Last year we talked about the “Everything Rally," where seemingly everything went higher. This year it seems that we are in the everything bear market, where everything is selling off. Stocks staged a summer rally bouncing 17% off their lows, only to give back all of those gains as we sit at the lows for the year. Bear market rallies like this are typical. Inflation continues to be the primary concern of 2022.

The Federal Reserve (Fed) raised interest rates twice this quarter, each time by 0.75%. This was their most aggressive tightening in a generation. These moves are their monetary policy tool to try and bring inflation from over 8% to their target of 2%. The Fed's actions have caused interest rates to rise by 3% for both short term and long term rates. As rates move higher, it causes bond prices to move lower. The bond market remains on pace to have its worst year in a century. The news and market activity has been difficult this year. We assure you that there are reasons for optimism in our Outlook.

Investment Strategy

In our September Investment Committee Meeting, we reaffirmed our current strategy. We are maintaining our neutral stock, bond, and cash allocation but keeping our conservative positioning in our stock portfolios. Your portfolio's US large cap value and low volatility holdings have each performed about 9% better year to date relative to the S&P 500.

Our strategy to shift away from our conservative stock allocation remains the same as last quarter. We will reduce our US large cap low volatility holdings in favor of US small cap stocks. When markets bottom, small cap stocks outperform larger companies by a wide margin in the first month, quarter, and six months of a new bull market. Low volatility stocks offer protection during unstable times but can lag behind the market in a strong rally.

We are continuously monitoring our checklist to make this shift. The first item on our list is to ensure that inflation has peaked. We also need to see an additional item or two from this list:

Valuations get cheap: We have set a target valuation range based on our expectations for earnings over the next 12 months.
Interest rates start to decline: 10-year bond rates are near their September peak. If rates stabilize or fall over a few weeks, this could serve as a signal.
The Fed changes its stance: The Fed is focused on slowing inflation by using restrictive monetary policy. If the Fed's messaging moves from restrictive to more accommodative or they adjust their inflation target from 2% to 2.5% or 3%, we would see this as a positive for the market.
The economy starts to recover: We will monitor leading economic indicators like purchasing manager index (PMI) to see when the data stops getting worse or if an economic soft landing occurs.

Outlook

Our short-term outlook remains cloudy, but we have reason to be optimistic about the markets in the next 12 months. Recession risks are elevated and the odds of one occurring in the next 12 months are at their highest level this year. Fears about a recession are centered around the Fed's policy moves. They have aggressively raised interest rates five times for a total of 3% this year. Concerns that the Fed could make a policy error or overdo it when raising rates to stamp out inflation is driving these fears. The Fed's 2% inflation target is a long way off but it takes time for their interest rate increases to work through the economy. The moves from the first half of the year are just now impacting economic activity. There are some signs inflation could be rolling over with used car prices declining, gasoline prices selling off and shipping rates pulling back.

If a recession does happen, it is unlikely to be a severe recession like 2008-2009. Unemployment is very low, personal and corporate balance sheets are in good shape, and consumer spending is unlikely to see a significant pullback given the strong job market. Whether we have a mild or a severe recession does have an impact on your investment portfolio. In shallow or mild recessions, stock bear markets fall around 30%, and we are about 7% away from reaching that level at the end of the quarter. Recessions also usually see corporate earnings growth slow or decline. This is something we'll be watching this earnings season closely.

You may be saying things look pretty bleak, but as promised, there are reasons to be optimistic. We think patient investors should be enthusiastic about the future of the markets.

High Volatility = Better Expected Returns: The Volatility Index (VIX) is a measure of fear or concern in the market. When the VIX is in a range of 15 to 20, it is considered to be a normal range. We are currently at 31. When the VIX is above 30 the expected returns for the S&P 500 turn dramatically in your favor. If you invest when the VIX is between 30 and 40 the median one year return is 22.1% and the market is higher 91.3% of the time. This far outperforms buying in normal market conditions.

Mid Terms Elections: The upcoming mid-term elections in November have typically provided a jump start to stocks. The nine months leading up to the mid-term election have historically seen underperformance but October and November in mid-term election years are typically very strong months. Investors don't like unknowns and taking the election outcome from an unknown to a known can serve as a catalyst.

Markets Bottom Before Things Get Better: As discussed in last quarter's Viewpoints, the bottom of the market occurs two to six months before the economy bottoms. Waiting for things to improve can lead to missing out on a rally. Investors look months and years ahead when making projections and don’t wait for the news to get better.

Every bear market in history has ended in stocks making fresh all time highs. The chart above shows that tremendous gains follow the pain from a bear market. It pays to be patient and the odds of good things happening in the not-so-distant future are flashing green.

US Market Viewpoints - Q3 2022