As we reflect on the first half of 2022, we feel it is important to reaffirm the benefits of your long-term strategic investment goals. Your portfolios are designed to meet your long-term mission whether it is providing for retirement spending, funding legacy goals, providing for education, etc. It is natural for investors to fall victim to recency bias and focus on short-term volatility. However, the true risk to an individual or organization is not being able to meet your current and future obligations.
Parrish Capital’s investment process is driven by our “Liquidity Window” philosophy which mandates that any funds needed in the next three to five years, should be invested in high quality fixed income investments that mature at or near the time of the need. Assets not needed for consumption outside of this window are invested in high quality growth assets (stocks). This is all important as you rely on your portfolio for your retirement spending obligations, having your liquidity covered alleviates the need to sell growth assets (stocks) in adverse markets like today. We feel it is extremely vital to be able to ride out volatile periods and harness the benefits of long-term growth of the market. This is not only imperative to overcome inflation, but also to grow your assets to the levels needed to fund your spending through your life expectancies. You can rest assured when your spending needs for the next business cycle are covered.
Market Review – Quality and Valuations Matter (again)!
After a superb year for the markets in 2021 which witnessed the “Great Reopening” and healthy performance in all corners of the capital markets, the first half of 2022 was a doozy. The stock market as defined by the S&P 500 declined -20.5% through June 20, 2022, which is the worst start for the market since 1970 and the sixth worst back to 1928. The Dow Jones Industrial Average’s -15.3% first-half decline was its worst since 1962, while plunges of -29.5% by the Nasdaq Composite and -23.9% by the Russell 2000 produced each index’s worst first half on record. There were not many places to hide as seen by the Bloomberg U.S. Aggregate bond index drop of -10.7%. One bright spot was commodities led by oil which rose 40% during the quarter along with many other metals and agricultural commodities.
We have written ad nauseam over the years about the high-flying valuations of many of the popular growth stocks that dominate the headlines- stocks that we have avoided. We have also written about how a few overvalued names attributed to the overall performance of the S&P 500 and Nasdaq Composite. For instance, at the end of 2021 the top five S&P 500 index components accounted for over 22% of the total index weighting compared to just over 10% for the bottom 250 components. In fact, in 2021 those components exceeded the last major peak in S&P 500 concentration which was during the tech bubble. That type of concentration risk was very misleading to the average investor and presented challenges to “closet indexers” who basically thrived off of momentum plays with little regard to valuations and proper diversification.
Parrish Capital’s long term investment strategy has always focused on valuations and favored value stocks. Over the long term, U.S. value stocks have generally outperformed growth stocks by over 2.5% based on average annualized returns since 1926. While value stocks performance are subject to disappointing periods, mean reversion often shows up quickly and in large magnitudes, as they did in in the first half of 2022. The valuation compression was brutal for growth stocks as the Price to Earnings ratio declined well over 30% in the face of higher interest rates. Higher interest rates have a profound negative effect on companies that have yet to achieve profitability. In the first half of 2022, our discipline paid off across sectors as we witnessed much less of a decline relative to the market. In the end our high quality and value focus showed better downside resilience.
No Friend of Mine and the “R” word
As we alluded to last year, 2022 has been defined by the actions of the Federal Reserve. The Fed is no longer a friend of the markets as they go on a scorched earth path to dampen inflation. The so called “Fed Put”, which is the market belief that the Fed would step in with accommodative policies to limit the stock markets decline beyond a certain point, has been dispelled. For years, the threat of inflation was a constant topic; especially with the loose monetary policies since the Financial Crisis and the more recent backstopping of the global economy due to Covid. With inflation running at 40-year highs, the Fed’s only option is to move forward audaciously with increasing interest rates and deleveraging the balance sheet. Year to date, the Fed has raised rates three times with the most recent 75 bps increase on June 15, 2022- the largest increase since 1994. Runaway inflation is economically detrimental to consumers, and given the current stage in the economic cycle, could breed stagflation where price growth remains persistent in the face of slowing growth. The Fed will remain vigilant because the possibility of the capital markets becoming sclerotic to future Fed action is also great.
Taming inflation will take a herculean effort not seen since the days of former Fed Chairman Paul Volcker. Like then, the Fed misjudged inflation but to an even greater degree today, persistent supply disruptions from COVID-19, a commodity price spike due to Russia’s invasion of Ukraine, and tightness in the US labor markets created a perfect storm. What’s more, the largest component of inflation rents is on the rise. At nearly one third of the CPI index, rents are increasing as landlords recoup bargaining power lost with eviction bans during COVID-19. This is a conundrum for the Fed as increasing mortgage rates crowd out renters at the margin from becoming homeowners putting additional upward pressure on rents. We feel this is an under-appreciated inflation risk.
The Fed’s balancing act has taken a sharp turn away from stimulation of the economy to extraction of excess. The narrative throughout the market is the Fed’s battle between inflation and a recession. While it is still possible for the Fed to navigate the US Economy to a soft landing, the harsh reality is that the Fed may push the U.S. Economy into a recession- if we are not already in one. While it may feel like we are already in a recession with constant mention in the media, a trip to your local shopping district says otherwise.
The recognized technical definition of a recession is two consecutive quarters of contracting GDP with a widespread drop in spending. GDP contracted -1.4% in the 1st quarter of 2020 and the Fed’s in house GDP forecast points to a -2.1% decline in the U.S. Second Quarter GDP to be reported on July 28, 2022.
Another potential prelude to a recession is an inverted yield curve or when the 2 Year Treasury yield is above that of the 10 Year Treasury. An inverted yield curve is ominous because it can signal investors are putting long term security over access to capital (i.e., more demand for longer term Treasuries drives yields below shorter-term issues). However, keep in mind an inverted yield curve is not always a harbinger of a recession, so one cannot confuse causation with correlation. The yield curve has inverted three times during the current cycle.
Navigating the Path Forward
The stock market is in Bear status at more than 20% down from its peak and the risk of a possible recession are increasing in the near term. This begs the question – what does that mean for the market and more specifically your portfolios?
While every bear market and recession are different in terms of length, decline, and recovery- every downturn in the past has been followed by a recovery that typically extends into new record territory. We believe now is the time to allow your portfolio to do its job. In our opinion, a lot of bad news has already been priced into the market even with a modest probability of more downside. In other words, we feel the biggest declines are most likely behind us.
From a Bear market perspective, one year after reaching a market trough post World War II, the market has averaged 43.7% increase. In all but one instance, the market bottomed and was on its way higher months before the recession was over. Many times, the National Bureau of Economic Research (NBER)- the official announcer of recessions, dates recession starts and conclusions earlier than generally expected.
As illustrated in past newsletters, missing the 10 best days of market performance as measure by the S&P 500 would have cost you more than 40% of the return from 2002 through 2021. Furthermore, 7 out of the best 10 days occurred within two weeks of the 10 worst days. With this, we advocate that you stay the course with your long-term growth portfolios. It is impossible to time the market and futile as it relates to your portfolio to do so.
Also keep in mind that while recessions can be painful in the near term, downturns in the economy remove excesses, reallocate capital to more productive areas, and typically leave surviving entities stronger. As destructive as the financial crisis of 2008-2009 was to the economy, the financial and banking system is stronger because of it. We suspect that the most carnage from the current cycle will accumulate in the speculative spaces such as Cryptocurrencies and risky asset classes like SPACs. Higher quality companies with pristine balance sheets often times come out of weaker environments even stronger.
In regard to inflation, The Journal of Portfolio Management conducted a robust study of asset returns during the eight hyper inflationary periods going back to World War II. The inflation adjusted results showed that there were few places to hide with weak returns for a range of asset classes including stocks, bonds, real estate, etc. What was missed in their analysis was performance after each period. Parrish Capital internal research found that the average post inflationary period returns for the 1-year and annualized 5-year periods were outstanding at 23.84% and 15.22%, respectively. While past performance is not a guarantee of future results, these findings were very encouraging for the future.
Our tag line at the end of previous newsletters “Stay Focused, Ignore the Noise, and May Prosperity be Yours” comes to mind at this time. We have vast experience investing through the market cycles, and we have high conviction in our disciplined high-quality approach. Parrish Capital’s Core Portfolio maintains a defensive value posture with above market allocation to Healthcare, Staples, Energy, and Financials. These positions have served you well in the current environment, and we are properly positioned for the cycle reset. We never rest on our laurels and are fully prepared to take advantage of opportunities in many of the areas that have become more attractive including many of the once overvalued names we avoided in recent years.
We expect the volatility in the market to remain persistent. All eyes will remain on the Fed for the foreseeable future. We believe the Fed will continue to raise rates until they see substantial progress with inflation. The market is currently pricing 175 basis points (1.75%) of additional rate hikes between now and year-end with four Fed meetings left. This will without a doubt put pressure on economic activity and asset prices. As mentioned above, we believe most of the damage is done with stocks, but there is still modest risk to the downside.
On another note, Real Estate has been resilient the past few years. With mortgage rates at a 14-year high and rising, we expect a moderation in demand and a high single digit decline in prices for Real Estate in general.
As is typical in times of market volatility, there is a plethora of bad advice about safer more secure and productive opportunities to invest. Many of these “products” come in the form of insurance- more specifically whole and universal life insurance or something of the like. In many cases, it is being described as “Infinite Banking”, “Be your own bank”, or “Private Family Banking Strategy”. While the merits of life insurance are tremendous and absolutely necessary to cover the financial risk of losing a primary earnings income, funding trusts, and many other financial prudent reasons, the concept of being your own bank through insurance is a fallacy. We believe that generations of wealth have been squandered following up on such products, including annuities in some cases. The Cons outweigh the Pros considerably including fees, liquidity, control and especially growth. If you have been approached regarding any questionable products and would like further insight, please feel free to give us a call.
Luke Martin is an Account Executive for Parrish Capital. Luke will be working on the day-to-day operations, compliance, research, and also social media marketing.
Luke Martin received his BSBA in Finance from the University of North Carolina-Charlotte, and he is currently working on completing his MBA. At UNC-Charlotte, Luke played linebacker for the football team and was also a team captain. Luke recently got engaged to Tabitha Morrison and is expected to get married May of 2023. Outside of Parrish Capital, Luke enjoys playing golf, coaching, and spending time with family.
We feel it is vital to meet at least once a year to review your financial situation. If your financial situation has changed in the last year, it is important to set up a time either in person or via phone, so we can take the necessary steps to properly structure your portfolio and update your investment policy statement.
In closing, we at Parrish Capital are looking forward to an outstanding second half of 2022. Thank you to all the clients that continue to trust us with their life’s savings. If you have not done so already, don’t get caught unprepared for unexpected events. Take the time to plan for the future by constructing a financial plan. Give Ryan Moledor a call at 678.231.7863 to set up an initial consultation.
As always, ignore the noise, stay focused, and may prosperity be yours.
Beyond the Market
It seems like regulations are changing on a regular basis. If you receive an email from our assistant Kenedy regarding compliance documents, please take time to review, sign and email back to Kenedy per the instructions in the email.