Dear Clients and Friends,
More than halfway through 2023, I can say one thing definitively: 2023 is nothing like 2022 and that is good news for investors. In my fall newsletter, I gave my predictions for when we might exit the then raging bear market. I assigned a 50% probability to a bear market exit before June 30th, a 30% probability that it would end later in the year, and a 20% chance that markets would stagnate or deteriorate further. There is no magic here. Not knowing the future, I just used the past as my guide. The odds-on favorite won, and we exited the bear market on June 8th, with the S&P 500 Index 20% above its October low.
How We Exited the Bear Market
High interest rates make borrowing for consumers and businesses more onerous, housing less affordable, and a recession more likely. So why is the market up? The answer lies in the nature of markets: they are forward-looking and have started to price in an end to rising interest rates and lower inflation. To the extent that inflation and interest rates decline somewhat, but then plateau at an uncomfortably high level, markets could very well become less enthusiastic. That is a risk to bear in mind. However, the base case at present is that we escaped a recession and got inflation under control.
As it turns out, the bear market lasted 9 months and saw a maximum drawdown of 25.4%. That made it a relatively mild one, compared to the average 34.2% drop and 13-month duration of bear markets since 1950. Thank AI and the Magnificent 7 – Apple, Microsoft, Nvidia, Amazon, Meta, Alphabet, and Tesla. Without them, 75% of the rally would be erased. It is not a great sign for a rally’s longevity if it is so concentrated. Encouragingly, however, since July other stocks and sectors have sprung to life too, which suggests that perhaps there’s some gas left in the tank.
International Investing for the Next Decade
Over the last decade it has not paid to diversify your portfolio internationally. US stocks produced an average annual return of 12.5% vs 5.0% for non-US stocks, as measured by the S&P 500 Index and the MSCI World Index ex-US, respectively. And it is not just the last 10 years. Since the recovery from the Global Financial Crisis commenced in March of 2009, US stocks have been the place to be, earning 16.5% annually on average, versus 9.4% for international stocks. When I bring on new clients, I almost always observe from their account statements that they have little international exposure. Good – if they held those positions for a long time, through the ups and downs. Many investors – and their advisors – exhibit recency bias; the belief that the recent past is likely to persist. Some biases pay off sometimes but that doesn’t mean they are good to have. Possibly the biggest force of market nature is mean reversion. Meaning that over time, assets with similar risk and earnings growth potential should produce similar results.
Now, I will be the first to admit that probably on balance US companies are better run, more profitable, more innovative, and more shareholder friendly. Those attributes afford US stocks a premium over say their European counterparts. However, the outperformance of the US stock market has come from that premium increasing ever further, not from ever higher earnings growth and profitability. At some point the gravitational pull of mean reversion will take hold and international stocks catch up, even if US companies remain more profitable, better run, and more innovative.
I like to consider stock market forecasts over 10-year windows, which I think is a fair timeframe for a forecast to play out or to be proven wrong. The last decade belonged to the US market, the decade before that belonged to international stocks, returning 9.3% annually vs 7.6% for their US counterparts. Currently the price-earnings ratio of the US stock market, as measured by the S&P 500 Index, is 22.85 versus 13.27 for international stocks. What that means is that an investor is willing to pay 70% more per dollar of a company’s last year’s earnings if that company is located in the US. I think that is an unsustainably high premium and predict the next 10 years will see international stocks outperform even if the US economy continues to shine, as that premium shrinks. Check back with me in 2033 and hold me accountable!
Real estate Predictions
Most people’s biggest investment is their home. Or so the narrative goes. Personally, I think looking at one’s primary home as an investment does not fully capture the essence of owning a home. It is first and foremost a place that provides shelter, a sense of being rooted in a place & community, pride of ownership, and security – as in you are not beholden to a landlord’s continued willingness to rent the property under acceptable conditions at a fair price.
Therefore, comparing primary real estate to say stock investments is not apples-to-apples. For example, if you owned Apple stock instead of a primary residence, you would not have to fix (or arrange to get fixed) a leaky toilet, do a remodel to keep the property fresh, or mow the lawn at Apple HQ in Cupertino, CA. Conversely, owning Apple stock does not provide shelter. I get that it is not an either-or proposition, and the majority of Apple stockholders are homeowners.
However, the point is that most people buy a house they would like to live in and expect to come out ahead, if timing, location, and the property’s desirability line up reasonably well at the time of sale. Most stock investors, however, buy stocks solely in anticipation of future dividends and price appreciation, making “stocks vs real estate” a fraught comparison.
Why waste words on distinguishing a home purchase from buying purely financial assets? It is to understand that home prices don’t necessarily respond as predicted to rising interest rates, as buyers and sellers are motivated by other factors as well. When mortgage rates breached the 5% level in the Spring of 2022, there was a lot of chatter about the level at which mortgage rates would lead to declining home prices. Personally, I thought that somewhere between 6 and 7% prices would fall because it would zap demand. Interestingly, mortgage rates are now at 7%, demand has been completely zapped, but prices are slightly up year-over-year, after declining only modestly from the peak.
Apparently, would-be sellers with low mortgage rates are not willing to move – if they are not forced to – keeping inventories low enough to underpin the market for the dwindling pool of buyers still willing & able to get a mortgage at 7%. So, what will happen next?
I don’t have a record of accurately timing the real estate market, so keep that in mind, but I predict that mortgage rates will fall modestly and won’t be the boon to real estate prices that might normally be associated with a drop in rates. When interest rates fall towards 5% – perhaps no time soon – there might initially be more demand than supply, firming up prices in the short term. However, eventually, the people who have been wanting to sell will list as they are willing to accept a 5% mortgage on their next home, increasing supply and offsetting any increase in home prices. So, if you are waiting to sell, your realtor will agree with you that now is a good time and I concur. If you are waiting to buy, your realtor will also agree with you that now is a good time and I am not so sure. However, if you let life events dictate your timing, you will probably be fine in the long run and remember: you can make many happy memories in your new home, it’s not just a financial asset.
Climate Change as an Investment
According to NASA, June 2023 was the hottest June on record. July looks fairly certain to be confirmed as the hottest month ever recorded on planet Earth. In Florida, scientists have started taking coral out of the ocean to prevent it from bleaching, as water temperatures there have breached 100 °F. Coincidentally, what state is the number one destination for domestic migration in the US? Florida; the state with the highest share of its population at or near sea level and in the path of hurricanes! The 2nd and 3rd place go to Texas and Arizona, the hottest states in the Union. It is so easy to offer bleak evidence of climate change, but it is not motivating most people. You motivate people more by inspiring them than by lecturing or scaring them, in my opinion. In fact, I may have lost some readers on just the first few sentences of this paragraph alone.
To be sure, although I find climate change alarming, I am not an alarmist. It is draining to the messenger as well as his or her audience and perhaps time is better spent solving problems than stewing in them. I get the need for scientists to speak the truth no matter how uncomfortable. However, the messenger has to match the message. I am not a scientist or a journalist, but an investor. So how to best approach climate change from that perspective?
Climate change is not investable if the investment thesis does not match reality. Investing in air conditioners – and I would choose heat pumps – makes sense in a hotter world. If you are investing in Michigan grocery chains on the basis of increased demand from climate change induced migration, you may be waiting for a long time. The problem is timing. Perhaps in 2050 the Upper Peninsula will become a renowned wine growing region, taking the crown from drought-stricken and fire-scorched Napa Valley. But that to me is not an investable theme. I have yet to meet a Michigander who finds the winters there pleasant or someone who would like to move there for climate reasons, despite the weather.
Rather, I would want to invest in something that has a high likelihood of paying off in the next 5 to 10 yrs. That can be climate change related, but it has to be rather acute. Heat related illness, for example, is underdiagnosed in the US. According to the Journal Nature, 61,000 heat-related deaths occurred during the summer of 2022 in Europe. The official number reported in the US – which also experienced excessive heat much like Europe – has averaged about 1,000 per year as reported by the CDC in recent years. The US death toll is most likely underreported by 1 to 2 orders of magnitude (10-100x). An interesting – and impactful – investment might be to invest in a clothing company that makes lightweight, loose-fitting clothing and will see its wares in hot demand as the scope of heat related illness becomes crystalized in consumers’ minds. Of course, these ideas are always limited by whether one can find investable companies that can profitably address the perceived needs. The point, however, is to illustrate the line of thought.
So, whereas you will continue to see the topic of climate change in my newsletters, I intend to not rehash the grim facts, but to find profitable and possibly impactful investments for a hotter, drier, and wetter climate (yes; both), with more extreme weather events.
Work-life balance is not a steady state but rather a balancing act. I am pleased that I sent my newsletter out late this time, because it meant I put a camping trip in the Deschutes National Forest with my 4.75 year-old – that’s what he says when you ask him how old he is – ahead of my (artificial) newsletter deadline. I need to make choices like that more often; a mid-year resolution. I hope your summer is joyful and memorable too and you are able to prioritize what matters most to you.
Jan P. Schalkwijk, CFA
JPS Global Investments