Q3 2022 Commentary
The third quarter brought continued volatility to all major asset classes.
The quarter began with an encouraging rally. July was the strongest month for stocks since 2020. By mid-August, the S&P 500 had risen more than 17% off of its lows, recapturing more than half of the year’s losses.
Unfortunately, the second half of the quarter erased all of those market gains (and more). The S&P 500 closed the quarter at its lowest level in nearly two years. Markets ended September with three consecutive losing weeks, including back-to-back weeks of losses in excess of 4.6%. It was the most relentless three-week selloff since the financial crisis lows in 2009.
As with the first half of the year, losses were not isolated to stocks. Spiking interest rates have led to, arguably, the worst year for bonds in the history of the United States. A generic 60/40 stock/bond portfolio, which has historically done a great job at diversifying risks, has lost 20% so far this year. That would be the worst year for such a portfolio since 1937. Adjusting for inflation, the -26% real return would be the worst on record.
The historic jump in interest rates finally bled beyond investment portfolios, with housing prices falling for the first time since 2011 (real estate being the median American’s largest asset).
With inflation running persistently hot, even cash is losing its value at the fastest pace in a generation.
Headlines may suggest that the lone place to hide has been in commodities, but that is only true if you were well ahead of the price action. The Goldman Sachs Commodity Index closed the third quarter below where it was in late January. Since peaking in the first half, the index has posted even worse peak-to-trough losses than either stocks or bonds (-27%).
It has been an absolutely brutal environment for investments across the board.
We have long-worried that such risks were on the table. A treatise on the history and effects of over a decade of cheap debt and unprecedented stimulus could not even be summarized in little space we have here. The end result, however, was rather straightforward: by 2021, stocks were priced at P/E multiples only ever surpassed during the tech bubble peak, justified by artificially low interest rates (and accompanying high bond prices).
It was the “everything bubble.”
Acknowledging that assets were expensive across the board, we have been very cautious across all active strategies in recent years. Buying opportunities were limited, and when we did add exposure, we were generally quick to sell back into strength. This strategy left us entering 2022 very defensively positioned, holding large amounts of cash.
We gradually deployed that cash in the first half, and by May, we were taking on the most market risk we have carried since the Spring of 2020.
Our core domestic strategy, Traditional Time Overlay, which focuses on high-quality stocks, has been most confident in accumulating equity exposure. We entered the quarter heavily invested, but by mid-August had once again moved back to majority cash allocations.
We took advantage of renewed market weakness late in the quarter, redeploying that capital by the end of September. We ended the quarter with allocations close to where we began, more than 90% invested in equities.
Options-enhanced accounts benefitted slightly from higher options premiums, but the lack of flexibility made it more difficult to capitalize on volatile market moves.
Global ETF based accounts have been less exposed to markets, on average, but have taken on higher-risk individual positions. This approach has been more reluctant to buy into the latest round of market weakness, beginning the fourth quarter with 60% allocated to cash and money market funds.
A year ago, this commentary questioned just how far the everything bubble could push against historically unsustainable valuations. It turned out that markets had only one more quarter of strong growth ahead of them.
Today, the question is how much cheaper will markets get.
At the close of the quarter, the Price/Peak Earnings multiple for the S&P 500 had fallen to 18.1. Over the last several years, that level has only been reached briefly during market dips. Stocks have not closed a single calendar quarter that cheaply valued since Q3 2013.
Stocks trading at their cheapest multiple in nine years make a fairly compelling argument for investment. If we take a longer historical view, however, the value story is less compelling. Since World War II, the average Price/Peak Earnings multiple at market lows has been 13.5 – 25% lower than today’s prices.
Though markets can certainly get worse, if we look back at the contrarian data that had us buying in Q2, much of that data is even more encouraging today.
One of our preferred sentiment metrics, the AAII survey, which showed plenty of signs of panic in Q2, became even more panicked in Q3. Bears jumped above 60% for two consecutive weeks to close September – the first back-to-back readings above 60% in the history of the survey – an emphatic contrarian buy signal.
Last quarter we pointed to massive equity fund outflows as another contrarian signal. Retail investors closed Q3 with six consecutive weeks of withdrawals from equity funds – the largest since 2020.
From a macroeconomic standpoint, inflation and rising rates are adding more volatility and uncertainty to the data (and market worries), but the most telling numbers come from employment data, which has been resoundingly resilient. The final initial jobless claims report of September came in below 200,000 – an astonishingly low number by all historical standards.
Similar to Q2, the market weakness in Q3 was accompanied by bullish corporate insider activity – further reinforcing our optimism.
We anticipate being active across all strategies in the fourth quarter– working to capitalize on opportunities that inevitably arise in volatile markets.