3Q 2022 Client Letter

Dear Clients,


The third quarter brought continued tumult and market volatility. The S&P 500 increased 12.75% from July 1 until August 16 on the notion that the Federal Reserve would pause its tightening policies sooner than previously expected. This hopeful thought was unambiguously derided by Fed Officials and the S&P 500 dropped 16.52% by the end of September. Total return for the S&P 500 for the quarter was down 5.88%, the third straight quarterly decline for the index.


The recent market volatility reminds us of two things: 1) price action of the market has been directly related to anticipated Federal Reserve policy, and 2) we are seeing an inverse relationship between economic news and market prices. For example, softer economic readings that indicate the economy is slowing or is weakening, reinforce the speculation that the Federal Reserve will pause its tightening cycle, which the market welcomes. The opposite also holds that strength and resilience in our economy promote higher interest rates and financial markets subsequently fall. The reverse relationship has created a warped mindset summarized by the cliché that “good news is bad and bad news is good.”


In retrospect, our Federal Reserve and central banks were slow to recognize growing inflationary pressures at the beginning of the year. While current readings may indicate that inflation is peaking, the levels of over 8% are well above the Fed’s target of 2% for price stability, indicating further action is needed. Unfortunately, the Fed’s instruments for fighting inflation are blunt tools that use retroactive data. Moreover, the Fed’s record of timing when to take its food off the brake is poor and usually too late. Their war on inflation may result in other broken things, including the families affected by rising unemployment, businesses that have indebtedness, currency relationships, and financial stability. The crisis to the pension system of Great Britain is an example of the impacts of rising rates globally on economies that are interrelated. Natural disaster, war, geopolitical tensions, and economic pain ahead have firmly tipped the psychological balance towards fear over optimism. In such an environment, caution and defense is appropriate.


Throughout 2022, the bond market added damage to portfolios holding fixed income instruments. Traditionally, bonds and equities react inversely, meaning when equities do poorly - such as in a recession - yields will go down and bond prices will increase. Historically, this made a 60% equity/40% fixed income asset allocation scheme quite resilient for investors. However, the inverse relationship between equities and fixed income broke down when the Federal Reserve pinned short-term rates at zero over the past decade. As we wrote about previously, rates had only way to go – up. As the Fed began their tightening policy and rates increased, bondholders suffered. Historically, this is the second worst return for a 60/40 portfolio since the data was first collected. There has been no place to hide among long-term financial assets.



As we head into corporate earnings season and an expected interest rate hike by the Fed, we anticipate continued volatility, i.e. “fear” in the markets. More downside is possible as tax-loss selling, margin calls, and fear-induced selling occur. Mid-term elections are likely to accentuate near-term volatility. A defensive posture is still warranted, but at this point the market has priced in recessionary fears and many stocks have become attractively valued. As we have said before, we agree with Warren Buffett’s adage to “be greedy when others are fearful, and fearful when others are greedy.” We remain confident in the long-term growth of high quality and attractively priced stocks held in our portfolio. We continue to build our shopping list as bargains emerge.


On a positive front, we want to highlight the Change Healthcare (CHNG) holding, that was acquired by United Healthcare (UNH). We initiated our stake in CHNG based on its attractive economics, leadership in a niche market, and competitive advantages. On January 6th, 2021 it was announced that CHNG would be acquired in an all cash deal for $25.75 per share (just over a 41% premium to the prior day’s close of $18.24). It was later announced that upon regulatory approval, CHNG would issue a $2.00 per share dividend that would increase the effective price to $27.75 per share (a 52% premium to the preannouncement price). It isn’t surprising that shrewd company managers looking to improve their own businesses are often looking for the same business characteristics that we are.


In conclusion, we know these are fraught times, and the next quarter will likely bring considerable noise and volatility. But historically, almost all bear markets (>20% decline) are followed by 1-, 3-, and 5-year gains with strong returns. In this way opportunity lies.


As always, we are here to answer any questions you might have and we look forward to speaking with you soon.