Barring a huge rally in the coming months, 2022 has been the most difficult investing year of my lifetime. This goes back to my first foray as a retail investor in 1987. Of course, in ‘87 I experienced the October market crash where the Dow fell 37% in one day. Stocks that year recovered almost all of their value by year-end, and bonds gave a pretty good rate of return. So there were places to make money.
How Rule of Thumb Investing is Working Out for People Right Now (Hint, it’s NOT good)
As we’ve talked about before, we knew this was coming. In 2019 we first started writing about the death of the 60-40 portfolio. An allocation of 60% stocks and 40% bonds has been a rule of thumb for decades. However, never before have stocks and bonds been more overvalued at the same time. Through three quarters of 2022, the 60-40 portfolio has lost 20.4%. The worst year on record. Nailed it… “conventional wisdom” strikes again.
U.S Government bonds, the bellwether of safety for investors in the past, are also down. Get this… by 17.1%. Yes, investors looking for safety have lost almost 20% from guaranteed investments. Not since the Depression have we seen US bonds plunge this far this fast. Nailed it again… but not a surprise to us as this was a part of our investing thesis since Covid.
Then came the inflation factor. We also wrote extensively about the coming inflation. The inflation we see today is not just from supply disruptions caused by Covid but a long-term lack of investment in such needed commodities as oil and gas and other natural resources. These industries have been absolutely starved for capital. It’s really pretty simple.
So how do you invest in an inflationary environment? Many investment publications recommended buying Treasury Inflation-Protected Securities, otherwise known as TIPS. TIPS are indexed for inflation so as inflation goes up, our investment should go up. Sounds reasonable.
So how have TIPS done these past 9 months? Year-to-date TIPS are down 13.1%… Okay, that doesn’t make any sense, does it?
Investing is Really About the Expectations of Others
Let me explain…
Let’s say you think oil prices are going up. In a simple world, you would buy oil and gas stocks and do pretty well. Makes sense intuitively.
But anytime you are investing, you are investing AGAINST THE EXPECTATIONS OF OTHERS. When others’ expectations of oil prices are much higher and already priced into the market, your oil investment might not perform as well as you thought. And the others in this case are retail investors, institutions, and full-time professionals. They have lots of data so you have to understand what’s already priced into the market. If you don’t, you’re the guy at the poker table who can’t figure out the sucker. And that’s probably because it’s you.
Now back to our TIPS example. If the expectations for inflation are low or nonexistent and inflation comes along, your TIPS investment will do quite well. If, on the other hand, TIPS or inflation expectations are very high and the actual inflation number turns out to be lower or even in line with what was expected, your TIPS investment will fall flat.
And frankly, this was the analysis that led us to sell our TIPS and move along. No sarcasm here, we nailed that call as well.
PIVOT! How Our Hedging Strategies Are Working Out
So our analysis has been directionally correct for the last 24 months. This led us to pivot a bit and add some hedging strategies to our larger accounts. How have they done??
There are several different ways to protect capital in times like this. One is bonds. However, we’ve talked at length as to why bonds would not work this time as a safe haven. And of course, that has proved out quite well.
Cash in the form of short-term US Treasuries has been a great way in the past to be ready for dislocations in the market and bide your time as asset prices correct. But this time has been different. With inflation running at 8% and rates on cash like US Treasuries below 2% an investor is penalized for being safe. This amounts to a loss of 6% per year.
So to protect our capital we established a tail hedge. A tail hedge is protection against a major loss event. Ironically, and not by design, our choice for our tail hedge was an ETF with the ticker TAIL. Cambria Tail hedge is designed exactly the way we would have done it. Over 80% of the fund is invested in short-term Treasuries, while the rest is invested in protective put options that mature every month. It sounds complicated, but it is actually quite simple, and it’s all rolled into one liquid fund that can be bought and sold without reservations.
We did our standard due diligence on TAIL and came to the conclusion that this is just what the doctor ordered. Despite the stock market being down 34% during the Covid lockdowns, TAIL went up 34%. But as I stated earlier this is the most difficult investing environment of our lifetime…
TAIL has outperformed stocks and bonds by a wide margin. Down 6.5% versus -17.1% for US bonds, -20.4% for the 60-40 portfolio and -30% for the NASDAQ. So I guess we won by not losing as much as others, but it’s a far cry from the asymmetric bet we were expecting. I won’t go into details as to why it hasn’t worked as well as in the past. But the upside here is that volatility is low right now so TAIL can buy more put options with the same amount of capital.
The Name of the Game is Finding Undervalued Securities
Of course, we’ve never held ourselves out as market forecasters, and neither should anyone else. It’s a fool’s game. Our job as investment managers is to find undervalued securities. In that capacity, it’s always interesting to follow great investors and understand what they are thinking.
Jeremy Grantham is often cited in my newsletters. Over a 50-year career, Grantham has offered his investors market-beating returns. While Grantham still thinks US stocks are overvalued, he thinks it’s time to dip the proverbial investing toe into the market. “When you buy stocks at a nice discount, you’re never unhappy 3 to 5 years later. You can’t expect to get the timing exactly right.”
Hedge fund maven Bill Ackman went on CNBC in March 2009 and firmly stated that buying stocks today is a no-brainer for long-term investors. Investor sentiment was at its lowest ebb that month as most retail investors simply didn’t have the stomach to buy stocks.
Today Ackman says “To me, it looks like high-quality stocks are really pretty cheap. I’m not saying it’s going straight up. And I have no idea what the next 12 months might be but it seems to me if you invest in high-quality beaten-down stocks, now is the time to do it.” Investor sentiment right now is probably even lower than it was in 2009.
As Ackman points out, no one knows what will happen in the next 12 months. The bear in me believes that the greatest asset bubble of our lifetime could not be popped with just a 20-25% drawdown. But the investor in me sees some pretty good value here. So that leads me to our strategy going forward.
Long-term Investors Take Note
In investing, timing is unknowable, so dollar cost averaging back in is preferred. This would mean reducing our TAIL hedge over the next 12 months and investing that cash in undervalued high-quality securities.
Fixed income is starting to look enticing again as rates have risen quite abruptly, decimating many high-quality securities in the process. It’s quite possible that the Fed’s focus on inflation might peter out if the economy gets too challenging. While Jay Powell has talked tough and probably will back that up over the next couple of quarters, it’s not inconceivable that the FED might have to take its foot off the gas and maybe even reverse itself in 2023. This would be a boon to stocks and bonds and probably put our economy back in the same cycle as before. High-tech issues such as Alphabet and Amazon would look mighty cheap in that environment.
Investors locking in fixed annuity rates of 4-5% today would look very smart in such a scenario. (See the announcement above and give us a call if you think this is a good option for you.) Waiting a year might imply lower rates. It’s difficult to comprehend rates going to levels of the 1980s or ’90s and staying there. Our debt service requirement would not be sustainable. We couldn’t pay the interest.
Below is a short analysis of current stock prices versus intrinsic value estimates taken from highly respected sources to drive home our point that high-quality stocks are good values. These aren’t our values but they’re pretty darn close.
This is just a small sample set but you get the idea, quality has been hit pretty hard. A long-term investor should take note. This is exactly what Ackman and Grantham are talking about. Doesn’t mean they can’t go lower in the interim but again if you have a plan of attack it takes that worry off the table.
My Personal Holdings as of the end of the 3rd Quarter
As of 09/31/2022, my five largest personal holdings are:
- Berkshire Hathaway
- Triad Business Bank
- Paramount Global
- Occidental Petroleum warrants
- Madison Square Garden Entertainment
This past year, we have received some really nice reviews and comments, so I just wanted to thank you for that. It keeps me going on those bad days and I greatly appreciate it.
To provide our clients with a unique experience they cannot find anywhere else, we think a lot and work hard. Despite the difficulties of this year, I think we’re in as good a place as we could be. Once again, thank you for trusting us. As always, if you have any questions or concerns, feel free to give me or Robbie a call at 217-824-4211 or at 573-808-1959. We’re always happy to chat.