John Maynard Keynes once said, “Markets can stay irrational longer than you can stay solvent.” And while solvency is not an issue, it somehow still grabs the sentiment of the market over the past year. The gist of the quote is that trends, both good and bad, can last quite some time. This was inarguably the case last year. The trend that kicked off in the first weeks of January continued the entire year, completely unrelenting, through the final trading days of 2022.
The optimist in me looks at long-lasting trends and views them as opportunities. A downward trend in the market allows for opportunities to raise cash on rallies and invest it at lower levels, ideally. This year offered investors three of those chances.
For more than a year, we have talked and written about a continued shift to quality. That word is subjective, but to us it means a combination of domestic stocks, treasuries and cash. Throughout this year we took opportunities as they presented themselves. We increased our cash position substantially through the selling of equities; we increased our allocation to treasuries through the selling of corporate bonds and some equities; and we increased the percentage of our stock holdings domestically by selling all international equities.
This last one deserves some expansion. While we decreased the total weighting of equities across our portfolios, we increased the weighting within that sleeve to domestic stocks. Essentially a bigger piece of a smaller pie. In fact, this smaller pie is all one piece, as we have for the second time in recent memory completely exited international stocks. Exiting our small emerging market position was a natural move to accomplish several goals with one trade. It allowed us to raise our cash allocation, realize losses, decrease our equity exposure and increase the domestic portion of our equity sleeve. A no-brainer.
While these allocation changes have helped, it’s hard to understate the difficulty and uniqueness of this year. Stocks, bonds and even cash had negative real returns, and there was essentially no beneficial risk off, with long-term treasuries significantly underperforming stocks.
As painstaking as the past year has been, a page has been turned and a new year has begun. Our job in managing assets is to be forward looking, so enough about the past year. The biggest question now is what will 2023 look like?
The outlook to start 2023 is much different from the outlook for the beginning of 2022. Twelve months ago, the Fed Funds rate was at .25% and the 10-year treasury was around 1.5%. Fast-forward a year and they are at 4.5% and 3.8%, respectively. Cash and bonds were both pretty unattractive and now, especially after the turmoil of the past year, getting paid to sit in cash and treasuries doesn’t seem so bad. These asset classes have once again become an attractive area for part of an asset allocation. Stocks as well. Even with downward revisions in earnings, the downward pressure that stocks have seen has led to cheaper valuations, with the forward multiple on the S&P 500 moving from the mid-20s to around 17. This is not an exoneration of the negative sentiment that has carried into this year, however it cannot be skimmed over. Last, the inflation narrative is completely different. Twelve months ago, inflation was beginning its dreadful ramp up, and the snowball effect was really just beginning. As we ring in the new year, the data continues to show inflation largely rolling over. CPI has started coming in with monthly prints close to the Federal Reserve’s 2% target, and everything from lumber to even crude oil has dropped precipitously from the highs. The environment is completely different from what it was this time 12 months ago, so naturally our allocation will as well.
Our equities will likely continue to have a value tilt. These are typically the companies that are making money now as opposed to those with a plan to make money in the future. We often define this as duration. Longer duration assets, or those with a longer timeline to return capital to shareholders, are punished more than companies that are returning profits now, during a higher interest rate period. It is hard to imagine interest rates coming down significantly enough to change our thoughts on value versus growth.
We continue to remain heavily overweight to domestic stocks versus international. We have long said that domestic stocks trade at a premium to international stocks for a reason: they are of higher quality. There will likely come a point this year when our maximum overweight to domestic equities loosens up a bit, however we are very likely to remain overweight domestically. When we look abroad the instability largely seen is unlikely to abate.
Broadly speaking, our equity allocation is at its lowest in years, outside of a short blip during Covid. Again, this speaks to the changing environment. While we had been bullish in equities for the better part of a decade, a portion of the overweight was due to the lack of return in other asset classes. Cash was paying close to nothing, and bonds were not much better. Fixed income has been the biggest area of change as far as outlook, due to the past year. As the chart previously used shows, long-term treasuries have performed dramatically worse than the S&P 500. What this means is that yields are finally attractive again. Gone are the days of 10-year yields with one handle. The entire asset class has become more attractive. Both treasuries and corporate bonds are now paying a respectable yield. That makes them a genuine part of an asset allocation, more so than just amounting to risk tolerance.
The main takeaway of all of this is that this year should be quite different from the last. The deck of cards we have been dealt to start this year is in fact much better than what we were dealt this time last year. The optimism when looking at the next year through an asset allocation lens is plentiful. Safe haven assets such as treasuries will undoubtably have a better year this year than last. Cash is once again more than an asset to have as “dry powder.” In fact, it will actively contribute to a portfolio’s total return. Equities, while maybe not out of the woods yet, are inarguably in a better spot now than they were at the stretched multiples to start last year. All of this culminates in what could be the most optimistic way to look at this year: optionality. There are plenty of investment options and asset classes that are in a much better place. Like most years, there will be rotating periods of outperformance for different asset classes and that is where our job gets fun and the alpha is to be found.