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September 2022 Performance Review

October 5, 2022

The hits to the bond market just keep on coming. Interest rates spiked up as inflation signs were alive and well, and the Fed hiked short-term rates by another 0.75%. The bond index was down 4.18%—a tremendous one-month hit—while more rate-sensitive longer-term bonds were down 7%+. The S&P 500 was down 9.2% as the recent rebound from the June low rapidly reversed to new lows for the year. Stocks have been rising and falling with bonds, which is why safer balanced portfolios are down so much this year.

Our Conservative portfolio declined 7.62%, and our Aggressive portfolio declined 6.36%. Benchmark Vanguard funds for September 2022 were as follows: Vanguard 500 Index Fund (VFINX), down 9.21%; Vanguard Total Bond Index (VBMFX), down 4.18%; Vanguard Developed Mkts Index (VTMGX), down 9.96%; Vanguard Emerging Mkts Index (VEIEX), down 10.17%; and Vanguard Star Fund (VGSTX), a total global balanced portfolio, down 7.84%.

For the year, our Conservative portfolio is down a whopping 22.36% while our Aggressive portfolio is down 17.01%. Ever since central banks have needed near 0% rates to keep sluggish economies out of recession, the safety value of bonds has been almost nonexistent. More stocks and a few short positions have delivered less downside risk than fewer stocks and more bonds. Risky holdings like energy and Brazil stocks have delivered positive returns this year, while safer funds investing in Europe are down 30%. It is an increasingly upside-down world.

The bond market didn’t have much positive return to spare in a slide (unlike stocks over the last decade, which are still way up) as yields have been very low for most of the post-2008 great recession era. With this year’s slide, the 10-year total return on the Vanguard Bond Index is 0.74%. The annualized inflation rate over this time has been 2.54% for a negative real return (inflation-adjusted) of 1.8%. The treasury bill return has been slightly worse, so cash really only looks good this year, not as a long-term holding.

Here is your best news: from the current yield of the bond index fund of roughly 4%, inflation would have to come in at almost 6% a year on average over the next decade to reproduce the negative inflation-adjusted return of the last decade. In other words, these are the best times to buy investment-grade bonds since the early 2000s.

For 2022, the S&P 500 is down (with dividends) 23.89%—not far off from our Conservative portfolio, shockingly, and our worst relative risk showing ever. Emerging market indexes are down 24.08% while developed markets abroad are down even more at 27.69%—odd in a down market for riskier stocks to perform better. The bond market is down 14.65% for the year, while longer-term bond funds are down 20%+. This is why Vanguard STAR, the 60/40 global balanced fund, is down 23.33% this year. At least both our portfolios are beating this solid benchmark.

While we should have had more cash, after 10-plus years of near-zero returns in cash, it gets too easy to reach for a “safe” yield of 1-2%. And then 2022 happens, and the bond market falls harder than ever before. This doesn’t mean we won’t see lower prices; however, it is time to dust yourself off and get back out on that yield curve. Stocks are down too, but other than foreign stocks, they are not at decade-plus valuation lows. The right move likely is to lock up some higher rates and, when they go back down after a bigger economic train wreck (which will boost bond prices), move the gains into even more distressed stocks.

Every fund category that doesn’t include shorting was down last month. The big hits were in real estate and China funds, both down just over 12% for the month, and both down roughly 30% for the year. Falling oil prices hit energy funds hard last month, but even with a roughly 11% hit, they are up 20% for the year. The same can’t be said for tech funds, which are now down almost 40% YTD. Oil seems to be turning back up, both from expectations that central banks are going to pause and because OPEC+ is going to cut production to maintain higher prices.

Supporting our Aggressive portfolio was a roughly 23% rise in both UltraShort Bloom. Crude Oil (SCO) and ProShares UltraShort QQQ (QID) as well as a near 8% jump in ProShares Decline of Retail (EMTY) and almost 4% in Proshares Short High Yld (SJB). It goes downhill fast from there, though most of our funds beat the S&P 500 last month. The biggest hits to our stocks were Franklin FTSE South Korea (FLKR), down 18.71%; Franklin FTSE China (FLCH), down 14.12%; and newly added Vanguard Communication ETF (VOX), down 12.5%. Bonds were all bad with all of our holdings falling harder than the bond index, topping out with a 10.2% drop in Vanguard Extended Duration Treasury (EDV).

With that being said, rates may not go up that much more—although riskier credit bonds could still collapse in a recession. The reason is that things are starting to break globally, and central banks are going to run out of room to fight inflation. The last casualty was the almost complete collapse of the UK government bond market. As leveraged investors had to unwind positions, their own central bank had to immediately start creating money out of thin air and buying bonds to support the market. Considering they are also trying to do the opposite—fight roughly 10% inflation by selling off the central bank balance sheet—this reversal was startling. It worked—possibly too well as investors now think they see the end of rate increases and the green shoots of the next low-rate cycle and are promptly jumping back into riskier stocks and commodities.

This is a dangerous game of Fed chicken. It would be the perfect time for governments to raise taxes to fight inflation and raise confidence in the bond market that debts will be paid and a debt spiral of high rates won’t happen. Instead, we have governments, foreign and domestic, left wing and right wing, state and federal, doing the opposite. We’re getting gas tax holidays and more checks in the mail. The UK is going to pay much of your energy bills (and tried to do a big tax cut), and Germany will too. This is of course the opposite of how you want to fight inflation—by reducing the amount of money consumers have to spend—and this was the foundation of the UK bond market mini-collapse. Since this subsidized demand will also send more money into Russia, where much of Europe’s energy still comes from, these populist policies are mind-boggling.

If government stimulus keeps up and central banks lose their nerve for raising rates, we may have inflation for longer than we think, and we may add back our inflation bond funds holding TIPS (which are down sharply this year). The damage to the housing market has already begun, with 7% 30-year mortgage rates. In all likelihood, home prices in formerly hot markets will fall 10-25% in the next year or so if mortgages don’t come way back down. This will cool down the economy and cause a recession in a very stupid and risky way. Apparently we’d rather avoid a small tax increase even if it means having to revisit the 2007 housing market crash.

Stock Funds1mo %
UltraShort Bloom. Crude Oil (SCO)23.34%
ProShares UltraShort QQQ (QID)23.06%
ProShares Decline of Retail (EMTY)7.78%
Proshares Short High Yld (SJB)3.95%
Proshares Short Bitcoin (BITI)-0.18%
Invesco CurrencyShares Euro (FXE)-2.52%
Franklin FTSE Brazil (FLBR)-3.97%
VanEck Vectors Pharma. (PPH)-4.95%
NightShares 2000 (NIWM)-6.46%
LeatherBack L/S Alt. Yld. (LBAY)-6.71%
Vanguard Value Index (VTV)-7.80%
Homestead Value Fund (HOVLX)-7.89%
Franklin FTSE Japan ETF (FLJP)-8.68%
[Benchmark] Vanguard 500 Index (VFINX)-9.21%
Vanguard FTSE Europe (VGK)-9.67%
Vanguard FTSE Developed Mkts. (VEA)-9.85%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)-9.96%
Franklin FTSE Germany (FLGR)-9.99%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)-10.17%
Vangaurd All-World Small-Cap (VSS)-10.79%
Vanguard Communications ETF (VOX)-12.50%
Franklin FTSE China (FLCH)-14.12%
Franklin FTSE South Korea (FLKR)-18.71%
Bond Funds1mo %
[Benchmark] Vanguard Total Bond Index (VBMFX)-4.18%
iShares JP Morgan Em. Bond (LEMB)-4.69%
Vangaurd L/T Treasury (VGLT)-7.91%
Vanguard Long-Term Bond Index ETF (BLV)-7.92%
Vanguard Extended Duration Treasury (EDV)-10.20%