Commentary: The Rabbit Hole
Updated: Aug 31, 2022
As market conditions continue to evolve, we will carefully and diligently monitor your portfolio to be certain that all of our principles are satisfied and that you have the highest possible chance of meeting your goals.
“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” -Winston Churchill
Where is the market bottom? A reasonable question that has no reasonable answer until the day has passed and the worst is behind us. Much like Alice’s drop down the rabbit hole, the ability to forecast a bottom in market prices is a fairy tale. I have noticed a parade of market prognosticators predicting the bottom in stock prices, the peak of inflation, and the top in bond yields over the past few weeks. It should be stated that all the market bottoms and tops I have participated in have been characterized by a noticeable lack of professionals ringing the bell, most recently the top of a few months ago. Most bottoms I have encountered were marked by panic and warnings of another 50% down to go. All we can do as humble evaluators of security prices is add more exposure to securities as likely future returns increase, and as valuations return to a reasonable level.
As of the date this article was written, the market indexes appear as follows:
To make matters worse for the typical asset allocator, bonds are down just as much as stocks. The iShares 20+ Year Treasury Bond Fund (TLT) is down 22.84% as of this writing. A plain vanilla portfolio of 60% stocks and 40% bonds is currently down 13% year-to-date (YTD). Just as the indexers and asset allocators had convinced the masses that their 401(k) accounts should be put on cruise control with widely diversified portfolios of cheap, unmanaged stocks and bonds, rates began to rise, and correlations converged to 1, and many investors have been left confused about how this could happen.
To be clear, we have no idea how far stocks will drop, or how high interest rates will rise. We can, however, value securities and invest when we are earning a return that is commensurate with the risk that we are taking. Our list of individual securities is much more robust than it has been since April 2020, and the earnings yield on our current 15 stock portfolio is approaching 10%. We are able to buy 2-year treasury bonds that pay more than 2.6% interest in an environment when cash is still paying .01%, and we only get an extra .5% to lock our money up for 10 years. In addition, 3-year corporate bonds are beginning to pay a return that we find acceptable given the required rate of return on most of our client accounts.
It is important to remember that bond prices decline as interest rates rise, but we expect to get all of the losses back as the bonds mature, barring a credit default. During a period of rising interest rates average annual returns will become a much less meaningful measure of progress, because even though our bonds may show losses, the income as a percentage of principal has risen commensurately, and we expect to be made whole over our period of maturity. We will continue to keep our maturity short while the yield curve is very flat (long-term bonds do not pay much more than short-term bonds) and will begin to increase duration if rates at the long end of the curve begin to rise. Keep in mind that it took almost 40 years for rates to drop from their peak in the early 1980’s to where they are now, so we expect the current rate cycle to last much longer than next week. As we begin to get paid more for corporate credit risk, we may begin to add high quality corporate bonds in order to capture the increased yield spread (difference between a corporate bond and a treasury bond as compensation for default risk).
The indexes as currently comprised do not give proper justice to how much stock prices have declined over the last 6 months. Over 50% of the stocks in the Nasdaq Index are down more than 50%, and over 5% of the stocks in the index are down more than 90%. Because of capitalization weighting, many of the smaller companies in both the Nasdaq and S&P 500 can drop precipitously while the index seems to perform much better. Conversely, the larger companies in the indexes can drag down results very quickly even if the smaller companies are increasing in price. This is why we do not pay attention to index levels when allocating your capital. We buy solely on the basis of the valuation of individual securities and the securities in the funds that we own. This discipline has allowed us to outperform stock and bond indexes so far this year, while taking significantly less risk, and maintaining significant cash to buy depressed securities.
We are in the process of updating our allocations to take advantage of lower stock prices. Many stocks that were astronomically overvalued last year are starting to reach a zone of reasonableness and we will begin adding some of these securities to our portfolios. We will not push all-in at any point; we will always maintain our discipline so that we have adequate liquidity to cover your needs for cash and so that we can continue to purchase securities if they fall further. Our allocations were the most conservative they had ever been heading into this decline, and as valuations come down our equity exposure will begin to rise.
We must clearly distinguish between volatility and permanent loss. It would be easy to mistake our defensive posture last year with wanting to eliminate stock and bond price fluctuations, but our positioning was much more focused on the risk of permanent loss given how high stock prices were, and how low interest rates were. As we add additional stocks and bonds to your portfolio our intent is not to shout “All Clear”; it is simply a manifestation of higher available future returns. Volatility will increase as we reduce cash and increase equity exposure. Our intent is to earn increased returns over the next decade, not the next quarter.
If inflation continues to remain elevated interest rates should continue to rise. This will cause bond prices to temporarily drop even further. In addition, a sustained rise in interest rates should continue to put pressure on stocks that do not produce current income, especially technology and biotech stocks. We have very little exposure to these securities but will continue combing through the bargain bin to find any that have been needlessly discarded. Our requirement will be that they actually produce earnings or cash flow that can be capitalized and discounted. We will not buy lottery tickets, even those that are on sale for 90% off.
Real interest rates have been negative for several years, and have just recently returned to positive territory. We will begin reducing our alternatives exposure slightly due to the existence of positive real interest rates. Our gold and silver exposure will be moderated, and our long-short exposure will be reduced. This may increase short-term volatility a little, but these securities were already subject to significant volatility. We will mostly maintain our merger arbitrage position as it should benefit from higher future rates.
Thank you for continuing to trust us to help you define and reach your goals. So far, our asset allocation has performed very close to plan, and our security selection has been very good. Keep in mind that markets move quickly and that what looks like a good plan on Tuesday sometimes looks like a bad idea by Thursday. We are making decisions to help you reach your goals over your lifetime, not by Christmas. So please be patient during the inevitable periods of time where we look wrong. Those times will come, and we will be very honest about admitting to our mistakes.
Our seven core principles are constructed for exactly this type of environment. We will never speculate with your money, and we will always buy securities with a margin of safety. We will focus our attention on reducing the possibility of permanent losses instead of reducing your long-term returns for the sole purpose of eliminating volatility. We will manage liquidity so that we do not have to sell at inopportune times and so that we can always buy more at lower prices. We will think about your success in terms of decades, not days. We will remain diversified, but only to the extent that we can carefully manage all of your exposures and know what you own. Finally, we will control costs to be sure that what we pay compensates us either in the form of higher returns or increased peace of mind.
As market conditions continue to evolve, we will carefully and diligently monitor your portfolio to be certain that all of our principles are satisfied and that you have the highest possible chance of meeting your goals. If you have questions about your accounts, your positioning, or the market in general, please do not hesitate to contact your wealth advisor, or me personally. We will be here in good times and especially in bad.
W. Allen Wallace, MBA, CFA, CPA/PFS, CFP®
Basepoint Wealth, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.