4th Quarter 2022 Outlook - The Medicine Tastes Bad
In this video, we discuss where the economy and markets are headed as we close out the year….AND… We use charts and illustrations to make it easy to understand. This quarter we discuss:
What’s causing negative stock and bond returns so far in 2022
Why long-term perspective matters
What’s really driving inflation
Are rates high enough? What history tells us about the Federal Reserve and interest rates.
What about all those stories about layoffs in the media?
Why you may not want to follow popular rules of thumb when investing in a challenging environment
Practical steps to take in your portfolio
Transcript:
Hi everyone. Welcome to our 2022 fourth quarter economic and market Outlook. At Capital Stewards, we're all about helping professionals make smart investing and retirement decisions. We are fiduciaries. That means it's a big word that means that we just get paid by our clients for our expertise and for our guidance, not by selling products like insurance or high cost investment funds.
We sit on the same side of the table as our clients and we guide them to make smart investing and financial decisions. More importantly, we're located right here in Huntsville and we work with families here every. Our model is the best of simple, modern experiences and personal advice so that you feel confident in your financial future. If you're looking for investment guidance, we'd love to connect with. You can schedule an intro call on our website
today I'm gonna share our view on the market's performance so far in 22. And more importantly where investors should be focused as we round out the last part of the year in the fourth quarter. Personally, September was a really great month. We got to spend some time with both sides of our family on vacation, both at the lake and down at the beach.
And so that was really, really great. And personally, I'm still celebrating. The Braves clenching, the NL East. Were recording this the first week of October, so that just happened and I'm not sure what I'm more excited about, one that the Braves won, or two that we beat the Mets doing it.
So if you're a Mets fan, not too bad. Try again. Next year if you wanna win the, or maybe we'll see in the playoffs. I say all that to make the point that investing even in challenging markets is about creating the levers that you need to spend time on the things that matter most to. So don't get distracted from the things that matter most in life. There's a lot of things out there that matter way more than money or markets, and that's why we do all of this. All right, so a little housekeeping before we dive in. If you're listening to the podcast version of this there's a video version on our website and you can see the charts and the illustrations that I'm talking about.
I think it makes it easier to digest. If you're watching the video, then you're in the right place. But also feel free to check out the podcast, a six figure investor for this and for other financial topics that you might find interesting. So let's dive in.
All right, so let's dive in. There are no secrets to successful investing. Successful investors apply wisdom and discipline over long periods of time to achieve goals. I'll say that again. There are no secrets. Successful investors apply wisdom and discipline over long periods of time to achieve goals.
So if you're looking for an outlook, that's gonna tell you five hot stock tips for the fourth quarter, this is not that. But if you're looking for real wisdom and expertise to help build a portfolio that's gonna accomplish your long term investment goals, and then how to think about where markets are currently in that longer term decisions set that you have, then you're in the right place.
We always start with looking at the long term and figure out where are we really at in the arc of history, because the best investors make long term investment decisions, so it's important to zoom out and understand where we're at. If you look at the long term, the s and p 500 is earning close to 7.4% on average every year over the last 25 years.
The impact of the decline this year has been real. It's dropped that average by about a percentage point from close to nine. And I think during draw downs it's especially important to look back at prior peak to trough declines versus today. So you can see some of those on the chart. The tech bubble, the great financial crisis in the Covid pandemic.
And for example, if you had invested in stocks, which is the s and p 500, that's the red line that's on the chart. Right before the tech bubble, you would still be a really happy investor today. The same thing is true with the financial crisis. If you invested in 2007 at the top of the market, you'd be really happy today.
And the same thing is still true of the Covid pandemic. If you had invested in February of 2020 right before market started to decline you would be a really happy investor today. And so you have long term investment goals. So it's important that you have long term investment decision making and long term investment planning in order to be successful as we go forward and don't get stuck in, in the day to day.
If we zoom in just slightly to the last decade you still experience significant stock market returns even after this year's downturn. Stock markets are above their pre covid peaks. Over the last decade, stocks have been the best performing asset class followed by real estate, which is the.
Darker gold line on the chart. And, and that those returns are only exacerbated if you're using debt. So for example, if you have a mortgage on your house, right, you get return, but you actually don't have to spend the entire $500,000 or whatever you spend on your house to buy your house. You only put the down payment in and then you use bank debt for the rest, right?
So the returns there are actually magnified. You'll also notice that over the last 10 years, bonds and gold have slightly underperformed inflation. We saw a really historic rise in stock markets after the pandemic, and some of that is now reverting back towards longer term averages. So if you look and you can see this I think really well over the last 10 years, you just see this meteoric rise of the s and p 500 from the, from the covid bottom all the way to the peak at the end of last year, very beginning of this year.
And. And it sort of makes sense that we give some of that back and your portfolio has benefited from that return over the long term. So even after the first half of 2022, markets are still returning over 11% on an annual basis. That's well above historical averages. So if you have long term investment goals, I keep going back to this point that were well planned, then you should be on track.
Even with a, a challenging start to 2022. And if you aren't sure if you're still on track I'd recommend talking to a professional like. Or someone else that you trust to build a long term investment. So let's talk about why markets have been so challenging this year and what's gonna happen in the fourth quarter.
And to do that we always start with what's going on in the economy. And as we've been suggesting for over a year now, rates have risen, they continue to rise. And this is gonna be the case for some time going forward still. We titled this Outlook. The medicine tastes bad because higher market downturns in stocks and bonds are the result of the Fed giving the market medicine, frankly to reduce inflation.
And as, as the Fed both increases their short term benchmark interest rates. That's what you hear about in the news. They also sell bonds out of their portfolio. Both of those actions. Uh, Interest rates to go up. And if you look at the chart, you'll see the interest rates. From last December the two year treasury was trading at 0.73%.
Now that same two year treasury is trading at 4.22%, so the yield's gone from 0.73 to 4.22. That's a, that's a historic. In short term interest rates, the same thing has happened across what we call the yield curve. We're just looking at different maturities of treasury securities. 10, The 10 year treasury has gone from 1.52 to 3.83, right?
A big rise there. And the same thing in the 30 year has gone from 1.90 to 3.79. So we've seen significant moves as the fad has given the market, this medicine of rising interest rates. And unfortunately, it doesn't taste good because it drives down returns both in stocks and in bonds. Let's take a look at inflation because that's what's causing the Fed to need to raise interest rates so much.
Cpi, and this is, this is still August data was 8.3%. , if we look at the chart, you'll see there's two lines. There's the CPI or the headline cpi.
That's 8.3%. That's what you'll hear most often quoted in the news. And then there's core cpi which is 6.3%. So food and energy prices are definitely responsible for some of the rise that we've had in inflation so far. This year, we broke out the components of CPI on the page. For August. And as you would expect, energy has been a key driver of inflation, but it's falling in its importance from 2.9%.
So it was responsible for 2.9% of the eight plus percent rise in July to 2.1% in August. So it's contribution is down month over month. And over the next couple of months, we expect both food and. To play less of a role in the inflation number going forward. However, that's why we started with, there's two lines on the page.
Core cpi, that green line, which measures inflation, excluding food and energy, is still up 6% for the year. And core CPI may be flattening out a little bit but it's shown no signs of actually moving lower so far. Shelter makes. One of the largest remaining drivers of cpi that includes rent, shelter, shelter measures, both sort of owner's equivalent rent, which is if you own a home, what you would be paying in rent.
It also includes just standard rent payments for renters that tends to move down really slowly with a la so even. If we see house prices around us starting to go down a little bit, or maybe it takes longer to sell those houses the shelter portion of inflation through owner's equivalent rent's probably going to be around for several more months.
So inflation is starting to come down a little bit or flatten out. But it's probably going to remain elevated for some time because that core CPI level, it's shelter and it's labor costs that are driving that. And those aren't things that are going to be remedied very quickly. With things that are going on in markets.
Let's look a little bit at labor. So, . If you look at the, at the labor market, we've looked at this chart for the better part of the last year, and you'll see that there's this historic inversion that we're still in where the number of job openings is measured by the JO Survey is still larger by significant margin than the number of available workers um, that are out there to take those jobs.
And you may start to see in the news you probably have heard, hey, employers are starting to announce layoffs and maybe they're not hiring as much. And that's true. US based employers announced 20,000 job cuts in August. That's 30% higher than the 15,000 that they announced in the same month, 2021 or a year ago.
So we're starting to see a little bit of, of a weaker job market. But the problem is we hear about job cuts in the news. Big companies, especially large tech firms. They're slowing, they're hiring, they're starting to lay off workers. However, they also announced 41,000 new jobs in August and that's down 55% from the 94,000 new jobs that were announced in August of last year.
So again, a little bit of weakening year over year. But so far this year, we're still hiring more people or we're creating more jobs than we have people to fill. So far this year, employers have announced plans to hire 783,000 people. That's an 18% increase, year over year, non-farm employment increase by 315,000 in August.
So what does all of that mean? We're starting to see the number of job openings move slightly lower. We're seeing less hiring than perhaps a year ago, but there's still a really big gap between the number of open jobs and the workers that are available to fill those jobs. One popular sort of thing that's out there is that maybe the jolt survey.
There's lots of jobs sitting out there that maybe aren't actually going to be filled. Economists that study the jolt survey. Indeed.com and other places, they don't really see material changes in the length of openings or the types of openings that are out there from before the pandemic. So I think it's pretty safe for us to assume that the openings are real and there's still real demand for workers and it's going to take a while for the economy to work off the open role.
So in the employment picture is getting a little bit better, but we've, we're we. Such a huge gap between the number of available jobs and the available workers that it's gonna take a long time for that to get back in place. And so in order to try to make that happen, the Federal Reserve is raising interest rates and they've done that significantly, as we talked about earlier, over the course of this year, from 0.25% or almost as zero, as low as the Fed goes to over three.
And that's the medicine that the Fed is giving the economy, trying to make the hiring market slow down, trying to make the real estate market slow down and make things more expensive so that we can qua inflation out of the economy. And the, the next logical question then is how far do they have to go?
How big does that rate height have to be for inflation to finally get stamped? And when we think back to our core CPI conversation that we were having, that's running north of 6%. When we look historically at the relationship between interest rates and the Fed funds rate and cpi especially core cpi, we see historically that.
The Fed has had to raise interest rates above the level of core inflation. And that's happened every single time. We've had significant inflation since the 1960s in order to stamp out inflation. So core CPIs running a little north of 6%. There still are some things around supply chains, food and energy and stuff like that, that are probably impacting inflation.
So, so real ongoing core. Inflation's probably somewhere in the. Um, But I think it's pretty safe to say that four, four and a half percent rate hikes are not gonna get it done. The fed's gonna have to hike north of five in order for inflation to materially slow. And that's where we have a little bit of a challenge because when we look um, What's going on in markets?
The market looking at the, the future's market that predicts future fed rate increases is expecting the Fed to only have to raise rates to about four and a half percent as we get through the first part of next year. And for that to be the peak and the cycle. And, and for their part, the Fed themselves publish um, a, a forward looking estimate of, of rate increases, and they expect the peak to be 4.6%.
So we're kind of at this 4.5%. Um, Next year. And then when you look at where inflation is and you look at what has happened historically it seems like that is a little bit it, it seems like it's gonna be a little bit challenging for for that to work. The fed's probably gonna have to raise rates more than they think and more than the market thinks in order for inflation to, to go back down.
But we are a lot closer to that point than we were back in the third quarter or in the second quarter. So we're definitely getting closer to the, to the point where we should start to see inflation. Roll over, especially in the headline, but we think it's gonna take longer. And it's gonna be a long, a longer draw down for core inflation.
Other thing to keep in mind is if the Fed's gotta raise rates so much, isn't that going to cause a recession? And it may, it may or it may not. It, it's very possible that we have a, recession. It's also possible that we have a positive quarter of slightly positive GDP growth, and then a negative quarter of slightly negative GDP growth, and then back positive.
And then back negative. We sort of drag along the bottom. Raising interest rates will cause the economy to slow. But I think it's important to look back at recessions. I think really recent history is, is, is what we're all naturally biased to and really recent history says, Hey, recessions are really, really terrible things.
We get really high unemployment. When, when covid happened, we shut down the economy. We had really huge negative GDP numbers for a quarter in the financial crisis. We saw something that had really high unemployment levels, changed the economy. When we look back in, at past recessions that the Fed created to stop an overheating economy those recessions tend to be smaller and shorter in duration.
And, and so even if the Fed does cause a recession I don't think that it has to be long and deep. It can be shorter and shallower. And so I don't think a recession should necessarily be a reason for you to abandon your investment plan. So what does the economic view mean for how we think?
Long term investing. So I wanted to spend a little bit of time in this outlook just talking about the importance of valuation. Valuation, especially when we think about stocks and the forward looking price to earnings ratio is one of the most predictive indicators of long term returns in stocks.
As a refresher, the price to earnings ratio is one way to think about the value that we receive when we buy a share of stock. The ratio is the price of a stock divided. Expected future earnings or profits over the next 12 months. Again, we're looking at forward price earnings ratios, not the current PE ratio.
Sometimes what you can find online is current numbers not looking at the future, but we're looking at the next year's earnings and what we're getting when we, when we buy by the share today. So if a company's expected, earn a dollar a share over the next 12 months and it's trading at $10, then it's priced to earnings ratio is 10 times.
Right? Fairly straightforward. We'll look at historical valuations in just a minute. But before we go there, I wanna look at the relationship between valuation or that forward PE ratio we talked about and future returns. So if you look at the chart, you'll see a lot of green dots that are all really tightly clustered together in the middle of the page.
And each of those dots is the s and p 500 return over a 10 year time period. And so that tight clustering means that the returns have, have been relatively highly correlated with Ford priced earnings ratio. In other words, forward priced earnings ratios may be a good indicator or future returns over a 10 year time period.
You'll also notice the gold dots on the page and the gold dots are kind of all over the place. And so what that means is that while the. Ford Price earnings ratio is a good indicator of returns over a long term time period over the next year. They're not a good indicator of what returns could be.
It's, it's more of a crapshoot. So we have long term investment goals. We wanna use data to make long-term investment decisions not try to use data to to, to try to time the market or to make short term market calls. Currently the PE ratio. Is 16.2 or 16 times earnings just a little bit over that, that historically, that implies about a 7% return in stocks over the next 10 years.
And we look historically that seems to sort of fit what we would think as average. If you look at the right hand side of this chart, you'll see we had a huge increase in the price earnings ratio on the backside of Covid, right, in that huge stock market run up. And now those things have, have normalized back down to, to something close to.
I think what's interesting in the past quarter we sort of had a round trip from average valuations in July where the, the market moved from late June through early August, up 17% and then all the way back down from the middle of August into the end of the quarter, down 17%. Because we didn't actually see any real change in earnings or in the economy or in the interest rate picture that I talked about.
The economy just decided that, or the market just decided that the earnings should be worth more. And, and obviously that turned out to not be not be the case long term. So, . Overall we've seen s and p earnings remain relatively constant. Obviously a lot of expectation that those are going to decline, particularly if we get that economy slowing down, we get a recession in the next year or so.
And we have currently very average price earnings ratios for stocks, which means that we should have average returns over Over the long term. The next question we get a lot is is this the bottom? And it's, it's really difficult to say cuz there's no bell that rings when we get to the bottom and says, Hello, I'm the stock market bottom.
I'm there. You should invest now. As we discussed it's a, it's a fairly good idea to look at valuation and use that as a predictor of long-term returns, but it's really difficult to use fundamentals to predict short term returns. I don't use a lot of psychology and technical data again, because it's more short term in.
Um, But I think it does provide perspective on how investors view markets. And in, in this particular chart we're looking at sentiment. And it's a comparison of the number of people that are bullish about the market to the number of people that are bearish about the market. Bullish people obviously think the market's gonna go up, bearish people think the market's going to go down.
And everyone is very pessimistic currently. You'll see it's one of the most , pessimistic times over the last couple of decades. And historically that has been. A good time to invest, but that doesn't mean that that pessimism can't go even lower. So again over the long term perhaps we're getting closer to the bottom than than the top.
So everybody is pessimistic and rightfully so. So what should we do? I think conventional wisdom is we should just buy utilities and value stocks and kind of grind it out. It's important not to let popular misconceptions about recession investing mislead you as earnings in the economy downshift into lower growth mode.
Growth has outperformed value in recessions going back to the 1980s. The same is true in slowing economies regardless of whether we get a technical recession or not. And that's because traditional value, stocks, banks, energy, utilities, old school stocks, they need the overall economy to grow for their business to grow.
They're generally slow to innovate. They don't take a lot of market share. Thus they need sort of a rising tide to lift all boats and to lift their boat. On the other hand, growth companies, they're building new business models. They're capturing customers, they're stealing market share. That growth activity continues regardless of what's going on in the underlying economy.
So those companies tend to fare better in recession. So it's important to let history and data be your guide to investing in recessions, not conventional wisdom. I also note we talked about this in the third quarter outlook back in July, and since July 1st of this year, growth is outperformed value.
It's also important to think carefully about your portfolio during rising rate environments, which, as I mentioned earlier, we expect to, to continue to be the case at least for a little while. Individual portfolios still often look something like the chart on the left is 60% in stocks, 40% in bonds, or maybe a little more or a little less depending on your risk tolerance.
However, a truly diversified portfolio. Especially when rates are rising and likely to be higher for the long term, should look more like the page on the right hand side or the chart on the right hand side of the page. It's more diversified. Institutional investors have been investing this way for decades now.
So it's not really new. Investors should own assets that do better when rates are higher. That includes things like commodities, real estate, infrastructure more, more diversification beyond just stocks and bonds is key. Building a solid, well diversified long term portfolio. And so if your portfolio is still 60 40, it's probably time to move into the modern era and make sure that you've got lots of different asset classes in your portfolio.
And, and to emphasize that point, I put a couple of examples in here. Commodities are up materially for the year. I think people understand that you've seen it at the pump. So I took a look at infrastructure and credit, less well known examples. We've been talking about these since the beginning of the year.
Infrastructure investments are up are, they're flat up slightly for 2022, which is kind of what we expect in an inflationary environment. But compared to stocks and bonds that are both materially lower, i'd, I'd rather be flat to down a percentage or two in infrastructure versus down 13 or 20%. And then the same thing is true with private credit which generally are adjustable rate structures that are linked to companies.
And their interest rates adjust upwards as rates go up. And so we've seen increases in the private credit market so far this year again, with down trends in both core bonds and in stocks Stockton. So diversification isn't just a nice euphemism and a pie chart. It helps drive real risk adjusted returns over the long term.
Let's talk a little bit about fixed income bonds. Now that rates have risen you can see treasuries and corporate bonds. High yield bonds are all trading more than their averages since, since the Great Recession. So if we look at the chart, you'll see that treasuries currently have a yield or the interest rate that you're earning on the, on the bond of 4%.
That compares to the average of 2009 of 1.6%. Investment grade corporates, 5.5% on average yield versus 3.5%, and then the higher yield yield space, 9.5% versus 7%. So relative to recent history, bonds are becoming more attractive and investors should be thinking about relocating back to bonds. If your waiting has s sagged over the course of this year it's time to consider sort of relocating and making sure that you're, you're not underweight.
Fixed income is also worth looking at municipal bonds as well, which municipal bonds, if you're not familiar, are issued by state local governments especially if you're a high income earner, intermediate term, or that's, you know, municipal bonds that have maturities between five and seven years.
They have tax equivalent yields over 7% for earn that are in the top tax bracket zone because you can write the interest off in your taxes. It's not considered taxable income. The, the actual, the quoted yields that you'll see will be lower than that, but af on the after tax basis, which is where muni bonds trade you'll see that the returns have the yields have increased pretty materially over the last year.
So there's an opportunity in the muni bonds space if you're a high income earn. And then as we move into the political silly season ahead of the election ahead of the midterms I wanted to spend a little bit of time on that because everybody always asks, Well, what, you know, what impact is the election going to have on the market?
It's important to remember that despite the commercials and what your friends say, core economic. And business fundamentals drive market returns, not politics. Core economic and business fundamentals drive market returns, not politics. Yes, I repeat it myself. That was not an edit issue. Now good policy can create growth over time and, and there's no real question regardless of party, what that is.
Lower taxes, appropriate levels of government spending. Not too much, not too little on the right areas like infrastructure of the military. Less regulation. Those are all good for the economy long term. There's no economic study out there that says otherwise. But you can't, What you can see is that neither party actually has sort of a a, a lock on making really great decisions.
If you look at one year lagged returns For stocks since 1930. You'll, you'll see that democratic presidencies over the year after a presidential election. The stock market's up 12 and half percent for Republican presidencies is up 13%. So not a huge difference. What you do see in non-election years, the market tends to do a little bit better.
And then in presidential years and midterm years slightly worse. So there is a little bit of a, of a sag in. in election years, although when you take out 2008 in Covid and some of the election years that happen to happen around really significant events that normalize us a little bit. So again, I, I go back to just this, this overarching point that core economic fundamentals drive market returns and not elections.
And so while we all want good policy I would not, I would not trade around hoping that you're gonna get some kind of a bounce or, or decline right after the election if it goes one way or the other. So what should I do with all this stuff that we talked about? So the first thing is to diversify into a modern portfolio that includes a broad group of assets beyond simply stocks and bonds.
The second is, On our modern portfolio, we, you know, we talked about if you're just 60 40, right? I think there's an opportunity there to do something that will, that will drive better risk adjusted returns or, or better returns with less volatility, which makes everybody happy. The second is tax loss harvesting.
This is another area that can get you in trouble. I think if you're investing in a taxable account, I, you're not a nonprofit or you're not investing in like an IRA or 401k or some other kind of retirement. Um, You should not adhere to the euphemism that it's only a paper loss if I don't sell it.
You should be selling your losses this year to capture those for tax purposes. And then we wanna replace those assets in the portfolio with something that's similar but not identical. So the rules there are complex and, and the tax benefits can be significant. So that's something that you should definitely consult a professional to help you with if you're not sure how to do that.
But don't just hold on. You wanna sell. Your loss is in taxable accounts but don't get out of the market. You wanna sell and rebuy immediately so that you don't miss any of the market return of the long term. And then lastly, rebalance. Calling market bottoms is really, really difficult. Most professionals think there's about a 50% chance of a recession, so that's about as helpful as flipping a coin.
That's not gonna get you very far. What will be successful is for things that are down this year that have declined, make sure that you're buying more of those assets to rebalance so that you'll have good portfolio returns over the long term. We do each of these activities on behalf of our clients all the time.
So if you're not sure how to proceed, it's super easy to schedule a call with us. You can get real professional guidance not financial sales or financial advice, but real professional and guidance, and there's a difference between those things. There's a link in the video notes. There's no sales pitch, I promise.
We won't even let you sign to work with us. If you, if you want, in that call, there's always several calls that we, we ask a lot of questions and try to really get to know you and wanna understand what your situation is. So if you reach out to us, like I said, you can reach out directly or you can schedule an intro call.
All we're gonna do is ask questions, get to know you and see if if there's a fit. And if there is, great. We'll talk about what that'll look like. And if they're not that's okay. And you'll get some, some free advice hopefully in the process. So thanks for tuning. And I look forward to seeing you down the road and talking to you.