Jan 23, 2023:
Bursting bubbles and a historically bad year for balanced investment portfolios
2022 was the year where a lot of the imbalances that we’ve been writing about for quite some time finally started to unwind. There was absolute devastation in areas that we referred to last year as bubbles (see Tesla, meme stocks, IPOs, SPACs, Crypto, and COVID-related former winners such as Zoom, Carvana, and Peloton). People who thought those things were easy money learned extremely hard lessons last year as they saw 50-90% or more of their value disappear.
And while most know that general stock markets were down in 2022, many don’t realize what a historically bad year it was for the combination of stock and bond markets across the world.
US and international stock markets were down 18% and 16% respectively, but the killer was that in a year where stock markets were down, the bond markets served only to compound the pain. Usually, when stocks are down, bonds help cushion the blow, but in 2022 the Aggregate US bond market returned -13% with global bonds even worse at -16%. Investors who preferred US growth stocks lost 33%, and long-term bond investors lost 26% for the year – the worst calendar year for long-term bonds in at least 230 years!(1)
For more typical, diversified, balanced investors, it was the third worst calendar year since 1950. Based on a 60/40 balanced mix of US stocks and bonds, the return was -16%. The only more painful years were 1974 with a return of -17% and 2008 where a 60/40 portfolio lost 20%. International balanced strategy numbers were very similar in terms of decline for the year.(2)
Surviving when there’s no place to hide
It’s never fun to see account balances going down, but our accounts lost less than might be expected, the Moderate or lower volatility models in particular. In a year where there was almost no place to hide, it’s all we could really hope for.
We were able to do relatively well by remaining patient and sticking with some positions that had frustrated us all in 2021. We continued to focus on fundamentals, valuations, and mean reversion. That had us avoiding those bubble areas, growth stocks in general, and long-term bonds. We benefited from having extra exposure to cash and alternatives, which were actually both up a little for the year. The alternatives particularly benefited from value stocks’ relatively solid performance compared to growth stocks during the downturn. Our overweight in energy/resources also helped the relative performance.
Patience and mean reversion: what goes up usually comes down… eventually
We’ve written and talked a lot about “mean reversion” over the years. That is to say that expensive areas of markets tend to fall to more average levels and that cheap areas tend to rise back up to more typical levels. As obvious and simple as it sounds, it can take painfully long and it’s never easy to resist when euphoria, dreams of potential riches, and stories of why it’s different this time dominate conversation.
Those periods where the expensive areas get more expensive can go on a lot longer than one might expect, and that can really test one’s resolve. But 2022 and the beginning of 2023 have been another good lesson in the patience it takes to stick with what makes sense for the long-term and the importance of doing so.
A couple of the dynamics that have really reversed and helped provide a boost to our accounts are the relationship between growth stocks and value stocks as well as the relationship between the US Dollar and just about every other significant currency out there.
The growth-value relationship is particularly interesting because as much as it has reversed recently in the US, globally it still has a long way to go to get back to a more normal range. We are positioned to benefit if this relationship continues to revert.
Relative valuation of global growth vs. value stocks
Source: AQR (sector neutral; see original post for details)
A note on market timing
At the beginning of October, the stock market was down about 25%, bonds were down around 16%, articles about recession were prevalent, and pessimism was high. The dollar was one of the only things that had been going up. Most people felt that the market was on its way down further and that the dollar would continue to rise. The temptation to try to get out of the way and then re-enter at lower levels was on a lot of people’s minds, and we had several clients express thoughts to that effect.
At the time, we wrote the following in a client letter:
Nobody knows when the decline will end. Some fear that it will be announced that we are in a recession and that such a proclamation would send the markets further down. Maybe, maybe not. Such determinations don’t become official until well after the fact and it would come to the surprise of very few. When something is already on everyone’s radar, a lot of it is likely already priced in. We know from history that the average US market decline in recessions is 29% and the median decline is 24%. With the US market down 25% at this point and global markets down about the same, we’re already at the median historical decline and only 4% from the average decline.(3) (Of course, the decline could go on to be worse than average, but the point is that a lot of the “work” of pricing in a potential recession has been done). We also know that markets tend to fall prior to recessions officially beginning, long before the announcement is made, and begin to recover long before recessions end.
Another concern is that high inflation will stick around, which is certainly possible. But again – this risk is well known, and already priced into markets. We don’t think anyone really knows whether inflation will be worse than markets are pricing in, or maybe a bit better. And this same thing can be said for any market risk.
The point is that this decline could certainly go a lot deeper and last for a while, or it could end next week. It will end, though, and undervalued stocks usually recover best and currency relationships tend to, at least partially, revert.
As it turned out, the recovery we’ve been enjoying started that week! Global markets have staged a powerful rebound since that time – international more than US, and our typical accounts more than either due to outperformance in several of our targeted areas.
It goes to show that you just never know what will happen in the short term, and that timing can be very unreliable. That’s why we take the long approach and try to focus on having diversified exposure to areas that have attractive expected returns based on their valuations and long-term fundamentals.
Looking forward, we are fairly excited about the prospects here. It seems like momentum might finally have shifted towards international stocks, which have been so undervalued relative to US stocks for years now. It reminds us of the gap between growth and value stocks, which persisted for a long time but then at long last started to correct itself in a dramatic manner. If we see a similar correction in the gap between US and international stocks, that would be very beneficial to our portfolios. (Even if markets take another turn down in the near term, which they very well could, any outperformance by international stocks would provide a relative boost).
Of course we don’t know that this valuation disparity will correct as dramatically as it has in growth vs. value stocks… and whatever is to happen, we certainly don’t know the timing with any reliability. But it’s nice to see that things have been moving in this direction lately, and given the size of the imbalance, it’s not hard to imagine it moving a lot further still.
Excerpted from a letter sent to clients on January 23, 2023.
1 – Source: Koyfin (SP/VXUS/VUG) for US/Intl/US Growth stocks; Bianco Research for bond returns and history
2 – Source: JP Morgan Asset Management
3 – Source: The Motley Fool for recession stats; Koyfin for prices