Wright Cove Capital: 2022 Year End
December 28, 2022
We came into 2022 with both stocks and bonds trading near all-time highs. The S&P 500 was trading at valuations (using the Shiller CAPE P/E Ratio) only seen prior to the Great Depression and Dotcom crash. Similarly, the rate on the benchmark 10-year treasury was a historically meager 1.52%. Our strategy throughout the year was to reduce overall equity exposure, while overweighting value and dividend growing stocks vs. technology and growth sectors. We removed longer duration bonds from portfolios and found shelter in cash, money market funds, T-bills, and more recently in short-term corporate bonds.
While it was a down year in nearly every asset class, these simple asset allocation moves helped preserve capital and dramatically outperform target-date funds and most passive index strategies.
We listened carefully to Federal Reserve Chairman Jerome Powell, who has made it crystal clear that fighting inflation is the Fed’s most important task at hand and has vowed to not stop raising rates or implementing restrictive policies until the job is done. Throughout the course of the last 6 months, sharp rallies in stocks have been followed by slow, steady declines as investors struggled to come to terms with the new realities of restrictive monetary policy. Ultimately, the Fed believes, and we agree, that the harm done by stopping restrictive policies too early far exceeds the damage of continued inflation.
We have confidence that if markets or the economy weaken to a certain level of “pain,” the Fed has the tools to quickly turn things around with a pause, pivot, or outright change in the path of interest rates. Despite the drop in stocks this year, it is important to remember that the total return of the S&P 500 is still up 23% and 55% over the past three- and five-year periods, well within historic norms.
When the Fed feels that they have accomplished their goal, or at least sees clear signs that inflation is normalizing, we anticipate a major rally in risk assets, and look to position portfolios to take advantage. However, we are concerned that many market participants are too optimistic of quick pivot by the Fed and are prematurely grasping for the good old days – taking on too much risk before it is warranted.
Our hesitancy of taking on “too much risk before it is warranted,” should not be interpreted as shunning stocks and all risk assets. 2022 was a perfect example of the importance of active asset allocation within different markets. With just a few trading days remaining in the year, the S&P 500 is down almost 20%, but within the index, there is a massive divergence between value and growth. Value stocks (represented by the Vanguard ETF: VTV – i.e. United Healthcare, Johnson & Johnson, Exxon, and JPMorgan) are down only 2%, but growth stocks (Vanguard ETF: VUG – i.e. Apple, Amazon, Microsoft and Tesla) are down 34%. This year, being overweight value vs growth was perhaps the biggest factor in overall portfolio performance.
The story is similar in the bond market. In what may turn out to be the worst year ever for bonds, longer duration bonds are off by 25% or more whereas a portfolio of shorter duration Treasury Bills had positive returns on the year. Those who held onto the same generic bond funds or passive indices that worked in the past, saw double-digit losses in their fixed-income portfolios this year as interest rates rose.
Heading into 2023, we are confident of two things:
- The risk/reward profile for investing in short-term bonds is much greater today than it was a year ago.
- Nobody knows if stocks will be higher or lower a year from now.
Thus, as we look ahead, we brace for more volatility in markets, but are energized by investment opportunities that have not looked appealing in the recent past. Short-term corporate bonds, tax-free municipals, and recently shunned value stocks, now offer very attractive returns that more closely resemble the historical returns of the S&P 500, but with much less price volatility.
We have talked and written at length this year about the last 15 years of ZIRP (Zero Interest Rate Policy) and what the effects have been on risk assets. Accommodative policies gave a tailwind to risk assets, but they also created a false sense of risk management and valuation metrics. Those who took more risk, who borrowed money cheaply and bought stocks and real estate generally outperformed the market – and that was the correct trade at the time, given artificially low interest rates and easy monetary policies.
To summarize, the status quo at the Fed has now changed. While we may see higher stock prices in the year ahead there are still severe headwinds that will make sustained gains more difficult than in the past. What worked yesterday, will most likely not be what works tomorrow – but there are tremendous opportunities in markets, and we are well-positioned and prepared to take advantage of what lies ahead.
We thank all our clients for their continued trust and support and wish all a happy and healthy New Year.
As always, if you have any questions or concerns – or would like to hear more about Wright Cove Capital, please fee to reach out.
Eric and Cass
Eric Leinwand, Principal – Eric@wrightcovecapital.com
Cass Tokarski, Principal – Cass@wrightcovecapital.com
The themes and strategies that we speak about and the positioning we take in portfolios are all customizable to best reflect each of our clients’ own unique goals and should not be interpreted as general investment advice.