Good afternoon,
With equity markets in bear market territory (i.e. at least 20% off of a recent high), I thought now would be a good time to update you on our strategies and thoughts. I’m writing this as the market makes new lows for the year. There are many topics to cover, I will do my best to be succinct yet thorough. Some of my comments will be repetitive from previous client notes, I wanted this note to be comprehensive for those that may not have read previous communications from our office.
First, I will outline the moves we have made to be proactive in what we felt was a year that faced many headwinds. We are constantly looking at ways to enhance client results and actively manage client portfolios. Please remember that, while accounts are down for the year, you have a significant tailwind from excess returns since 2019. It’s also important to remember that most clients are drawing 4% or less from their portfolio and a good portion of this is funded from dividend income. As such, you never need 100% of your money at one moment, which allows time for difficult environments to work themselves through the system and the market to recover.
Of note:
Stock Trades - Valuations started the year at elevated levels, especially for Nasdaq style growth stocks. As you may recall, we took profits in growth stocks and redeployed into areas where valuations were more reasonable. That shift has turned out well, growth stocks are down 30% in 2022 and value stocks are down about 12%.
January Note - A note was sent out on January 10, around market highs, encouraging clients to make withdrawals for upcoming expenses (including required minimum distributions from IRAs) which many people did.
March Note - In early March we sent a letter where we recommended selling a portion of stocks to create additional “dry powder”. In that letter we said that things could get worse before they get better, and it would be good to have additional liquidity to take advantage of lower equity prices in anticipation of an eventual market recovery. The position that we sold is now 12% lower from the time of that trade, so that was positive.
New money from clients is being invested slowly and opportunistically with finesse vs robotically. If you have any cash that you would like to add to your portfolio, please let us know.
Bond Trades - On the bond side, we dramatically lowered credit and duration risk by selling from high yield and reducing the interest rate sensitivity of our bonds. It has been a very difficult start to the year for bonds, but our lineup is down about half as much as the index.
Tax Savings - We have actively harvested tax losses where applicable which will make capital gains taxes lower now and in the future.
Proprietary Tools - We created the Recession Prep Checklist and Scorecard in 2019 and 2020, testing each family’s readiness for a downturn. This tool includes the Retirement Shock Absorber® a tested in the trenches technique to help clients understand their ability to weather market storms. In all of the work we do, we prioritize the experience a client has during difficult markets. With these tools, we want to demonstrate the ability you have to comfortably move through uncomfortable times.
We hope you can see that Brown & Co is taking an active point of view and making meaningful moves to help protect your accounts and retirement. When things are tough, like they have been with the S&P 500 down 10% in the last four days through yesterday's close, it’s tempting to want to “throw in the towel” or attempt some form of market timing. In my 40 years of being a professional investor, market timing has proven to be an elusive and unsuccessful activity (see Missing the 10 Best Days chart). Having said that, creating dry powder, reducing growth stock exposure and de-risking the bond positions does have a market timing sense to it, but we think of it as a commonsense perspective, combining fundamentals and experience. Lastly, your portfolio is (or has always been) anchored in quality large cap blue chip US stocks with strong financial statements, business moats and barriers to entry.
Our outlook:
The Fed is really between a rock and a hard place. The gargantuan stimulus provided during the Covid downturn is still sloshing around the economy and has yet to be absorbed. It seems record high inflation is the unintended consequence of the easy money policy that helped pull us through a complete shutdown of the economy. To get inflation under control, the Fed must slow demand in the economy which means higher interest rates and tight monetary policy. They really have limited ability to support the economy in a recession if there is nothing left in the tank. By raising interest rates now, they will hopefully cool off demand but, more importantly, will have the ability to lower them again when needed. Risk assets benefited from loose Fed policy and now are getting repriced for the current environment. It makes sense to get back to a normal policy, however it can be a painful process as we get there.
The US stock market - As I said in the Dry Powder letter earlier this year, it felt like things could get worse before they get better. I don’t see an immediate fix to lower inflation, that being a central concern. The zero Covid policy lockdown in China is still affecting the supply chain and inflationary pressures. The war in Ukraine is affecting food and energy prices and pent-up demand from consumers is contributing to inflation. You know exactly what I’m referring to if you have had to book a hotel, airline ticket or rental car lately. Stocks have the ability to pass on higher prices to the end consumer, which is a natural inflation hedge.
Valuations - On a positive note, valuations are far more reasonable now as compared to the beginning of the year. Corporate earnings are still good, but at risk if we tip into a recession. I would expect equities to go down more if we do have a recession and we would be thoughtful, but aggressive buyers. We do have money on the sidelines to add to stocks as I have said. We also believe the headwinds in bonds could last a while and have been advocating the traditional 60/40 (stock/bond) portfolio move toward a 70/30 portfolio to help meet return goals. This means you could have an additional 5-10% in potential Dry Powder. As valuations become more reasonable, we become more comfortable investing in this environment.
Bonds have typically been considered a safe haven when the stock market is down, but that relationship appears to be broken this year. Even cash is losing money when inflation is running at 8%. Interest rates have risen dramatically this year and bond prices are down. When you think about it interest rates are still relatively low considering the long-term average. The 40-year bull market in bonds appears to be over and managing fixed income will be challenging going forward. As I mentioned, we dramatically reduced the risk in fixed income and now have the opportunity to lock in higher yields as rates rise.
Real Estate - everyone knows that the housing market has been on fire since the 2008-2009 financial crisis and really accelerated during Covid. With 30-year mortgage rates now at 6% vs. 3% to start the year, demand has started to slow down. While you can’t see your house value move like the stock market, the cooling markets are becoming more apparent and sellers trying to get top dollar with multiple non contingent offers will likely see less action. If you have been thinking about selling something, I would do it sooner than later.
In summary, as the title stated "Nowhere to Hide", the moves we made were anticipatory. The next move will be the same in terms of being opportunistic during volatile times. No one can call a market bottom; we are constructive on the stock market even as we contemplate a potential recession with further declines very possible. You, as our client, have a well thought out retirement and investment plan knowing we have down markets around 30% of the time. While this is another unusual time and set of circumstances, we have been here many times before and have always benefited from a patient and thoughtful course of action. I appreciate the confidence you place in me and our team. It is an honor for us to serve you and your family. Please reach out at any time, we are always here to talk to you.
My best to you,