3Q22 Letter : "The Importance of a Long-Term Investment Horizon"
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The Futility of Short-term Forecasts
I first started managing institutional money in 2003, and continued doing so for over a decade. As an analyst, my busiest days were during earnings season, when the companies I covered would report revenue and earnings performance for the most recent quarter, as well as forward-looking estimates. Much emphasis was placed on whether the company under question would meet or beat Wall St. analysts’ estimates, as doing so would be the catalyst to drive a stock or bond higher.
Early in my career, I made a number of bets heading into earnings season, and was often right. This was an exciting time, as I’d make bundles of money over the course of days or even minutes. For a short time, I thought that I was better at predicting the future than my peers.
However, as years passed, and I became more experienced and more humbled, it became clear to me that not I, nor any other analyst or money manager anywhere could consistently predict the future. Some get lucky at times, others suffer major losses due to unforeseen events, and none of them are able to beat the market over time.
It also became clear to me my peers on Wall St. were expending a huge amount of effort to take risk by betting on events beyond their control. Earnings seasons were easily the most stressful part of the job, and significant energy was devoted to short-term forecasts that – as Howard Marks pointed out in his recent memo – “are rarely helpful.”
Trying to predict the future, especially in the short-term, is an exhausting and futile effort. As I reflect on my transition from hedge fund analyst to wealth manager, I’m grateful to have refocused my energy to help my clients build wealth over the long-term.
The Importance of a Long-Term Investment Horizon
In numerous letters and presentations over the last couple of years, I’ve emphasized that virtually all of my clients at Evolve Investing are long-term investors, who have the advantage of being able to look past short-term volatility. This perspective enables us to identify opportunities and also eases the stress and anxiety associated with short-term market fluctuations.
Importantly, a long-term perspective also tends to lead to better returns over time. Academic studies have shown that when investors focus too much on the short-term, and sell stocks as an overreaction to recent losses, they often tend to miss market recoveries as well as the benefit of compounding.
Moreover, it is nearly impossible to “time the market” (i.e. accurately predict when the market “peaks” or “bottoms”), and no professional money manager has proven their ability to do so over time. As Bill Miller pointed out in a recent quarterly letter, “We believe time, not timing, is key to building wealth in the stock market.”
The Inevitability of Market and Economic Cycles
Economic and market cycles are inevitable. As Howard Marks commented in another recent memo:
“when asked whether we’re heading toward a recession, my usual answer is that whenever we’re not in a recession, we’re heading toward one. The question is when. I believe we’ll always have cycles, which means recessions and recoveries will always lie ahead.”
Over the last century, the U.S. has entered recession 17 times. In the below chart, we are looking at the S&P 500 index from 1950 to today. Recessions are noted in grey, and we can see that the associated drawdown in the S&P 500 has ranged from 14% in 1960 to roughly 57% in 2008.
For context, the S&P 500 is roughly 25% off of its peak as of the close of 3Q22, vs. a historical average of 30% during periods of recession.
Over the 70+ year timeframe noted above, the S&P 500 has returned about 10% per year on average. So while short-term market cycles have been impacted by shifts in investor psychology and sentiment, the market has generally gone up over time.
My Thoughts on the Markets
Over the last several weeks I've had many conversations with clients and friends regarding financial markets. Some see the recent market weakness as a buying opportunity, whereas others want to exit markets completely and move their assets into cash. In almost all of these conversations, two questions ultimately come up: (1) Are we entering recession?; and (2) When does the market bottom?
Despite my inability to accurately predict the short-term future (see above), I’ll share a few of my beliefs regarding the current investment and economic environment:
I believe that a near-term economic slowdown or a mild recession is likely. This outlook is unchanged from my views in April and in July.
I believe that markets tend to “price in” economic expansions or contractions well before they occur. September 2022 was the worst month for the Dow and S&P 500 since March 2020, which in my view reflects a challenging year ahead for the housing market, earnings comparisons, and the global economy. Six months from now, I expect the market to reflect overall expectations for 2024 and beyond.
I believe that the market is pricing in a high probability of near-term recession, including a housing downturn, compared to a roughly 50% probability of recession as of early July. In a recent interview, David Kostin, a strategist at Goldman Sachs, commented that “based on our client discussions, a majority of equity investors have adopted the view that a hard landing scenario is inevitable.”
I believe investor sentiment is at a multi-year low. A recent Bank of America report suggests that investor sentiment is “unquestionably” the worst it’s been since the 2008 Financial Crisis. In my experience, lows in investor sentiment tend to coincide with lows in the markets.
How I’m Positioning
As mentioned above, virtually all of my clients at Evolve Investing are long-term investors, who have the advantage of being able to look past short-term volatility. In order to best serve my clients, I shift between more defensive and aggressive positioning as the overall investment environment changes, while also considering each individual’s unique level of risk tolerance.
Similar to what I shared in my 1Q22 and 2Q22 letters, Evolve Investing’s strategies remain generally defensive, with the following characteristics:
Lower technology sector exposure relative to the overall market.
Virtually zero exposure to European stocks and bonds.
Mostly larger companies that have solid balance sheets and proven access to capital.
A generally higher percentage of bonds and cash relative to equities.
Over the last quarter, I’ve made the following changes:
For clients who contribute cash to their portfolios on an ongoing basis, I am not rebalancing portfolios to invest into equities, and am instead holding larger cash balances or reallocating to short-term treasury bonds.
In our fixed income strategies, I’ve increased holdings of short-term treasury bonds and decreased high-yield bond holdings, which should reduce default and duration risk.
For several accounts, I’ve implemented tax-loss harvesting strategies to enhance tax-adjusted returns over time.
Earnings season is roughly two weeks away, and results should provide visibility into ongoing and expected business conditions, which will likely catalyze the market's next direction. I plan to follow these results closely, and when appropriate, capitalize on increasingly attractive opportunities to add risk across several industries including renewable energy and cloud computing.
As always, if you’d like to discuss any of the above themes and how your portfolio is positioned, you’re welcome to reach out any time. Thank you for your continued support and confidence in Evolve Investing.
Best,
Peter Hughes, CFA