Q4 2022 Compass Review

The world got a whole lot poorer last year.  There was almost nowhere to hide.  The S&P finished down 20% and the Nasdaq lost 33%.  Even long-term US Government bonds declined 29%.  Cash bought you less food at the grocery store.  This meant the classic 60/40 stock and bond portfolio had one of its worst years since the Great Depression, leading critics to question its long-term viability.

The good news is that our core value principles kept us away from the worst perils of excess.  While we suffered our fair share of losses, our clients’ portfolios generally held their value better than the overall market.  It’s in challenging years like 2022 that we are reminded of the wisdom that’s helped us navigate clients through market downturns for decades and should allow us to continue to do so into the future.  A quick refresher…

Investing is a tradeoff between risk and return. Academia measures risk through historical volatility.  If an investment fluctuates a lot, it is deemed risky, and if it is more stable it is less risky.  Sometimes this is true, but as we saw in 2022, historical volatility doesn’t always predict the behavior of assets or tell us how “risky” an asset will be in the future.  To us, a better definition of risk is when an investment or asset allocation fails to provide the appropriate return potential given the possibility for adverse future outcomes.  In this definition, an adverse future outcome is not a short-term fluctuation in price or volatility, rather it’s a permanent loss of money.      

For example, in a historically low interest rate environment, the risk of owning a 30-year bond significantly outweighed the potential reward of higher yield.  We had no idea that Covid would lead to mass inflation, we just knew that lending anybody money, even the US Government, for 30 years at 1.25% was a terrible long-term investment. In fact, that bond is currently 50 cents on the dollar!  Instead, we kept our bond portfolio duration short, and learned to live with low return expectations from our fixed income allocation.

When it seems too good to be true it usually is.  The same logic applied to our equity portfolio.  While there were tons of exciting stories these past few years, we had a hard time suspending our valuation belief in cash flow and earnings in favor of speculative future growth.  Accordingly, the air has been let out of all the bubbles created by free money: SPACs, work from home stocks, Crypto, meme stocks, Tesla, FAANG, and leveraged loans.  At some point, the air will get squeezed so hard, and the stories so unpopular that opportunities will arise from the ashes like in 2008 and 2002.  On the flip side, when it seems so bad that it feels like it can only get worse, it usually doesn’t.

Financial charlatans will always exist. We won’t name names, but it’s always after the crash when the pitfalls of celebrity investors, pundits, and fad-based trading strategies comes to light. 

Predictions are worthless.  Even worse, if used the wrong way, can be harmful. This is the time of the year when the big banks dish out their market forecasts for what’s to come in 2023.  Of course, little mention is paid to how wrong last year’s forecasts were.  Will there be a resolution to the war in Ukraine?  Will China’s reopening be successful?  Will the Fed navigate towards a soft landing?  We have no idea!  The freedom to avoid predictions allows us to build more enduring investment and financial plans, and our clients are better served as a result. 

Which is all good and well, but it doesn’t answer where we stand today.  On a positive note, it appears near term inflation has indeed peaked.  Commodity prices are down, although mostly still above pre-Covid levels.  The Treasury yield curve is inverted, which historically means a recession is coming.  Yet credit spreads remain stable and equities, while down, are still 15-20% above where they were before the first wave of Covid. 

Globally, China is attempting a comeback after three years of Covid lockdown.  That should help offset some of the commodity weakness, but it is hard to know exactly what the Chinese Communist Party will ultimately do.  Sadly, the war in Ukraine looks like it will drag on through at least the spring, but so far, warm weather has given Europe some breathing room.

Companies will likely have margin pressure as sales slow and labor costs remain stubbornly high.  As a result, unemployment could increase, especially in growth industries that over hired during Covid.  Despite margin pressure and modest layoffs, most of our companies remain committed to their investment plans, particularly as it relates to establishing new supply chains and factories.  That seems like the sensible thing to do to stay ahead of competition and plan for future growth opportunities at whatever interest rate the Fed settles in on. 

Overall, there is a lot of pessimism and broad prediction of recession in 2023.  While that’s certainly a possible outcome, there’s also a case to make for lower inflation and only a modest increase in unemployment.  Instead of guessing who is right, our best bet is to stay the course and do what we always do during market upheaval.  We’ll sell some of the stocks that have held up the best and buy what the market has given up on.  

Even more exciting is that the outlook for a balanced portfolio hasn’t looked this great in a long time.  After years of fixed income providing nothing more than a placeholder, we are finally seeing yields of 5-6% in high quality 3-5 year corporate bonds.  That is almost a livable yield, which takes a little pressure off the required return from stocks. 

All things considered 2022 gave us lots to be thankful for.  Life is slowly getting back to normal.  Kids are in school.  People are finding the right balance between the office and working from home.  Compass celebrated 25 years in business and launched our new website and branding.  Even with the market turmoil, we helped transition a number of clients into their retirement years.  From all of us at Compass, thank you for allowing us to do what we love doing and being able to work with such wonderful clients and friends.  All the best in 2023!

_{Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.}