September is typically the most volatile month of the year, and this past month was no exception. After spending the first half of the month in an uptrend, the S&P 500 rolled over and sank to new lows for the year. For the month, the S&P, NASDAQ, value/RPV and small caps/IWM all declined between 8-9% as increased recession fears gripped the market. The bond index lost 4.3% for the month. TWG conservative 60/40, moderate 75/25 and growth 90/10 declined 3.3%, 3.9% and 4.7% respectively. There was little to get excited about, and cash is king.
For the third quarter, the S&P 500 and the bond market both declined around 5% to close at annual lows. TWG conservative 60/40, moderate 75/25 and growth 90/10 were down 2.9%, 3.3% and 3.9%, respectively for the quarter.
WHAT’S DRIVING THE MARKET – Higher for Longer
The market responded negatively to Powell’s Jackson Hole speech when he took a notably firm stance on the Fed’s priority to keep raising rates until inflation reaches their target 2% level. He re-confirmed this steadfast commitment during the September policy committee meeting. While the market was anticipating another .75% rate hike after a hotter than-expected CPI data the prior week, markets sold off for the remainder of the month. What the market is anticipating is that the Fed will raise rates too high too fast, lowering the odds of a “soft landing”. In fact, a hard landing is looking more probable, and the concerns of the Fed making (another) policy mistake has increased. Their first policy mistake may be them not raising rates last year, when economic growth was strong, and continuing to believe that inflation is transitory. That was only a year ago, and a lot has changed during that time. Furthermore, a .75% rate hike is sizable historically, and the fact that the Fed has raised rates by .75% during their past three policy meetings is extremely aggressive. The market is becoming more uncomfortable that the Fed does not appear willing to pause to assess the impacts of these large rate hikes that are yet to be fully reflected in economic activity.
PORTFOLIO ADJUSTMENTS
We had several sizable reductions in equity exposure this month, occurring midway through the month when the market was 10% higher. These trims have helped reduce the pace of declines in your accounts. On September 6th, we trimmed RSP and VTV, and on 9/7 we significantly reduced exposure to RPV. We further trimmed SPLG and RPV on 9/27, SPTM on 9/28 and RSP on 9/30. As a result, we have accumulated a sizable position in cash to assist in limiting further downside while simultaneously keeping a couple “toes” in the water if you will. We are approximately 50% of our target exposure to stocks and bonds.
Month end allocations are as follows (approximate):
Conservative 60/40 – 30% stocks, 20% bonds, 40% cash, 10% low correlation/Alternatives
Moderate 75/25 – 40% stocks, 10% bonds, 40% cash, 10% low correlation/Alternatives
Growth 90/10 – 55% stocks, 35% cash, 10% low correlation/alternatives
Given the atypically high correlation between stocks and bonds this year, we have researched and introduced to our model portfolios two positions with a very low correlation to both stocks and bonds. These instruments serve to provide a hedge to an otherwise downward trending stock and bond market. First, VARBX, a merger arbitrage fund which was purchased on 8/30. This fund owns companies that will be acquired by another publicly traded company. It is typical for the acquiring firm to pay a premium for the company they are buying – a price higher than the current stock price. During the acquisition process, which often takes months to complete, the acquired company usually matures to its acquisition price by the time the deal closes. This built-in arbitrage is why this fund has a low correlation to the stock market, and we liken the movement of this fund to scooping up nickels and dimes. It likely won’t have extreme moves – either up or down, but it should be consistently productive and a place to find some small gains. The second fund is a managed futures fund, DBMF, that was purchased on 9/22. DBMF seeks to replicate the top trends of 20 large hedge funds in an ETF that is more liquid and lower cost (.85%) than the hedge funds it replicates. This fund can position long (betting on up moves) or short (betting on down moves) across commodity, fixed income, currency and equity futures, and re-balances weekly. This will give us some zig when the market is zagging, as managed futures strategies
tend to shine during times of market stress, which we are clearly in.
LOOKING AHEAD
All eyes will be on the upcoming Q3 earnings season to gauge the impact of the Fed’s rate increases. We anticipated earnings to be revised downward during the Q2, but companies held up much better than expected and reflected continued growth in year-over-year earnings. Over the course of the past three months, as the Fed’s rate increases have started to permeate into the economy, we anticipate this next earnings season will be more challenging, and likely to reflect a slow down in profits. How much earnings may decline overall is anyone’s guess, but we expect not only slower earnings grown from the prior quarter, but perhaps more cautionary future guidance as well.
The impact of higher borrowing costs, a still tight labor force, rising wages, and higher input costs from general inflationary forces will likely be reflected in a slow down on profitability and some declines in margins. Inventory control has been a challenge for some large cap retailers, such as Target, and more recently Nike, which can sour sentiment. Nike, a global bellwether, cited supply chain issues over the past year resulted in delays in the arrival of seasonal wear, which will need to be discounted as we enter the holiday shopping season simply because those goods are already out of season by the time they hit store shelves. This need to discount sale costs will dent margins, thus reducing earnings. We suspect Nike is not the only retailer that is experiencing these challenges.
We understand these are difficult times, and three consecutive quarters of market declines are concerning, to say the least. However, we want to note that the magnitude of declines are not to levels that will take an inordinate amount of time from which to recover. Our large cash position will insulate your account from fully participating in any further declines of the market, and the YTD results are down approximately 10-15% less than our benchmark. We have observed recently the model portfolios declining, on average, less than half of the market during down days, and participating in a little more than half of market advances.
Even with the likelihood of a recession increasing, it is our position that this will be a more ordinary recession, and not one similar to the dot com or great recession in years past. Banks are much more well capitalized today, and the labor force too strong for us to see large systemic risks cropping up. To us, this is simply a readjustment of asset prices due to an inflation spike caused by imbalances stemming from the pandemic which requires tighter financial conditions to abate ongoing higher prices. When inflation pulls back meaningfully – and we believe this is only a matter of time – then the Fed can take pause, stop raising rates, and eventually will be able to get the Fed funds rate down to a more neutral rate. Once earnings decline and trough, the market will anticipate better days ahead and will begin to price this in. Once the cleansing process and re-alignment of stable prices and neutral fiscal and monetary policies is complete, we would anticipate the market moving back up and to the right. Our primary goal in managing risk and reward is to keep the losses manageable and enable your accounts to get back to new all-time highs much sooner than would otherwise be the case if we simply did nothing.
We wish you well.
