Dear friends,

Welcome to the darkest and brightest season of the year. Each year we share the reminder of a long and resolute human impulse: to stare into the gathering gloom, frozen fields, and biting winds and to declare, “we will not surrender to the darkness, within or without. Light the fires, summon the family, call our friends and set the table. Tonight, we rejoice together.”

The midwinter holidays ahead – not just Christmas but Saturnalia, Yul, St. Lucia’s Day, Dong Zhi, Yalda Night and a dozen other celebrations rooted in other cultures and other traditions – are, at the base, expressions of gratitude. They occur in the darkest, coldest, most threatening time of year. They occur at the moment when we most need others, and they most need us. No one thrives when they’re alone and each day brings 14 to 18 hours of darkness. And so we’ve chosen, from time immemorial, to open our hearts and our homes, our arms and our pantries, to friends and strangers alike.

Don’t talk yourself out of that impulse. Don’t worry about whether your gift is glittery (if people actually care about that, you’re sharing gifts with the wrong people) or your meal is perfect (I love Stouffer’s frozen mac and cheese, by the way). Take advice from Scrooged. Tell someone they make you smile, hug them if you dare, smile and go.

Oh, by the way, you make me smile. I’m endlessly humbled (and pleased) at the realization that you’re dropping by to see what we’ve been thinking. Thanks for that!

Managing this market, preparing for the next

In the month of November, Vanguard Total Stock Market Index (VTSMX) soared 8.3% and the guys whose livelihood depends on your willingness to invest ever larger amounts in the stock market have begun celebrating “a market bottom” and imaging a sharp rebound in 2023.

They might be right. We wouldn’t bet on it. Valuations remain historically high, and the recent bounce hasn’t helped matters. It is not clear – especially in light of November’s strong jobs report – that the Federal Reserve is ready to relent on its interest rate raising cycle. While there once was a “soft landing” at the end of a Fed tightening cycle, that happy outcome has occurred only once. Consumers are spending record amounts but mostly by drawing down savings and accumulating debt. Investors have lost a cumulative $22 trillion in 2022 (with the sole bright spot being that Elon Musk has personally lost over $100 billion).

Too, there is that issue of the party which assumes control of the House of Representatives in January. The St. Louis Post Dispatch (11/27/2022), likening them to toddlers, warns:

Anyone who might be offended by the comparison between unruly toddlers and a GOP House majority should consider the words of Rep. Jason Smith, R-Missouri, who is in line for a major budget post under the incoming GOP House majority: “The American people expect Congress to use every tool at its disposal” to press the Biden administration on issues like taxes, energy policy and the border, Smith said recently, “and the debt ceiling absolutely is one of those tools.”

Translation: Holding America’s full faith and credit hostage to an array of partisan issues — as Republicans did a decade ago, kneecapping the government’s credit rating for the first time ever — is something Smith and his cohorts are vowing to do again.

In 2011, the Republic-led refusal to raise the debt ceiling triggered the Black Monday sell-off where a trillion dollars in market value was lost in a single day.

In our 2022 year-end issue, we’ll develop four themes for you to consider. Our preview for them:

1. Respect managers who have cash available to deploy: we’ve earlier described them as “the dry powder gang” and talk about them just below.
2. Respect the ability of short and ultra-short fixed income investments to adapt quickly to rising interest rates.
3. Favor high-quality over high momentum, stable growth over aggressive growth, and dividends over buybacks since all of those characteristics hold up better in markets where investors have grown fearful.
4. Identify opportunities in small caps (especially small cap value) and emerging markets (especially emerging markets value) because those are widely regarded as the last pockets of reasonable risk-return balances on the planet.

We’ll share the receipts and name names. For now, the key is remembering that you can manage the current turmoil without hiding under a rock and missing out on the long-term gains still available to you.

In this month’s issue, Lynn Bolin lays out the prospects of a 2023 recession and the tools for managing through it, Devesh Shah reflects on what to do if you can’t find the magical Manager G and on what you have to celebrate, while the Shadow lays out a record of the industry’s most significant changes in the past month. I profile Towpath Focus, a fund that’s off your radar but – perhaps – should be at the center of it and another newbie that you can, well, probably do without.

Checking in on The Dry Powder Gang

In 2017, we urged you to consider The Dry Powder Gang. These are experienced equity managers who embrace an absolute return mindset. That is, they recognize that stocks make money in the long term but can inflict absolute misery in the short term. As a result, they are managers willing to dial back their equity exposure when equity valuations become irrational, and the risk-return calculus turns sharply negative.

We described them this way:

They are, in a real sense, the individual investor’s best friends. They’re the people who are willing to obsess over stocks when you’d rather obsess over the NFL draft or the Cubs’ resurgence. And they’re willing, on your behalf, to walk away from the party, to turn away from the cliff, to say “no” and go. They are the professionals who might reasonably claim, “we got your back!”

In a world where interest rates fell steadily to, then below, zero and stocks had only two settings – high and higher – they were loathed by individuals and institutions. Some liquidated, most saw substantial outflows and many barely held on. Most offered reasonable absolute returns during the “no one is as smart of Cathie Woods” phase of the market, though their relative returns were often atrocious as otherwise rational managers started sneaking Bitcoin into their portfolios just to remain competitive.

If you think that the future is apt to be less driven by across-the-board market gains and more marked by periodic dislocations, you should consider whether it’s time to look more closely at absolute return and absolute value investors.

The Dry Powder Roster

Full disclosure: Snowball owns shares of FPA Crescent and Palm Valley Capital; he had previously owned Intrepid Small Cap but moved that investment to Palm Valley when Intrepid’s managers launched the new firm.

Thanks, as ever …

New Year’s blessings to our indispensable regulars, from the good folks at S&F Investment Advisor in lovely Encino to Wilson, Gregory, William, the other William, Brian, David, and Doug.

Many thanks to Bruce & Silina (we’re so glad to hear that we’re making a difference for you, thanks!), Jonathan, Binod, Philip, Jeroen, John H, and Debbi Burnett in memory of our departed friend and the love of her life on the one-year anniversary of his passing. (Quick note: pick up the phone and call your friend. You know the one, the one you’ve been venting to and laughing with for years but never quite get around to calling much anymore. You won’t realize how much those calls mean until you can’t place them anyone.)

If you’re so disposed, please do consider contributing to MFO. Of our 18,000 readers, about 1% chip in. Making it 1% plus 1 would be a gain! It’s tax deductible, it lets us keep the lights on, and raises the prospect that we might be able to share a year-end gift with the folks who – without compensation – make this all possible.

Thanks!

We are approaching the end of an extraordinary year, one that has left many of us – citizens, investors, employers, workers, and parents – feeling whipsawed, anxious and confused. Much of that comes from the sense that we can’t figure out what’s behind this year, so we don’t have much hope about managing, much less thriving in, the year ahead.

I entirely agree with your feelings, but I’m here to suggest that you take a deep, cleansing breath. We’re doing better than you know, and if we keep our wits about us, we’re going to do okay.

In this two-topic article, I will first address the mythical Manager G brought up by Howard Marks.  The second part compares the diversified portfolio in America versus the rest of the world to show how thankful we have to be this season despite the carnage in the portfolios.

1. Howard Marks, What Really Matters, and the search for the Asymmetrical Manager

In his recent memo, What Really Matters, Howard Marks gave us yet another set of invaluable investment lessons. Avoid the event and economic noise, don’t pretend to know stuff when you don’t, avoid short-term trading and poor performance measures, and for the majority, the passive indices are just fine.

Howard Marks, co-founder of Oaktree Capital, author of The Most Important Thing: Uncommon Sense for the Thoughtful Investor (2011)

None of these are new to the readers at MFO, but it’s always good to get an erudite, timely, and thoughtful perspective on things that don’t work. When those lessons come from a market guru like Marks, we listen ever more carefully.

If you are inclined to beat Mr. Market, Marks offers some advice. As I wrote in my opening column for MFO in Feb 2022, each investor must ask themselves, What is Your Edge? Only if and when you find that elusive Edge, do you have yourself a ball game.

Marks’ memo referred to asymmetrical returns. He gave examples of theoretical managers, and at the pinnacle was Manager G. She possesses so much investment alpha that when the market is up 10%, she is up 20%. And when the market is down 10%, she surprises us all, and instead of being down with the market, she is actually up 5%!!

Does she exist? More specifically, does she exist in the mutual fund world? Members of the MFO Discussion Board reflected on this topic and concluded that Manager G might be a mythical character, much like Loch Ness or Big Foot.

Fund mandates, fund managers, and the market environment change with time. To search for Manager G is to invest significant time staying on top of all the changes. Maybe the right practical question is not if there is that magical manager, but what kind of market environment might allow for some talented managers to finally show their skill.

Will interest rates be more normalized going forward? Will the financial sorcery of the last twenty years be less prominent in the future? Will dividends and profit matter once again? Or will investors be sucked back into chasing phantom returns from completely wasteful schemes? A thoughtful manager cannot be expected to outperform the mania of the dotcom bubble or the 2020-2021 free-money era.

Readers of Mutual Fund Observer are uniquely empowered to have an informed opinion on this subject. The very versatile MFO Premium website is a gold mine for manager and fund metrics and profiles. Through the monthly commentaries, David Snowball and my fellow columnists have dived deep into funds that have the potential of outperformance. The active and buzzing Discussion Board leaves no stone unturned in discussing noteworthy (good and bad) fund managers.

My promise to the community was to be open-minded about active management. Research tells me that under the hood of 5900 funds, there are indeed a handful of funds, where the managers are thoughtful, battle-tested, outperform relative to their indices, and produce absolute returns. These managers are likely to be active investors in spots where passive indices are constructed poorly, sport heavy concentrations in sectors, and construct long stock and bond portfolios while avoiding the land mines.

Stay thirsty, my friends. And pray that common sense returns to our nation’s financial infrastructure and participants. That will help us all continue to reap the bounty of America The Beautiful.

2. America The Beautiful

Diversified portfolios invested in US stocks and bonds are down about 13-15% on the year so far. Inflation has reduced our purchasing power by another 7-8% this year alone.

Assuming we agree that we knew it was coming, there is still the problem of “What would you have done about it?”

Let’s ask the inverse question. Who made money this year, and would we have done what they did? By and large, four categories of investors won:

1. 1. Energy Equity investors
   2. Value funds & Berkshire Hathaway
   3. Investors who shorted bonds heavily
   4. A handful of esoteric and exceptionally talented stock and bond managers (at hedge funds and mutual funds)

Which of these cases apply to you? Would you have gone all in on energy stocks? Would you be like Stewart Horejsi and put all your money in Berkshire? Would you have known in advance which active fund managers would have zigged when the market zagged? And would you have had the gumption to invest enough with those fund managers, knowing full well that they underperformed their asset classes in the last few years? Or would you have taken to trading bond futures for a living?

The good part about knowing what it takes to win in a year like 2022 is that we can see that even if we had the blueprint, we might not have executed it well.

The reason people have stuck to the basic, diversified portfolio for a few decades now is that the damn thing works about as well, maybe better, than one can expect it to. We take the diversified portfolio for granted for one principal reason – it’s an American asset portfolio. We need to look at the rest of the world to appreciate what we have here. The kind of American capitalism, financial markets, and institutional strength that we have come to take as a given is not easily replicated everywhere.

This year alone, the US Dollar Index is up 11%, which means if you are lucky enough to travel abroad, your trip is discounted by 11%.

Compare the plight of the citizens of Argentina, where the Peso is down 62% this year versus the dollar. Or the Sri Lanka Rupee, down 81% on the year, and out of fuel supplies. In Turkey, the Lira is down 40% this year, and in Egypt, the Pound is down 56% against the US Dollar. Does it even matter what a diversified portfolio would look like in these countries? Investment returns are meaningless when the currency makes all of your assets worthless in purchasing power terms.

Across all of Europe, with the Euro down 10% versus the US Dollar, inflation of 8-10%, and diversified investment portfolios down 10%, the loss of purchasing power, locally and in US$ terms, is very real. We are talking about the developed world, not an emerging market country.

Whether one takes the 20% depreciation of the Japanese Yen, the 10% in Australia/New Zealand, or the 13% selloff in the Chinese Renminbi, the news is simple. If you don’t have US dollars, and you don’t have a US dollar portfolio, the year 2022 has been far cruel to the individual saver.

Even in the UK, America’s closest financial system equivalent, despite the commodity-heavy stock market is up 7% on the year, a theoretical 60/40 portfolio would be down 11% in GBP and down 22% in US$ terms.

There are a handful of countries that are OK – Mexico from reshoring and India because of its secular growth – but they are truly the (lucky) exceptions.

When we understand the performance of diversified American stock and bond portfolios through the lens of a worldwide meltdown in purchasing power and investment portfolios, we realize how beautiful the American system is.

What is not ok is to rely too much on that benevolence. The world is in a lot of pain, and this time around, there are no central banks to the rescue and no government money-printing machines being primed. The pain in the rest of the world will manifest itself in the USA in one form or another.

All too often, we disregard Howard Marks’ advice. We try to find that one stock or try to trade around too much.

Investors should remember that asset allocation decides the majority of returns. While we should think about how much we want in stocks versus bonds, we should also decide how much we want in the Capital Markets at all, rather than earning a cool 5% in the Bank CD.

Happy Holidays to all of the readers, and thank you for taking the time to share the investment journey together with the MFO columnists.

I hope that Readers enjoyed their Thanksgiving as much as I did and wish everyone a safe and happy holiday season and a prosperous new year.

I expect this Santa Claus Rally will give way to a New Year’s hangover as investors start to anticipate a recession more than they fear inflation. On November 10^th, the Consumer Price Index for all Urban Consumers was released to show the inflation rate increased by 7.76% from a year ago and 0.44% from the previous month which is still a high annual rate of 5.3%. The minutes of the November Federal Open Market Committee Meeting provide insights:

The staff, therefore, continued to judge that the risks to the baseline projection for real activity were skewed to the downside and viewed the possibility that the economy would enter a recession sometime over the next year as almost as likely as the baseline. (“Minutes of the Federal Open Market Committee November 1–2, 2022”, FOMC)

I consolidated the outlook from the Federal Reserve Bank of Philadelphia’s Fourth Quarter 2022 Survey of Professional Forecasters based on thirty-eight forecasters surveyed. The outlook is for slow growth during the first three quarters of next year with a high risk of a negative quarter. Unemployment is expected to rise modestly and inflation to fall to three percent by the end of the year. 

Source: Created by the Author Using Fourth Quarter 2022 Survey of Professional Forecasters

Signs of a recession are increasing. The Conference Board’s Leading Indicator has been falling for eight consecutive months as reported by Greg Robb at MarketWatch in “Economy May Be in a Recession Already, Conference Board Says, After Leading Index Drops for Eighth Straight Month.”

RECESSION WATCH

Consensus is building among economists, business leaders, and fund managers about the probability and severity of a recession next year. Mohamed El-Erian is the President of Queen’s College in Cambridge and chief economic adviser at Allianz. Dr. El-Erian wrote “Not Just Another Recession” in Foreign Affairs (11/22/2022, free registration required), describing his belief that we are headed for a severe recession and that shocks will become more frequent. The reasons are longer-term trends in global supplies, less liquidity from central banks, geopolitical risk, climate change, and instability in financial markets. Dr. El-Erian advises that households, companies, and governments need to learn to navigate this new economic and financial shift.

Theon Mohamed at Markets Insider summarized the views of a dozen business leaders in “Jeff Bezos, Elon Musk, and Ken Griffin Are Sounding the Alarm on a US Recession. Here Are 12 Dire Economic Warnings from Elite Commentators.” I relate most to the quote from Jeff Bezos, founder of Amazon and Executive Chairman, who said, “Take as much risk off the table as you can. Hope for the best, but prepare for the worst.”

Steve Goldstein at Market Watch describes that “Fund Managers Are Overwhelmingly Forecasting Stagflation Next Year With No One Anticipating Goldilocks Scenario.” Mr. Goldstein describes a survey of 309 people managing $854 billion in assets, where 92% expect below-trend growth and above-trend inflation next year. The fund managers are underweight stocks and overweight cash. Mr. Goldstein summarizes expected returns as:

Over five years, the fund managers anticipate 6.1% per year returns in the S&P 500 4.8% returns from U.S. corporate bonds and 4.2% returns from U.S. government bonds. (Steve Goldstein, “Fund Managers Are Overwhelmingly Forecasting Stagflation Next Year With No One Anticipating Goldilocks Scenario”, MarketWatch, November 15, 2022)

Recession is my base case, and I have already taken risk off the table. How does an investor prepare for this investment environment? Matthew Fox at Market Insider describes Michael Hartnett’s view from Bank of America that investors should consider buying bonds in the first half of 2023 and stocks in the second half. Short-term bonds are a good investment when rates are rising, and longer-duration bonds rise in value as interest rates fall.

STRATEGY ADJUSTMENTS

For a great summary of likely rate hikes, I refer Readers to a Bloomberg article by Steve Matthews and Chris Anstey, “Wall Street at Odds.” Wall Street is looking for rate hikes to nearly 5% by June of next year and tapering to 4.4% by the end of the year. Suze Orman elaborates on building Treasury ladders courtesy of Dana George at the Motley Fool in “Why Suze Orman Thinks Treasury Ladders Are a Good Investing Option.” Ms. Orman makes the point that “it’s wise to make sure a slice of their portfolio is guaranteed.”

Having to take withdrawals at the bottom of a bear market can devastate retirement savings. One of my strategies to reduce this risk is to lock in treasury yields in order to match withdrawals for 2025 through 2030, with yields currently ranging from 3.8% to 4.4%. This will lock in about 30% in one conservative Traditional IRA and, to a lesser extent, in other portfolios. I prefer to invest in multi-asset funds for simplicity, but this change to strategy will result in shifting into a more active approach instead of multi-asset funds.

The chart below shows that the current yield curve, as of November 26^th, has remained high for durations less than two years and fallen significantly for longer durations compared to November 1^st. Short-term rates will rise, and longer-term rates are likely to invert further.

TRENDING FUNDS

I track nearly three hundred funds in over one hundred Lipper Categories using MFO Premium’s MultiSearch. I rank these funds based on Momentum, Risk, Risk Adjusted long-term Return, short-term returns, and Money Flow. The top-rated Lipper Categories are shown below. Average metrics are shown based on three-year performance. Monthly returns and percent below the 52-week high are from Morningstar. At this point, I am not adding to equities, and I am seeking to extend bond durations.

The highest-rated funds per top Lipper Category are shown below. I have sold some funds to create Treasury ladders but still own PQTAX, FMIL, GPANX, VGENX, and FSRRX. I plan to reduce inflation hedges further next year.

Closing

I follow the Bucket Approach with a Safety Bucket containing very conservative short-term assets. My risk is concentrated in longer-term Buckets. Allocations are based on withdrawal strategies. The Treasury ladder approach described in this article is for a conservative Traditional IRA, where I intend to take accelerated withdrawals.

With the world population now at eight billion people, the demand for natural resources is rising. Natural resources such as oil, copper, and rare earths are finite resources. New discoveries will be made, technology can reduce costs, and higher prices will convert marginal resources into viable projects. Geopolitical conflict and COVID have disrupted supply chains in these boom-and-bust industries. I recently purchased a solar system to reduce the long-term risk of energy disruptions and inflation. The potential benefits include converting gas utilities to electric over time and the possible purchase of an electric vehicle in the future. It is a small contribution to managing climate change.