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We Survived

Posted: Jared Jameson

Successful investing is about survival. Survival means avoiding losses that can’t be recovered when the market turns. Unfortunately, some investors will not survive 2022. Investors in cryptocurrencies, Cathie Wood’s ARK fund, many wildly overpriced technology stocks, and long-term, risky bonds have lost the game permanently.

All WJ clients survived 2022. Market losses jeopardized no one’s financial plan. Clients are now positioned to fully recover losses in the near future with some cooperation from stocks and bond markets. In this WJNotes, we discuss performance, the economy, portfolio positioning, and expectations for 2023. We also discuss a change to our portfolio benchmarks.

The following chart shows world stock market performance this year vs. every year since 1969. You can see it has been a bad year but not the worst.

It's been worse

However, on the bond side, the story is different.

Tough year for bonds

Global bonds experienced their worst year by far since 1999. And possibly the worst year in centuries, although we don’t have the data to prove it. Your WJ bond portfolio performed better than the index portfolio shown in the chart because of our focus on short-term bonds early in the year.

On the brighter side, the primary alternatives we use in portfolios, managed futures and reinsurance were up 14% and 4%, respectively. And alternatives, plus bond positioning mentioned above, allowed us to beat our benchmarks for the year.

What happened this year? Inflation.

 

Pandemic

The surge in inflation from COVID was historic. 2022 inflation will be the highest in decades. However, on the positive side, inflation appears to have peaked several months ago. We expect this trend to continue next year.

Inflation in and of itself is bad for investment markets. Markets were made worse this year by the Federal Reserve’s (“FED”) dramatic actions to bring inflation down. The FED’s short-term bond rate (blue line below) increases were unprecedented in both magnitude and frequency. Long term rates (red line below), which the FED does not control, increased in sympathy, as the following chart shows:

2022 Interest Rates

And the FED is not done, they will likely continue to increase rates in the beginning of 2023.

So, what do we expect for the economy in 2023? 

 

The FED’s past and future rate increases will slow economic demand which has already begun:

Economic Strength Indices

And their actions could lead to a recession.

Leading economic indicators are pointing to recession

The recession could be mild, or severe. We don’t know at this point.

Regardless, the large rate increases this year have created an opportunity in bonds. So, over the past 6 months we’ve:

  1. Sold outperforming alternatives, taking profits, and bought bonds.
  2. Bought longer maturity bonds which will benefit if rates decline in 2023.
  3. Aggressively harvested tax losses in several bond funds.
  4. Exited tail risk protection in favor of bonds.

The stock market may have another challenging year next year, especially if we have a severe recession, but bonds will almost certainly provide protection, unlike 2022. With a current yield of 6%, and upside if interest rates fall, your bond portfolio will likely return high single digits to low double digits next year vs. a loss of 6% this year.

Please join us in late January at our 2023 Outlook Luncheon to discuss all of these issues in more detail.

2022 was a challenging year for all investors. Thank you for allowing us to guide you through tumultuous times. We hope you have a Happy New Year.

Benchmark Change

 

A portfolio’s benchmark will typically reflect the client’s strategic allocation before any active changes are made.

An appropriate benchmark should:

  • Reflect how a client would invest to reach their goals given their risk tolerance.
  • Be a starting point when thinking of how to invest the portfolio.
  • Provide context to the performance of the active portfolio.

We consider these criteria when creating the benchmark and will make changes if we feel the benchmark no longer satisfies them.

As such, we believe our current benchmark, while appropriate, does not match what we typically see in client portfolios. We are implementing the following change:

  • Changing the bond portion of the benchmark from:
    • 50% Vanguard Total Bond Market Index (BND)
    • 50% SPDR Nuveen Barclays Municipal Bond (TFI)
  • To:
    • 100% Vanguard Total Bond Market Index (BND)

Eliminating the municipal bond portion of the benchmark makes sense for a few reasons.

  1. Municipal bonds are not appropriate for tax-deferred accounts which represent over half of what we manage.
  2. Our models have averaged about a 25% allocation to municipal bonds, despite the benchmark’s 50% weighting.
  3. The municipal bond fund used in the benchmark has proven to be inappropriate, as the duration/maturity profile is very long, much longer than any fund we’ve used in our client’s portfolios.
  4. BND is a “Total Bond Market Index” and represents the return associated with owning all taxable bonds, which is appropriate to give context to our active bond performance.

The performance of TFI and BND has been very similar historically, so we don’t feel this will have a material impact on the benchmark’s performance going forward. In fact, since municipal bonds typically pay a lower yield due to their tax advantage, the new benchmark will likely have a higher yield. Still, we think the change makes sense to better align the benchmark with how we intend to manage portfolios.

We will make the change on January 1, 2023. If you have any questions, please let us know.

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