It is always surprising the effect a short period of time can have on an investor’s experience. We noticed this early on in our existence at ASI while compiling results for our institutional clients. Just dropping off a bad quarter of performance and picking up one good quarter can significantly change not just the short-term results but also the longer time periods. This is why we place much greater importance on long-term numbers when reviewing investment performance here at ASI. It is also why we spend a great deal of time evaluating the investment managers we utilize and what is causing their numbers to be what they are.
The past year we have seen two very different six-month periods as investors. The six-month period ending March 31st, 2023, was quite good, and the six months prior to that were not enjoyable whatsoever. For the most recent six-month period, stocks, as measured by the S&P 500 stock index, were up over 15%! This was much appreciated by investors as the previous six-month period from March 2022 to September 2022 was down over 20%. Depending on when you’re looking at your results, you’re seeing two very different outcomes for each time period. Most of 2022 was difficult for investors as stocks and bonds declined at the same time. Concerns about inflation, a looming recession, war in Ukraine, and rising interest rates dominated the headlines.
With interest rates at historical lows and what initially was seen as transitory inflation becoming more stubborn, the Federal Reserve moved interest rates swiftly higher to try and slow the economy and the pace of inflation. The chart below illustrates just how quickly rates rose compared to the last several interest rate increase cycles.
Source: Russell Investments
While many people, including the Fed governors, believed that rates would increase in 2022, no one foresaw the magnitude of what we experienced in such a short period of time. Fed governors are responsible for setting the overnight lending rate between financial institutions and thus have significant influence on short term interest rates. Longer-term interest rates, however, are established by the overall bond market and reflect where bond investors believe rates will be in the future. The following two charts illustrate what the Fed governors thought they would do with respect to expected rate increases in 2022 and where they actually ended up at year end. The second chart shows what is called the ‘yield curve’ as of 12/31/2021 vs. 12/31/2022. What is clear from the first chart is that the Fed did not anticipate having to increase rates nearly as high or fast as they did to try and get control of inflation. The second chart is also quite interesting as it shows what is called an “inverted” yield curve. A “normal” yield curve provides investors higher yields as you invest in bonds with longer maturities. Intuitively, this makes sense. If you are loaning your money to someone for 6 months, you typically would be willing to accept a lower interest rate as you will have your money back in six months and your risk of default is over a short period of time.
Conversely, if you were going to loan your money to someone for 10 years, the risk of not getting your money back is much greater due to the longer time horizon, so you would require a higher interest rate. Makes sense, right? Well then, why is the yield curve currently paying a higher interest rate for short term bonds than longer term bonds?
The simple answer is the bond market does not believe that short term bond rates will stay where they are. Investors believe rates on short-term bonds will go down in the coming months.
Source: JP Morgan
Over the last six months we have seen stocks and bonds recover some of their losses from earlier in 2022. Since October 1st, US large cap stocks are up 15% and the US aggregate bond index is up 4%. Much of this recovery can be attributed to the overall stock and bond markets’ anticipation that inflation will continue to decline over the next several quarters with the Fed’s goal to reach its target of 3%. It also reflects the overall market’s anticipation that the economy will improve and that we may already be experiencing the recession that the markets were so concerned about throughout 2022. Historically, during my 38-year career in this business, the definition of a recession was two consecutive quarters of negative Gross Domestic Product (GDP). As you might recall, this took place in mid-2022. However, it was not defined as a recession by the National Bureau of Economic Research (NBER) at the time because several other economic indicators did not point to a recessionary environment. What we know about recessions is that by the time the economy is finally declared to be in a recession, markets often have recovered a great deal of their previous declines, so waiting on the sidelines for the recession to be over historically has been a poor investment strategy. The chart below illustrates this well.
The reality is that attempting to accurately predict recessions, interest rate increases, or stock and bond market movements over and over again is a near impossible endeavor. That is why year after year roughly 80% of professional fund managers fail to add value to client portfolios, and the 20% that do outpace the markets change from year to year. While 2022 certainly was challenging for investors, we were happy to see that many of the managers we utilize to invest your assets in performed very well relative to their respective parts of the market.
The following chart illustrates the percentage of outperformance relative to the area of the market the funds were investing in.
If we do not lose as much when markets are declining and can keep up or outpace them when markets are doing well, our long-term investment results will be better than the overall market’s results.
We know that enduring losses in your portfolio is unsettling, and it is easy to get caught up in the media and all its predictions. Market volatility is part of investing and I wanted to share with you some of our thoughts on how quickly markets can move and how just six months can make a big difference in one’s investment experience. ASI’s process is grounded in decades of experience. We have delivered results for large institutions using our investment philosophy and have adapted this expertise to deliver our personal wealth management clients. In our 25 years, we have successfully navigated many market cycles, and it’s this experience that will guide us through this one as well. Stay the course, we have done the planning and this part of the cycle is included in the plan assumptions.