Q3 2022 Update – Opportunity Begins
On October 14th the Wilshire 5000 index had declined -26.17% from the start of the year while the more tech and growth-heavy Nasdaq had declined -34.03%. These are pretty good-size declines that should be expected from time to time in equity markets. Now, what should our response be as long-term investors when faced with such large declines that shake many to the core?
“If you can keep your head when all about you are losing theirs, If you can wait and not be tired by waiting, If you can think and not make thoughts your aim, If you can trust yourself when all men doubt you, Yours is the Earth and everything that’s in it.” – Rudyard Kipling
If you have not read this classic poem by Rudyard Kipling; please ignore my ramblings and take time to read the complete script. It will mean much more for your life than anything I am about to pen. It is one of my favorite poems of all times. When my oldest son, Gavin, recited it for a school project it nearly made me cry. It’s a lot of life lessons wrapped up in a very short poem. https://www.poetryfoundation.org/poems/46473/if—
Now back to investing. Like the poem and many areas of life; successful investing is all about keeping your head on straight when the world around you is swirling. Over the past 2 years, we have seen many tested to keep their head on straight. In 2020 we saw many bail to cash during the covid crisis and miss out on the extreme market bounce from the bottom. In 2021 we saw many chase ‘silly’ stocks and poisonous pyramid schemes like Crypto. Much of the emotion is likely fueled by greed and fear of missing out rather than sustainable long-term investing. Fast forward 12 months and the pendulum has swung to the other side. In Q3 we saw fear start to rule the markets. The quarter ended with equity markets down -26.05% (Wilshire 5000) from the start of the year and bond markets down -14.38% (Aggregate Bond Index) from the start of the year. This was a large decline on the backs of inflation and rate hikes as outlined in our Q2 commentary. To be sure, the inflationary, interest rate and employment figures will not disappear overnight. We expect these macro pressures to largely determine the broader course of market returns over the next 12 months. A tug-of-war between inflation, the Fed, and corporate profits will continue to create a choppy market for the foreseeable future. These variables are well out of our control and could easily change as fast as the wind. Hence, the wisdom in staying the course and riding out the storm.
As for company fundamentals, we are just at the front end of seeing corporate profits deteriorate. While topline growth (revenue) has remained solid at around 9% year-over-year; the bottom-line profits are taking a large hit. This should be expected during an inflationary storm. Companies increase pricing as much as possible which increases revenue, but they must pay more for expenses and thus have lower profits. To counter this trend, companies will start to cut expenses which often means layoffs. How deep these cuts go will reflect and fuel how deep the economic decline will get in 2023. As the world swirls around and people lose their heads; we will be looking for opportunities to strengthen the portfolios. The silver lining of fast-rising rates is a new opportunity in many lower-risk investments such as bonds. As of 11/16/2022 the 2-Year Treasury now yields 4.40%. Not a bad return for a fully liquid treasury backed by taxpayers. Within the equity markets opportunities are starting to show in some very high-quality names because of rising rates and re-valuations. Companies with little to no debt that offer huge cash flows with high returns on capital are starting to look attractive again. Google is down over 30%, Amazon is down over 40%, and Microsoft is down nearly 30%, just to name a few. These are cash-rich companies that will be around 5,10 and most likely 30 years from now. They had very likely become a little stretched on valuation entering the year after some massive run ups but today they are starting to look like a much better deal. This is not to say they are cheap by any means but a good example of strong companies finally selling at very reasonable levels again. Our opportunity set of good investing ideas is growing quickly! As we see these types of declines continue, we will look to rotate into or buy more shares of high-quality companies at solid values that align with your plan. *Please note this is not advice on any of these companies; we need to understand your full plan and diversify into proper selections that match your objectives.
Long-Term Confidence – How we keep our heads on straight
Investment confidence long-term rest in understanding what drives investment returns. In the end…we believe all investments are worth the long-term cash they can generate discounted back to present value. Tell me the long-term cash and long-term rates and I can get you a fair value to pay! Of course, this is a laughable statement. No one knows exactly what the terminal interest rate will become long-term…or what an investment’s exact bottom line will look like. Large wall street firms, CNBC, and the full investing media have found a way to convince people they have some valuable new insights to offer in this regard. However, they usually reflect the mass crowd thinking that occurs during heightened emotions. When things are good, they justify the good and when things are bad, they extrapolate the fear. In this way, we hold an extreme competitive advantage over larger wall street firms with droves of analysts, researchers, and portfolio managers. Most of them are simply paid to market and raise new money rather than doing sound conflict-free research. We know all this human emotion loves company. Misery loves company and optimism breed the fear of missing out. It is why we see fads like crypto take off and feed themselves without a shred of fundamental value long term. How do major wall street firms with thousands of managers and analysts get caught up in pyramid schemes like crypto’s FTX? Or why do they get caught up buying massively overvalued ‘hot stocks’ at the peak when we know the earnings do not support those valuation levels? Easy…’ group think’!
Groupthink is a phenomenon that occurs when a group of individuals reaches a consensus without critical reasoning or evaluation of the consequences or alternatives. Groupthink is based on a common desire not to upset the balance of a group of people.
I would argue that Groupthink is the largest risk for investors and kills or alters many financial plans each year. Our collective abilities as clients, planners, and managers to keep avoiding groupthink provides a large advantage. Remaining disciplined, long-term focused, and steadfast to the plan will ultimately drive our combined level of success as investors. Avoiding the groupthink of 2021 served us well as we sidestepped many investment traps. Avoiding negative groupthink today and during 2023 will serve us equally as well.
To this extent, we remain laser-focused on owning investments that sustain long-term cash flows. Old fashion as it might be; focusing on long-term profits, diversification, and balanced portfolios remains a winning recipe. We continue to search for opportunities during the declines and slowly rotate into some new areas. As mentioned in the last quarter’s update, we remain cautiously optimistic!
From our Q2 Update: If these data points continue, we would expect inflation to begin moderating between now and year-end. Our current slowdown (…maybe a shallow recession) has already greatly curbed demand expectations. If this continues it becomes a simple time lag before we see the actual inflation data reflect.
In recent weeks we have seen improved inflation reports greatly help the markets. We think it will be a rocky tug-of-war between sticky inflation categories such as housing expenses and demand-driven categories such as consumer goods. It won’t be a straight line down but we would expect the Fed to take its foot off the accelerator greatly in 2023. The big question will shift to corporate profits. So far earnings for quality companies have held in well and most of the market decline has been a result of higher rates and a value/expectation reset. As the higher rates work into the system, we would expect a continued slowdown in corporate earnings during 2023. How slow and how the fed responds will ultimately determine the next 12 months in equity returns.
As always, we never know exactly what the future holds. The market will continue to go up and down to some extent. We remain focused on the real business values and aim to maintain a healthy group of investments that can compound in line with your long-term financial plan. If things worsen we will continue to opportunity seek investments that align with your goals.
Let me again say THANK YOU! Our success together is an equal part great team, great advisors, and great clients. We feel extremely blessed to get up every day and do exactly what we love doing. If we did not serve such great families, we would not love what we do nearly as much. It remains a tremendous honor to steward your hard-earned assets and continue helping you meet your long-term objectives. Don’t hesitate to reach out if you have any questions or concerns.
(1) Data reported by custodian Goldman Folio Institutional.
Index results such as the Wilshire 5000, S&P 500 do not reflect management fees and expenses and you cannot typically invest in an index. Evergreen Wealth Management, LLC is a registered investment adviser. The 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.
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