2022 Q4 Newsletter
By Jason Lesh, Managing Principal
I write this newsletter to you with profound gratitude for placing your trust in us to manage your hard-earned money - I’d like to think of it as a partnership and we each have had a role to play. 2022 was a remarkable year by many accounts. The Federal Reserve raised rates at a faster pace than ever seen before. Record high valuations were tempered or crushed depending upon the headline. The war in Ukraine exploded to ensnare the entire globe and cause a reevaluation of political alliances, supply chains and energy policy.
As portfolio manager, Nick’s letter begins by looking forward and focusing on what may lay ahead: how we are positioned to not just weather the uncertainty, but take advantage of it. But I find myself pausing and reflecting on last year. And I keep coming back to one very strong emotion: gratitude.
For the above-mentioned reasons, the S&P 500 was DOWN 18.1% in 2022. Most investors, when concerned about the stock market, will balance a portfolio by owning bonds and fixed income. The aggregate bond index was DOWN 13.0% in 2022. If the two primary asset classes that usually move opposite of each other are both down double digits – what are you supposed to do? I have jokingly said that the only way to have avoided large losses last year was to have Nick Fisher manage your investments. But that doesn’t do justice to the phenomenal job and out performance that he displayed. It can be a very stressful job and It takes a lot of intestinal fortitude to know when to be aggressive and when to be cautious. And I tip my hat to Nick for an amazing job managing true risk, volatility and opportunity.
I have done my best to communicate with each of you over the years. I believe we have done a great job helping you navigate the investment landscape and its impact on your specific situation. Without this, Nick would not be comfortable making the allocations he has. If he was worried that our clients would react to the daily machinations of an inefficient market, then he would be more likely to have been invested like everybody else out there and have suffered substantial losses.
As we look forward to the rest of this year and beyond, we will communicate determinedly as this market volatility continues. We will continue to be cautious where needed, and search for opportunities and value wherever we can find them. And we will continue to be grateful for your trust in us – it’s a partnership that proved wonderfully successful last year and hopefully for many more to come.
I hope this note finds you well and look forward to connecting soon!
I have a strong sense that stock prices will return to pre-covid levels or worse. All signs are pointing toward a recession. This would mean that stocks have significantly more losses ahead, but that doesn’t mean that stocks will go straight down. Markets have responded extremely well to the fastest rate hiking cycle in history. But how long will this last?
A lot of investors are conditioned by the last shock, i.e., the March 2020 Covid related market crash and rapid rebound. Historically this is not how recessions work. Recessions are long and difficult periods with multiple corrections and rallies before a bottom is found once all the buyers are gone. Recessions flush out imprudent risk takers and we are still seeing the “meme stocks” rallying into this new year signifying that this reset is in its infancy. The anecdote is to own good businesses at good prices. In the absence of this, the best strategy is to be patient. And for the first time in a long time, we can earn a respectable 4-4.5% for patience.
The last two recessions took more than a year to flush out. Examples of recent recessions: Stock market high in March of 2000 and the stock market low wasn’t until fall of 2002. Stock market high in 2007 and stock market low wasn’t until March of 2009. This will be a process, not unlike other recessionary periods. There will be volatility in both directions. We had unprecedented global liquidity since March 2020 which sent stocks to all-time highs and that is now gone.
Last quarter we discussed the change in tides within financial markets. Inflation was running at 40-year highs and the Federal Reserve (Fed) was forced to act in a historic way to quell inflation. The Fed Funds rate is now more than 4.25% higher than it was just a year ago (not to mention the Fed’s open market operations of quantitative tightening). With this unprecedented change in monetary policy investors have adjusted the price of assets accordingly. For the first time in living memory, investors have experienced a double digit decline in both stocks and bonds.
With a double-digit decline in stocks, why aren’t investors and yours truly more excited about buying stocks?
There is a whole generation of investors who have not seen this scale of monetary tightening. It is very likely that this will lead to recession. In fact, as we discussed last quarter, the Fed may be acting with a direct mandate to reduce wage pressures. The deleterious wage/price spiral (see our Q3 Commentary) can be quite persistent once it takes hold. If this is the case, then we should expect a recession…almost by definition the Fed will not stop until unemployment increases. In other words, earnings will decrease, companies will be forced to right size their work forces, and wage growth will moderate.
According to economists, the fed funds rate is a very effective tool, but it works with “long and variable lags” which can take as long as 18 months to take effect. So, how will we know that recessionary conditions are setting in over this period of time or vice-versa the Fed has achieved a miracle and soft landing?
Michael Kantrowitz, the Chief Investment Strategist at Piper Sandler has offered an interesting framework to monitor recessionary conditions using the H.O.P.E. acronym.
Housing - as a proxy for the economy is a significant indicator of economic expansion or contraction. Building materials, appliances, furnishings, decorations, etc. are all driven by housing growth.
Orders - as housing slows, companies across the board begin accumulating inventory and therefore slow their ordering of products.
Profits – as inventories increase with lower unit sales, profit growth slows and eventually declines.
Employment – Once profits decline, management teams must right size their work force and unemployment increases.
So, where do we stand with regard to the HOPE framework? Answer: it’s not looking good!
Housing has slowed substantially, especially in new construction where current inventory of new homes across the country is nearing all-time high levels. To be clear, existing homes haven’t slowed nearly as much and some areas of the country are much stronger than others, but the momentum in the last few months of 2022 is decidedly negative. The Institute for Supply Management, Purchasing Managers Index is showing significant contraction. This would suggest lower profits in the first and second quarter of 2023. Again, until corporate profits decline, it is not likely to lead to the last component of the HOPE framework which is employment until 3rd or 4th quarter of this year.
Now is not the time to be aggressive. Once housing bottoms, we can look at those areas of the market most sensitive to an economic rebound for confirmation.
As we discussed last quarter:
"Many of our holdings, such as Berkshire Hathaway, Fairfax Financial, Markel, Palm Valley Capital and more have resiliency at the core of their management/capital allocation process. In fact, we believe this approach of resiliency is a key differentiator that benefits portfolios in times of distress. These managers use their experience, cash, and strength of balance sheet to whether the economic storm and occasionally act boldly when prices and liquidity deteriorate. This sows the seeds for future investment returns. These managers don’t just talk about it but have a 30 and 40+ year track record of demonstrating resilience as a first principle and shrewdly acting when prices are low and future returns are favorable.”
In addition to resiliency within the companies we own, we can create resiliency within our asset allocation process. This means we can own less risk during these uncertain times and be happy collecting dividends and interest from short-term treasuries and money market securities. To be clear this is not sexy, nor our long-term goal, but when the market has become more casino than prudent investment, its ok to exit and wait for better odds. Thanks to rising rates, we can now earn 4.0-4.5% as we wait.
As we begin this new year, we are truly thankful for your support. We are excited for the future and while preparation for the changing seasons within the market is not always pleasurable, we are prepared for the inclimate weather of the market and be rest assured we will have sunny days again.
