The third quarter market activity reminded investors of two facts: 1) the equity markets are subservient to the larger debt markets, and 2) the Federal Reserve is the ruler of both markets. After the Fed’s 0.25% interest rate increase in May 2023, the S&P 500 surged by 11% through July. Then, hawkish commentary from the Fed in August reinforced that the central bank would tame long-term inflation by keeping interest rates “higher for longer”, even if a recession ensues. It was a wonderful summer up to that point partially because the equity markets were disregarding previous Fed commentary with the same message. In fact, during the summer months, Fed Futures priced in rate cuts in 2024, in direct contrast to Fed comments. Markets seemed to wake up to the unwavering Fed remarks in August: long-term interest rates increased dramatically and equity markets declined through quarter-end.
The Federal Reserve’s dual mandate is to keep prices stable while promoting full employment. Chairman Powell introduced the idea of “transitory inflation” in 2021, but it’s clear that nobody is using this phrasing to describe the current level of inflation or its trend. While inflationary readings have moderated over the last six months, readings are above the Fed’s 2% target and a tight labor market threatens to drive employment costs – a very sticky form of inflation – even higher. After the Fed’s August commentary, long-dated bonds sold off considerably, driving rates on the 10-year treasury to 4.6%. The third quarter represented one of the worst returns in the long bond market since 1926 with long Treasuries declining 11% in the quarter. As equity valuations are derived from the present value of future cash flows, higher interest rates increased the discounting mechanism and drove equity valuations lower through quarter-end.
S&P 500 (Equal Weight)
iShares Core U.S. Aggregate Bond Index ETF (AGG)
We wrote in our second quarter commentary: “If this new bull market continues to mature and equity market participation broadens as past cycles have, we are well positioned. We have come a long way since last October’s lows and the emotions of the market and recent obsessions are subject to change; a possible correction of 5% could occur at any time.” While no investor likes market corrections when all long-term financial assets temporarily decline, they are a great time to concentrate capital on investments that will not only survive, but thrive. An anti-fragile portfolio is our goal. Our emphasis on quality (high profitability and ability to self- finance) and value are in line with the maxim “it’s better to stay ready than to get ready”.
The acronym “TINA” (there is no alternative) was used to describe the flow of capital into U.S. common stocks during the prolonged period of low interest rates. With domestic interest rates at zero, and below zero internationally, there was little to no positive return potential for fixed income investors. Investors were tacitly encouraged to accept more risk and buy stocks as equities offered a yield that was greater than investment grade debt with the built-in option for growth of principal over time. The current investment environment is unsettled due to the unknowable impacts of government fiscal and monetary policies, prospects of a global slowdown, war in Ukraine and the Middle East, and a polarized political environment. We believe this information is reflected in the equity market valuations, which are telegraphing that there is opportunity for those that are well positioned, long-term oriented and ready. Presently, with yields of over 5% for maturities of 1 to 3 years and just under 5% for 10-year Treasuries, investors have reasonable alternatives to stock and an important diversification opportunity. “TINA has left the building” (G. Seizert; October 2023).
While we cannot say if the current conditions will lead to a mild or moderate recession (or one at all), market pessimism produces prices that are advantageous to long-term investors like us. As we review our portfolio businesses, we like their balance sheets, low prices relative to intrinsic value, and their management teams which use volatile times to outmaneuver competitors. As the great investor Shelby Davis said, "you make most of your money in a bear market, you just don't realize it at the time". We at HBCM stand vigilant and ready to pounce on any opportunities that the market may present now and in the future.
Heron Bay Capital Management, LLC (“HBCM”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where HBCM and its representatives are properly licensed or exempt from licensure.
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Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. You cannot invest directly in an Index. Return data sourced from FactSet and Orion.