A Rough Quarter

A Rough Quarter

“It’s not about whether you are right or wrong, but about how much you make when you are right, and how much you lose when you are wrong.”

— Stanley Druckenmiller

The 1st half of 2022 saw stock prices decline by the largest percentage since 1970. The year-to-date 2022 returns for the S&P 500 and NASDAQ were around -20% and -30% respectively. The 2nd quarter was a particularly difficult one as all major asset classes experienced broad price declines – stocks, bonds, precious metals, real estate (as measured by REITs), crypto-currencies, etc. Cash was the best performing asset class, but still lost 4%+ of its purchasing power this year due to high consumer inflation and low interest rates. For the 2nd quarter alone the S&P 500 was -16% and the NASDAQ was -22%. Growth stocks, in general, were hit the hardest.

The hard part about inflationary bear markets is that there is nowhere to hide. Both stock and bond prices declined amidst deteriorating investor sentiment and rising consumer prices. What caused the broad declines in investment prices in 2022 was a decrease in credit’s availability and an increase in credit costs. The Federal Reserve continued its campaign to tighten financial conditions to quell inflation. Prior to the beginning of this bear market cheap and easy credit created a speculative environment that propped up asset prices. Many investments were extremely overvalued going into 2022.

As financial conditions tightened, deleveraging and liquidations brought lower prices. The period prior to this bear market (2020 – 2021) was one characterized by rampant speculation fueled by huge amounts of liquidity from the Federal Reserve. As consumer inflation increased, the working class and retirees were hit hard, which necessitated the excess liquidity to be withdrawn.

Interestingly, resource investments (energy and materials) held up pretty well because 1) they tend to do well in an inflationary environment; 2) prior to the bursting of the bubble resource developers were among the most reviled investments due to the widespread adoption of ESG investing tenets (environmental, social and governance principles – which eschew the development of traditional energy sources) – therefore those investments were cheap; and 3) the coordinated political and economic campaigns against the energy industry starved producers of investment capital and predictably caused supply shortages, higher prices and, paradoxically, a massive increase in the value of producers’ reserve assets. Hence, many resource producers’ stock prices rose.

As you know, I have been critical of Fed interventions and continual stimulus because they cause distortions in perceptions, behavior, expectations and incentives – hence distortions in pricing. Stimulus prevents markets and economies from clearing out the past’s malinvestments. Distortions in perceptions and incentives lead to the formation of beliefs and trends that become entrenched among market participants, which leads to misbehavior. This misbehavior has real world consequences such as high investment risk, labor and energy shortages, high and rising prices and large-scale wealth transfers.

When the distortions are inevitably purged by markets, they carry the unintended consequence of causing real damage to real people. Excessive stimulus induces people to take ill-advised and poorly understood risks and it makes the system vulnerable to shocks. Stimulus, in effect, also borrows growth from the future. It prohibits the younger generation from making investments (stocks, bonds and real estate) at reasonable, market-determined prices instead of over-inflated prices. And inflated asset prices make it harder for everyone to make money without taking high levels of risk. None of this, of course, is good.

It concerns me that unelected academics have so much influence over the American economy and are allowed to manipulate the price of credit and encourage such malinvestment and widespread mispricings. The attendant booms and busts have negative consequences to households and the loss of confidence in the integrity of the system can have generational effects.

It would not be as big a concern if the Fed didn’t have a poor track record, which includes proclaiming that the subprime market and housing bubble was “contained” in 2008; or in 2019 when the Fed fueled an asset bubble amidst a perfectly healthy economy; and then last year declaring that inflation was “transitory” when it was anything but. It is worrisome that we now rely on the very same Fed to engineer a “soft landing” (a gentle economic recovery) when that has never been done with inflation above 5%. And it will likely be very difficult with government debt-to-GDP over 130%.

The insidious and frustrating thing about Fed-created bubbles is that many of the wrong people are rewarded by them, and many of the wrong people get hurt. Speculators, traders, hedge fund and private equity sponsors, Wall Street institutions, lenders, financiers and the incautious all benefit. Many assume massive amounts of risk with other people’s money, get paid huge fees to do it, then cash in and retire. The risk-averse do not benefit at all because interest rates are held at zero for years, even decades, while the cost of living rises.

Then when the bubbles unwind, the wrong people are punished – the working class, retirees, savers and risk-averse suffer rising prices, declining retirement plan balances and home prices. It is a large-scale form of wealth transfer from those who can least afford pain to those who can most afford it.

But as stewards of your capital, it is not for us to adapt to a world that we wish existed. Rather, it is to adapt to the world that does exist. Since we cannot change the system, we need to navigate it by doing the homework on the investments that we do make to decide whether they are worthwhile to own for the long-term.

The good news is that investment prices today are much more reasonable than they were 6 months ago. Moreover, some sanity, caution and reasonableness has returned to investors’ perceptions. Therefore, the universe of strong investment candidates has expanded. Also, strong rebounds after such dramatic declines, such as that seen in the 1970 bear market (below), can happen quickly.

We don’t show this graph to suggest that such a rebound will necessarily happen again. It is just to demonstrate how markets sometimes work. 2022 is a very different environment than 1970 and oftentimes bear markets take some time to sort through. The important elements for investment success through tough times are consistency and focus on what to own coming out the other side. And the ability to keep emotions in check and resist the temptation to react.

We still do not believe that the best long-term opportunities exist in the most popular megacap tech stocks such as Microsoft. Microsoft is priced (the market value of the company) at 10-times sales a high price for any company. Yesterday’s winners are likely to remain challenged because they are still not cheap and we are entering an environment where the revenue growth rates of the last decade will be difficult to maintain. As you can see from the graph on the next page, the price-to-sales ratio of Microsoft’s shares is still well above where it was for most of the period between 2004 – 2020.

As far as inflation goes, we believe that it will decline as the economy slows, but it will likely remain stubbornly high for a while. Due to high debt levels the longer-term problem will likely be deflation, not inflation. For now, we will continue to be in a period of tightening monetary policy and financial conditions as the Fed is forced to address supply chain disruptions and a tight labor market that have brought rising prices and shortages. Someday the Fed will become less hawkish on interest rates, but we are not there yet.

We strongly believe in Warren Buffett’s philosophy of not losing money. To us, that means selecting investments that are priced well and carry a low risk of a permanent loss of capital. It does not mean trying to time the market, or trading around volatility. It means not overpaying for stock and avoiding bankruptcies. We want to own great businesses that trade at attractive prices and let time work in our favor. The distortions that resulted from excessive stimulus has made that difficult as many investments were overpriced. But looking forward, we believe that long-term returns have the potential to be very attractive in many investments.

We hope that you have enjoyed this summer. Thank you for your interest in our communications. We work hard every day in order to make high quality decisions for our clients, to be informative and thoughtful and to deliver a superior experience. We hope to hear from you soon.

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