Previously, in this very newsletter
In our newsletter in January of 2022, we anticipated that the Fed was at the beginning of a sustained run of interest rate increases and, when combined with emerging high rates of inflation, that we were entering a period in which both the equity and bond markets would be stressed. That this was the end of a long run of easy money and stimulative policies (both monetary and fiscal), and that in this “Stressed Market” episode, proactive risk management for the sake of defense would be just as important to realizing better results as would a focus on offense.
For what it’s worth, our expectations have come to be realized. We do not say this as a kind of “I told you so.” Our intent is more to say that strategy must incorporate risk management and that a single, one-dimensional approach that is only about offense in an episode of easy money will not be a sustainable discipline.
The Stressed Market
So, what are the factors contributing to The Stressed Market? We have already listed inflation and higher interest rates. We would add a slow growth economy, valuation risks, and the pressures contributed by fiscal and political factors, both domestic and geopolitical. This seems like a moment when just about everything is stressing the marketplace!
Year-to-date, the U.S. market has been a study in contrast. There is a handful of companies that make up the so-called “Magnificent Seven.” A tech-centric group that has delivered outsized performance and has grown into a highly concentrated influence in the S&P 500 Index. It has been a year of the “Fat and the Flat,” where a few mega-companies are getting fat, and the rest of the marketplace, the “S&P 493,” turning in what has been a basically flat result. Dividend payers and small- and mid-caps have also been in the flat this year. Profit growth for the S&P 500 Index is now expected to come in around 2% for the year.
So, what is the right approach in a stressed market?
- First, do no harm.
- A. Stay out of the froth. The froth is made up of premium valuations and expensive stocks. When the market corrected last year, the more expensive glamour stocks sold off much more than the rest of the market.
- B. Focus on high-quality companies. Focusing on high quality is our jam. We prioritize a great balance sheet and a superior business model.
- Make sure that you get your asset allocation right. Do you have a custom fit of offense and defense?
- Focus on selectivity. It is more important now to differentiate your portfolio from the market than to replicate the market.
When it comes to allocating to defense in Fixed Income, get a defense that actually defends. Intermediate and long maturities have taken a beating in the stressed bond market and have not defended. Our short-duration strategy has been in the black while most bond funds have been in the red.
Strategic over Tactical
It is essential to maintain a strategic approach focused on your long-term goals, even when the siren song of tactical reaction is calling you. Experience tells us that it is calling you to crash on the rocks.
In this environment, we draw confidence from the bottom up, not from the top down. That is, we have confidence in the better businesses that we invest in, much more so than the idea that the “top-down” macro is going to lift all boats. This has given us better results in the stressed market and is contributing to our goal of compounding at better rates over time.
Partners in this Important Cause
So, in a year and nine months from now, what will be the good advice that we can reflect upon as being constructive to our cause?
Regularly revisit your asset allocation. When you allocate to defense, have a defense that defends, stay invested in your equity allocation, and be selective – letting quality and reasonable price be your guide. Stay out of the froth, and don’t let the political tail distract you from the fundamental dog. Be a rational, strategic investor. We are confident that this approach will stand the test of time, even for the next year and nine months. And we look forward to being your partner through this “Stressed Market” episode.
