Photo Credit: AP
INVESTMENT ENVIRONMENT
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Source: Orion Advisor Services, AlphaGlider
As in the first quarter, we saw both global equity and fixed income markets sell off aggressively in the second quarter of 2022. Global equity markets were down 15.8% as measured by our equity benchmark, MSCI ACWI IMI,^d with the US market performing slightly worse, down 16.2%. Emerging markets were down only 11.5% on the back of strength from the Chinese stock market. The US fixed income market, as measured by our fixed income benchmark, Bloomberg US Aggregate,e was down 4.7% as rates rose across the entire yield curve.
Over the last 12 months, global equity markets were down 16.5%, with the US market down only 11% while emerging markets fell over 25%. The US fixed income market declined 10.3% over this period.
The first half of 2022 was one of the worst six month periods for diversified US investors over the last 100 years. As shown in the chart below, only during the early and late stages of the Great Depression, the 1970s bear market, and the 2007-2008 Global Financial Crisis were six month returns for a diversified balanced portfolio worse than what we just experienced (as measured from the first of each month for investors in a 60% S&P 500, 40% US Aggregate Bond portfolio).
Source: @awealthofcs, AlphaGlider
Although it was bad enough that the S&P 500 lost 20%+ during the first half of 2022 (the worst start since 1970), the real hurt to diversified portfolios came from the simultaneous 10.4% decline in the US fixed income market. During times of severe stock market declines, bond prices usually go the other way, thereby buffering the hit to a diversified investor’s portfolio. But 2022 has been anything but usual, starting the year with Fed rates pegged to the floor and consumer prices set to explode due to Covid-related supply constraints and aggressive government stimulus driving demand. And then Russia invaded Ukraine, triggering a massive spike in energy and food prices globally. The Fed, and other central banks around the world, had little choice but to raise rates and curtail their quantitative easing programs in order to restrain demand, and with it, price inflation.
The Federal Reserve (Fed) raised its overnight rate by 75 basis points (0.75%) in mid-June, to a range of 1.5% to 1.75% — its largest rate hike in a single meeting since 1994. The Fed has guided to at a minimum 50 basis points increase at its next meeting in July, but has warned that it could be 75 basis points if inflation trends continue to run high. The “hot” June jobs and Consumer Price Index (CPI) reports seem to indicate that we’ll get at least 75 basis points, and perhaps even 100 basis points. June saw a 5.1% year-over-year increase in the average American’s wages while consumer prices were up 9.1%.
The Fed’s aggressive, albeit delayed, response to runaway inflation seems to be gaining some traction — at least within the investment community. Conventional wisdom among investors is that the Fed will be successful in bringing inflation back down to its 2% target in relatively short order. Below is a chart of the market’s expectation for average inflation over the next five years. After peaking a bit above 3.5% in late March, it is now below 2.5% as I write. Fed board members are guiding to making their first rate cut in 2024, but the market is currently pricing in that they will make it in mid-2023. From our point of view, it looks like the market is pricing in a recession later this year or early next year that will damage demand and employment sufficiently to get on top of the inflation problem in the US. Here at AlphaGlider, we too see a recession hitting, if we’re not already in one. However, we are less confident that subduing inflation will be as easy for the Fed as the market is making it out to be. Although we’re not calling for stagflation as our base case scenario (i.e. slow economic growth with stubborn high inflation), we think there is a higher probability that it could happen than the market believes.
Russia made slow but steady progress in Ukraine during the quarter after scaling back its military objectives from full regime change to only control of the Luhansk and Donetsk regions (aka the Donbas), and of the coast between it and Crimea which it invaded in 2014. By early July Russia was able to take full control of Luhansk, and is now redirecting its attacks on Donetsk. The global economic repercussions of the invasion, specifically higher prices for oil and gas, look to be stubbornly persistent. Even if Putin were to cease his attacks tomorrow, we believe the West will continue to attempt to economically isolate Russia for as long as Putin remains in power, leaving the West short of energy. However, a ceasefire in Ukraine would likely help restore Ukraine’s vital exports of wheat and sunflower oil, important staples in many poor developing countries.
PERFORMANCE DISCUSSION
In another quarter in which both global stocks and bonds fell badly, AlphaGlider strategies beat their respective benchmarks. Most of our strategies were down about 85% of the decline experienced by their benchmarks.
Rates rose across the yield curve during the quarter, hurting bonds of all durations, but particularly those of longer durations. Our strategies’ average bond durations were 1-1.5 years below that of our fixed income benchmark, the Bloomberg US Aggregate Bond Index — thus they faired better than the index which was down 4.7% during the second quarter.
The makeup of our equity holdings also benefitted our relative performance against our global equity benchmark, the MSCI ACWI IMI Index, which was down 15.8% during the second quarter. We were underweight US equities which lagged the index, while we were overweight emerging market equities which were still down, but somewhat less than the index. Within US equities, we benefitting by a skew toward value and quality companies which fell less than the overall US market.
One of the detractors to our strategies’ relative performance was our large positions in Treasury Inflation-Protected Treasuries (TIPS). Usually future inflation expectations increase when interest rates increase, but that was not the case in the second quarter — rates went up but future inflation expectations actually declined (see chart in previous section on 5-year inflation expectations), punishing the value of our TIPS holdings. Another relative detractor was our holding of physical gold. Bonds, especially longer durations ones, became more attractive relative to gold as their real yields rose during the quarter (i.e. bond yields rose faster than expected inflation rates).
As in the first quarter, our ESG strategies lagged their corresponding Core strategies due to their significantly lower exposure to well performing fossil fuel companies.
The following are individual funds that particularly helped, and hurt, our strategies’ relative performance during the quarter:
2Q22 benefactors to relative performance:
+2.8% Vanguard Market Neutral, VMNFX
-0.5% Vanguard Short-Term Treasury, VGSH
-1.2% Vanguard ST Inflation-Protected Securities, VTIP
-1.8% iShares ESG 1-5 Yr Corporate Bond, SUSB
-1.9% Vanguard Short-Term Corporate Bond, VCSH
-5.0% Fidelity MSCI Consumer Staples, FSTA
-9.1% Vanguard FTSE Emerging Markets, VWO
-10.2% Vanguard Value, VTV
-10.9% iShares Global Clean Energy, ICLN
-11.1% Vanguard Dividend Appreciation, VIG
-11.3% iShares ESG Aware MSCI EM, ESGE
-12.2% Nuveen ESG Large-Cap Value, NULV
2Q22 detractors to relative performance:
-21.4% Fidelity MSCI Information Technology, FTEC
-6.7% SPDR Gold MiniShares, GLDM
-6.1% Schwab US TIPS, SCHP
AlphaGlider strategies also outperformed their respective benchmarks over the last twelve months. The relative outperformance was greatest for our more conservative strategies (~80% of the benchmark’s fall).
The fixed income side of our strategies was the biggest contributor to our outperformance as our heavy concentration in shorter duration bonds and TIPS benefitted in a 12-month period of rising rates and inflation expectations. Our fixed income benchmark was down 10.3% over this period.
Our positioning within equities, which was being overweight foreign markets and underweight the US market, was a drag to our performance. Our global equity index was down 16.5% over the last 12 months while the US market was only down 11.0%. However, we did benefit from a skew towards value and quality within our US equity allocation. One of our best performers over the last year was our out-of-index exposure of physical gold.
The following are individual funds that particularly helped, and hurt, our strategies’ relative performance during the last 12 months:
LTM month benefactors to relative performance:
+2.8% Fidelity MSCI Consumer Staples, FSTA
+1.9% SPDR Gold MiniShares, GLDM
+1.0% Vanguard ST Inflation-Protected Securities, VTIP
-2.9% Vanguard Value, VTV
-3.8% Vanguard Short-Term Treasury, VGSH
-4.8% Schwab US TIPS, SCHP
-6.2% Vanguard Short-Term Corporate Bond, VCSH
-6.2% iShares ESG 1-5 Yr Corporate Bond
-6.5% Vanguard Dividend Appreciation, VIG
-7.5% Nuveen ESG Large-Cap Value, NULV
LTM detractors to relative performance:
-26.3% iShares ESG Aware MSCI EM, ESGE
-22.4% Vanguard FTSE Emerging Markets, VWO
-19.7% Vanguard Europe, VGK
-19.1% iShares MSCI Singapore Capped, EWS
-18.9% Vanguard Global Ex-US Real Estate, VNQI
OUTLOOK & STRATEGY POSITIONING
As the opening chart on 60/40 portfolios showed, 2022 has been an extremely painful period for diversified investors, including for us. However, there’s a silver lining in times like these — valuations are more attractive now and are set up for better returns going forward than they were entering the year. The challenge for investors is to not lose too much in the downturns, and then to be positioned to take advantage of the market’s inevitable rebound.
The following chart shows the 20 worst quarters for the S&P 500 over the last 96 years. You’ll see that the most recent quarter (red box) qualifies for the 16th worst quarter in this time period. The interesting part of this chart is that it shows cumulative returns over the subsequent one, three, five and 10 year periods for the other 19 worst quarters. On average, the S&P 500 was up a healthy 18.6% in the year following its quarterly collapse (red oval). Of the 19 episodes that have one-year data, 14 were in positive territory. Of the five episodes that were in negative territory, four were during the Great Depression, and the fifth was in the bursting of late 1990s dotcom bubble. The average annualized returns after the first year are more pedestrian though, mainly due to severity and duration of the Great Depression bringing down the averages. I did the math so you don’t have to; the average annualized return for years 2-3 was 8.6%, 8.6% for years 2-5, and 7.2% for years 2-10 — ok, but far from great and below the S&P 500’s long term average over the last century.
Source: @awealthofcs, AlphaGlider
Still, it must be a wonderful time to dive back into US equities with the S&P 500’s more recent history of bouncing back strongly after weak quarters? Well, we’re not so sure as its valuation remains stretched despite the 20% haircut it received in the first half. We were heavily underweight US equities entering the year and we continue to maintain that position despite US equities recently experiencing one of it worst quarters on record. We are buying some US equities, but only to the extent required to rebalance our portfolios. Since our US equity funds fell more than most of the other funds in our strategies, we need to top up them up to get them back up to their specified weightings.
The chart below shows what we’re getting at when we say that US equity valuations are still stretched. Each blue dot represents the S&P 500 valuation as measured by the cyclically-adjusted price-to-earnings (CAPE) ratio (x-axis) at the beginning of each month, and the S&P 500’s subsequent 10-year annualized real (after inflation) return (y-axis). Entering 2022, the S&P 500 had a CAPE of approximately 37.5x. There aren’t many months that the S&P 500 had such a high CAPE, but in the few that were, the S&P 500 had slightly negative subsequent 10-year returns. After its poor 1H22, the S&P 500 is still historically expensive at approximately 30x. If history (i.e. this CAPE chart) is an indicator, we should only expect 1-2% real annualized returns over the next decade from the S&P 500 — which qualifies as a lost decade to me.
Source: Real Investment Advice, AlphaGlider
Source: Wall Street Journal, Semper Augustus
The last lost decade for the S&P 500 was the 2000s and was the product of starting with high valuations (~45x CAPE) and unsustainably high corporate profit margins. As the following chart breaks down with the dark blue bars, S&P 500 returns were negative over the decade as all of the sales growth (+5% per year) and dividend payouts (+2%) were offset by compression in profit margins (-3%) and the multiple that investors were willing to pay for earnings (i.e. the price-to-earnings ratio, -4%).
The chart also shows the components that made up the S&P 500’s massive 16.6% average annual return in the 2010s (in the light blue bars). Although revenue growth, dividend payouts, and share counts were similar between the two decades, there was a major reversal in changes in corporate profit margins and the multiple that investors were willing to pay for earnings.
As operating margins tend to be cyclical over time, it seems irrational that investors would pay a more for a dollar of earnings when operating margins are unsustainably high (and thus that dollar of earnings is unsustainably high) than for a dollar of earnings when operating margins are unsustainably low. It should be the other way around. But this is the logic that goes into creating investment bubbles and oversold market bottoms. It was the case in 2000 when fear of missing out reigned supreme, and in 2010 when fear of losing money had taken over. We worry that the S&P 500 in 2022 looks a lot more like the S&P 500 of 2000 than like the S&P 500 of 2010. Specifically, we believe that US corporate profit margins are unsustainably high at the moment, putting their current earnings at risk of falling in real terms over the next decade. Likewise we believe that, 13 years into this bull market, investors are paying too much for each dollar of those current earnings. We fear that US margins could revert to the mean for many possible reasons, such as a recession hitting revenues, rising input costs, rising labor costs, rising tax rates, and rising borrowing costs — all things that didn’t happen or were working in the opposite direction throughout the 2010s.
Wouldn’t it be great to be able to go back to 2010 to put more of our portfolios into the S&P 500? Yeah, I think so too, but alas, Elon Musk has been too distracted with Twitter to bring a time travel machine to market. However, international equities may be the closest thing out there today to the S&P 500 of 2010. The chart below, which dates back from April before the Q2 hit to valuations, shows CAPE ratios (aka PE10/Shiller PE) over time for the US, emerging markets (EM) and developed markets excluding the US (DM). The US is trading at over double the CAPE ratio as both developed and emerging markets, and not too far off levels seen in the late 1990s dot-com bubble. Meanwhile, international companies are operating with more modest and sustainable profit margins, and are priced much more reasonably. It would be great if international companies expand their margins and for investors to (irrationally) increase the multiple of earnings they’re willing to pay for them (like what happened for US companies in the 2010s), but their real returns will still be satisfactory (4-6% per year) even if there’s no improvement in these areas.
Another silver lining coming out of the first half of 2022 is that bonds are now paying much higher yields. Not only will that contribute to higher returns via interest payments, but may also restore bonds’ negative correlation to stocks. This could be extremely helpful if stocks see another leg down, which is likely to happen if we experience a recession that is more severe than that currently priced in by the markets.
Shifting gears a bit, we are pleased to announce that three of our exchange traded funds (ETFs) saw management fee reductions during the second quarter. While we are accustomed to getting regular fee reductions on our Vanguard ETFs, we also got them from Schwab and State Street (SSGA) this quarter. SSGA cut its fee on our physical gold ETF, GLDM, from 0.18% to 0.10%. Schwab cut its fee on our intermediate-term TIPS ETF, SCHP, from 0.05% to 0.04%. Vanguard cut its fee on our large positions in its core US aggregate bond ETF from 0.035% to 0.03%. All AlphaGlider strategies benefitted from these moves, between 0.0014% and 0.00058% ($14-$58/yr for $1m portfolios), with larger reductions for more conservative strategies, and for our Core strategies.