SFM 3rd Quarter Update 2022

Market Synopsis: Third Quarter 2022

Many of you are aware that after 40 years of low inflation in the US, the price of goods and services consumers are paying is currently rising by 8% per year. This is a backwards looking measure and over the last few months the pace of inflation has not reversed as quickly as experts had hoped. Since May, the US Federal Reserve has been working to reduce inflation by raising interest rates. This is a proven method to reduce consumer and business spending and lower price increases. Unfortunately, it takes some time for their actions to show much progress in reducing inflation, and this is one of the reasons that inflation has remained stubbornly high. Quite simply, raising interest rates makes everything more expensive and people and businesses hold back on some of their purchases. Without restricting the economy in this way, inflation could run hot for years and destabilize confidence in the U.S. dollar as the world's reserve currency. 

Unfortunately, the result of this rapid rise in interest rates can be seen in the stock and bond portion of investment portfolios. Markets have reduced future expectations for company growth in this higher rate environment, which has forced stock prices down. At the same time, the rapid rise in interest rates has temporarily devalued bonds, which have had their worst year ever. The combination of stocks and bonds declining to this degree is unprecedented, but not unexpected. Rising interest rates have always been the primary risk for traditional conservative bond investments and this is why we moved our clients' portfolios into alternative investments so much over the last few years, which can benefit from higher interest rates and higher inflation, and this has certainly helped the overall investment performance this year as we expected. The rise in interest rates to a restrictive level will be temporary. As soon as the Federal Reserve sees inflation drop to levels it’s comfortable with, they will signal their desire to reduce interest rates again (to boost the economy) and growth expectations will start rising again. With the extreme amount of negativity and pessimism built into the stock market currently, a little good news (such as a decline in inflation or an end to the war in Ukraine) will cause a sharp rise in stock prices. We don’t know when this will happen, but when it does, we have positioned our portfolios to take advantage of it.

While it is hard to frame the losses this year as good news, for retired investors looking for income from their portfolios there is a positive aspect. A year ago, a short-term U.S. treasury bond was paying 0.25%/year and the same investment bought today is now paying 4.4%/year. This is good news for the future returns for all investors. Another piece of good news that came out this week is that the 2023 cost of living adjustment will increase social security benefits paid out by +8.7%, the highest increase in 40 years. This means that all retirees in the US will get an 8.7%/year raise starting in January! This will also increase future social security benefits for all Americans. Another benefit to the market decline is for younger families making regular contributions to an investment portfolio (whether at SFM or in your 401(k) Account). Now you are buying the same company stocks that you were a year ago, but with the stock price at a discount (stocks are on sale). This allows you to buy more shares per dollar today, despite the profits of the businesses and the long-term intrinsic value of these companies being the same or higher than a year ago. It is important to understand that the recent market declines have not been because of declining profits at companies. The market decline is due to fear and a reduction in expected growth rates for companies because the cost of doing business increased. 

Eventually the rise in interest rates will help bond investors (including the bonds in your SFM portfolio) earn higher income. Getting there is painful though as this reset caused a decline in the prices of existing bonds, as shown by the US Aggregate Bond index decline of -4.8% in the third quarter and -14.6% in 2022 year-to-date. The increasing possibility of a global recession as the central banks around the world fight inflation caused stock prices to continue their declines in the third quarter. The US stock market, represented by the S&P 500 large company index, declined in the third quarter by -4.9%, the technology-heavy Nasdaq Composite index lost -4.1%, and the US small company Russell 2000 index declined by -2.2%. The largest stock losses came from foreign stocks in the third quarter as the demand for our currency rose and the US dollar appreciated compared to other foreign currencies, decreasing the value of investments priced in other currencies. These currency issues and other concerns caused the Foreign Developed Markets EAFE index to decline by -9.3% and the Emerging Markets index to drop by -12.5% in the third quarter. This brings the 2022 year-to-date return to -26.8% on foreign stocks, -25.3% on the global stocks (US and foreign), -24.8% on the S&P 500, and -32.4% on the Nasdaq index. The good news is that our clients' portfolios at SFM benefited from our investment strategy’s long-term underweighting in foreign stocks…which helped increase client returns strongly over the long-term as these markets underperformed 9 of the last 10 years. 

Despite the down quarter, some of the individual stocks in our client accounts outperformed the US stock index in the third quarter, rebounding from previous declines, such as the ecommerce and cloud computing leader Amazon.com +6.4%, the software leader in the architecture, engineering and construction industry Autodesk +8.6%, one of the world leading generators of solar and wind energy NextEra Energy +1.8%, and the orthopedic implant leader Stryker +1.8%. Other positions that outperformed included the health sciences equipment producer Danaher +1.9%, the consumer technology giant Apple +1.3%, and the coffee chain Starbucks, which gained +6.9% in the quarter (but SFM clients all gained +16.8% in the quarter since we just trimmed the position at an opportune time). Starbucks stock benefited from reduced uncertainty after hiring a new CEO and increasing their near-term profit expectations, which we took as a good opportunity to reduce our position in this company. Meanwhile, some individual stocks trailed the U.S. stock index in the quarter including the alternative investment manager Blackstone -6.9% (despite very strong gains on the investments that it manages), the business software leaders ServiceNow -20.6% and Adobe -24.8%, and the social media firm Meta Platforms -15.9% (formerly known as Facebook). 

As we mentioned above, the US bond market continued to decline in the quarter as inflation stayed high and the US Federal Reserve continued to raise interest rates. The good news is that the SFM investment strategy for bonds is strongly outperforming this bond index as the bond portfolios we manage have avoided many of these losses. So, while the US bond market index returned -4.8% in the quarter, many of the bond positions in our client portfolios outperformed including the WisdomTree Floating Rate Treasury ETF +0.44%, the SPDR Bloomberg 1-3 Month T-Bill ETF +0.44%, the Royal Bank of Canada Inflation-Protected Bond +1.0%, the Rational Special Situations Income Fund +0.6%, and the Thompson Bond Fund -1.08%. 

As has been the case throughout this year, alternative investments have shown to be ballast for SFM client portfolios and have continued to rise in value because they offer protection against rising inflation (real estate investments & structured products) and rising interest rates (Private debt). These alternative Investments offer extremely valuable diversification and have been an important part of our SFM investment strategy in recent years. Their true value is on display this year as these alternative investments have increased your overall portfolio return while also reducing the portfolio risk and the volatility. Similar to the last two quarters, the strongest performing section within the alternative category in the third quarter (due to its inflation-protected cash flow) was private real estate such as the Blackstone Real Estate Income Trust +1.9%, the Starwood Real Estate Income Trust +1.8%, and the Bluerock Multi-Manager Real Estate Fund +1.0% (if owned for the full quarter). These positions all strongly outperformed their benchmark, the publicly traded real estate index, which was down -10.4% during the third quarter. Our private debt or loan investments also strongly outperformed their benchmark due to the adjustable-rate income that we earn from their loan portfolios (this income has risen along with interest rates YTD from around 7%/year to 9%/year on average). Compared to their benchmark (and especially compared to most other asset classes) these private debt investments performed extremely well in the quarter including the Cliffwater Corporate Lending Fund, which gained +1.8%. In addition, the income-paying Structured Products (issued by high-quality banks such as Bank of Montreal and Morgan Stanley) earned a return of around -1% on average in the third quarter due to their downside protection and the strong annual income we continue to receive. Meanwhile, as with any category, these alternative investments do not all always move in the same direction, and so not all the positions appreciated during the quarter. 

In summary, as we get to a new normal with higher rates and sustained inflation there will still be attractive opportunities for growth and income for our clients. Although we feel the next 3-6 months will continue to be rocky, and we do expect a recession, we feel that the longer-term outlook is still strong. This means that the best approach is to continue to hold stock investments over the next few months and at some point, when [over even before] the Federal Reserve signals a change in policy and stops raising rates, the market should form a base and start to rise again. In the meantime, if you are concerned about your portfolio or have seen a change to your financial situation, please let us know. We can update or start your financial plan and ensure you are still on track to reach your goals despite the tough year. 

As always, we appreciate the continued trust you place in us, and we welcome any thoughts or comments that you have.

Chris, Glenn, Sam, David, and Molly