replaced, a similar but more defensive strategy that has a large tail hedging component (something we’ve discussed in previous notes). These two funds have also outperformed stocks and performed more in line with bonds.

The alternatives portion of the portfolio altogether returned a positive 10%, versus a stock and bond blended return of -15%.

Recent Trades

We understand that outperformance doesn’t taste as sweet when there’s a negative sign in front of the return number, but there’s a huge benefit to outperforming in a down year. We can sell out of the things that have done well (alts, short term bonds, etc) to buy the things that have done poorly (stocks, long term bonds, credit) for cheap! This is called a “rebalancing premium,” and is a powerful contributor to returns.

To that end, we’ve placed a variety of trades this year, and expect more to come in the second half of the year.

  • Tax Loss Selling: Whenever you have a position that’s at a loss, you can sell it for the tax benefit and swap into a different, but similar fund. After 30 days you can swap back into the initial position and still keep the tax loss. We did this in many accounts where the opportunity was available.
  • We added a bit of tail protection in case stocks broke lower. This also allows us to be more aggressive when we rebalance since we’ll have that protection if we’re too early.
  • We have steadily simplified the stock portfolio over time and continued that effort this year. This means fewer funds, cheaper funds, and less aggressive bets within the stock model.
  • We’ve started to add more duration to the bond portfolio by buying long-term treasuries. Rates have risen significantly, so the yield is much higher. In addition, if the economy were to significantly slow, long maturity treasuries usually provide additional protection.
  • We are also adding high-yield corporate credit bonds to the portfolio. High Yield bonds started the year yielding close to 4%, and today are yielding about 8.5%! These rates may continue to increase, but being paid 8.5% to wait isn’t a bad deal.
  • Finally, we’ve started to take profits from the alternatives to fund some of the above purchases. We’ve only started selling out of alts and into riskier assets, and plan to continue doing so throughout the rest of the year as the market calls for it. We want to be careful about the pace we do this, as there’s plenty of risks remaining in the economy, as we’ll discuss next.

What Happens Next?

As mentioned in the introduction, the Federal Reserve has a dual mandate. They are to pursue the economic goals of maximum employment and price stability. Simplistically, these are competing goals. The basic concept is that strong economic growth leads to low unemployment but higher inflation. Whereas stagnant or negative growth leads to high unemployment and low inflation. This view is simplistic because, in the 1970s for example, we experienced high unemployment and inflation simultaneously (i.e., stagflation). The exhibit below represents the simplistic view.

So how does the Fed influence unemployment and inflation? Primarily by adjusting short-term interest rates. The housing market provides an excellent example of the impact of interest rate changes. To temper an overheated real estate market, Fed rate increases lead to higher mortgage rates, leading to falling demand and lower prices. Conversely, if the Fed wants to stimulate the housing market, they cut interest rates. As a result, mortgage rates will fall, and housing demand will increase, leading to rising prices. Interest rate increases and decreases similarly impact many other industries throughout the economy.

The Fed recognizes inflation is too high. To reduce inflation, they began increasing interest rates this year. Increasing interest rates will slow the economy and increase unemployment. But hopefully not too much. Moving from here:

To here:

Without going here:

The last scenario shown above is a recession. In a recession, we can expect significant additional losses in the stock market.

And to make the Fed’s job even more complicated, interest rate adjustments work with a lag. Rate adjustments may not have an impact for months or years. Match this fact with a Fed that meets eight times a year, and” flying blind” may be too generous a description. Basically, they are making decisions without being able to judge the impact of their previous twelve decisions.

Our view is a recession seems likely. The current 20% decline in stocks seems appropriate if it is a minor recession. If it is more significant, stocks will decline further. The magnitude of the recession will depend on the path of inflation and the Fed’s reaction to it. And will take many months to play out.

Despite significant near-term economic headwinds, the future looks brighter than it has in many years. The decline in stocks and the historic decline in bonds mean returns in the future will be higher. High enough that we recently increased our return estimates in financial plans. As always, we are available to discuss your portfolio or financial plan.

Disclaimer: PAST PERFORMANCE IS NOT A GUARANTEE OF CURRENT OR FUTURE RESULTS. Historical examples included in this WJNotes do not, nor are they intended to, constitute a promise of similar future results. The WJ benchmarks represented herein are the benchmark allocations from which most client portfolios are designed. Specific client portfolio allocations, risks and returns can and may deviate from these benchmarks depending on accounts and types of investments available through each account. Future market views by WJ Interests, LLC may vary significantly from the historical examples presented herein and no one receiving this summary should assume that WJ Interests, LLC will be able to replicate successful views in the future.
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