Investment markets worldwide continued their negative momentum in the third quarter, making 2022 one of the worst years on record in equities and fixed income alike. Inflation continues to be the focal point for investors as the Federal Reserve Board has clearly stated that their only objective now is to tame inflation through higher interest rates and the draining of excess liquidity. Many are asking if the U.S. is in a recession. The markets are starting to assume a recession, but the economic data suggests we have not yet entered one. We must remember that markets typically hit their lows before the worst pain is felt, as investment markets are forward-looking and will discount before we feel it in the economy.

As measured by the MSCI All Country World Index, the global equity market declined 7.2% for the quarter. Adding in the loss from the first half results in a 25.7% decline for the world equity markets in the first nine months of 2022. Auour equity strategies outperformed their benchmarks, falling 5% in the quarter and 19% for the year through September.

Growth companies across developed markets continued their decline yet outperformed modestly value during the quarter. While growth companies fell 3.5%, value experienced a 5.6% decline in the third quarter as recession concerns rippled throughout all aspects of the economy. Though the dispersion in returns between value and growth companies year-to-date has narrowed a bit, the underperformance of growth companies is expected to continue as investors look for more near-term certainty that value companies provide versus the long-term opportunity that many growth companies look to promise.

Smaller companies suffered a bit less in the third quarter, falling 2.1%. We would love to say this is a positive sign for future returns, but at this time, it seems a bit like a consolidation of past losses rather than a change in trend. Other riskier equity categories continued to produce declines. Emerging markets declined 13% in the quarter, culminating in a loss of almost a third of their value over the past nine months.

Fixed-income markets also continued declining, falling 6.9% as market participants digested higher-for-longer inflation expectations and the increasingly hawkish tone from the U.S. central bank. Investors have grown accustomed to having fixed income stabilize a portfolio when equities weaken, but this year has been different. Fixed income dropped 20% in the year’s first nine months, adding insult to injury felt from equity allocations.

There were no places within the fixed-income markets to hide from price compression, as the impact was felt across the entire yield curve and every credit category. Staying the course with our defensive positioning in lower-duration instruments paid off and helped to dampen the decline. Auour fixed income strategy performed relatively well in the quarter, falling 3.3% compared to its benchmark falling 6.9%. Through September, Auour has experienced an 11% loss in fixed-income relative to the market’s 20% decline.

The concerns we have shared over the past two years continue to reveal themselves in the investment markets. Though we have focused most of our conversations on our concerns, it is imperative to remember that markets can quickly discount the negatives. Historically, as fear of continued declines grabs headlines, it is at these times that long-term investment opportunities present themselves. We need to remember that economic storms pass and bring about clearer skies. Our high cash levels allow us to weather the storm and look for opportunities as the skies brighten.

• Equity markets have gone up 80% of the time when viewed on a 6-month rolling period. They have experienced 10% or greater declines over a 6-month period approximately 10% of the time.
• Of the worst downturns over the past 60 years, the market has recovered to its past high within 18 months… on average.
• Equity markets reach their low before the worst of the economic downturn.
• Emotional response to market volatility results in investors losing more than 25% of the market’s opportunity.
• The downturns do not necessarily lead to negative annual returns.

We have discussed the instabilities in the markets and the economy. We have been adding to our cash positions since Thanksgiving of 2021 as we looked to mitigate an expected adverse market environment. In the first quarter of this year, some questioned as to why we were not fully invested. Now that the major indices are down 20% to 30%, we are being asked why we are not fully in cash. The answer is we look to be approximately right rather than precisely wrong. To have the confidence to move to an extreme requires much more than a recession. It would likely require a banking crisis.

There is little doubt that the inflation wave we are experiencing and the fight against it will be painful. And the markets will have to reflect it. Which they are. Now.

Investment markets—both equity and fixed income—discount future events. When those anticipated future events are positive, no one questions that discounting. However, when the future becomes darker, the downward adjustments are not easy or graceful. When the market is finding its correct level, the changes are typically abrupt, halting, and clumsy. Of course, dramatic data and big swings between the ups and the downs can make people feel uncertain and out of control. The danger is when feeling like that brings people to act on fear and regret—regret that “I should have sold all of my portfolio in…”

Consider, however, that historical market movements have demonstrated the best time to buy (or sell) is when the opposite action would feel most comforting. Our models, based on pattern-recognition over decades, have been working, so we will continue to follow their unemotional and empirically tested direction.

We firmly believe that market bottoms and tops are processes and should not be viewed as discreet points in time.

The costs to do it well.

Large firms spend large sums of money to hire analysts specializing on understanding the drivers of an industry, the key players within it, the subtlety of a management team’s focus and drive.  As I was one of those guys, I traveled quite a bit to meet face to face with management teams.  Riding in the delivery trucks to meet customers, speaking with suppliers, etc.  All with the idea to develop a deeper understanding into the means a company drove value creation… or destruction.  I was trained by ex-CIA interrogators on methods to question management teams to detect deception.  We retained forensic accountants to go through companies’ financial statements.  These are the actions of the large mutual fund complexes, institutional asset managers and the established specialized hedge funds.  It must be viewed with a skeptical eye when someone attempts to invest in single securities without this level of detail.  Their competition is doing it.  If they are not, I suspect that they may be at a disadvantage.

Reinforced with empirical evidence

This is not to say it’s impossible to outperform these large complexes.  I will be the first to suggest that the large institutions have their own problems that harm their chances to outperform on a consistent basis.  But one must be cognizant that a a manager in the suburbs with limited resources has considerable headwinds.

To make matters worse, considerable evidence suggests that between 63% – 95% of professional managers underperform their mandates.  This has been shown to be true across investment styles, market caps, and economic conditions.  So, the net effect is that you need to believe that your manager is in the top 5%-20% of all managers around the globe to justify his desire to stick you in individual securities.  Those aren’t great odds…

The elephant in the room

To make matters even worse, stock picking may not even be that important compared to other factors.  In repeated studies, it has been shown that over 90% of the variation in individuals’ historical returns can be attributed to two factors; market participation and asset allocation.  That would indicate that individual stock selection has a very minor impact on your long term returns. Combine that with the fact that most managers underperform, it’s hard to understand why you should pay them for their skill at all.

All is not lost

It may sound like I am being harsh towards active managers.  I am.  Most deserve it.  Not all of them, but most.

The above studies’ results have most definitely influenced the architecture and processes of Auour. From a rational review of the current research, we have decided to approach investing by attempting to control the factors that drive performance; market participation and asset allocation.  And to do so with an eye on costs.

The above is not to say that all active managers are poor.  We are true believers that great investors exist.  Our experiences suggest that they focus on small companies or more esoteric investments where information inefficiencies tend to be larger.  Auour looks to identify those that have demonstrated skill over the long term and over various economic conditions and integrate them into a cohesive investment plan to drive stability in philosophy, durability in process, and performance in our clients’ assets.