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  • Writer's pictureMichael Handy

Third Quarter 2022 Newsletter

Third Quarter 2022 – The third quarter of 2022 followed the downward trend as the market correction continues. No areas of the market were spared for the third quarter and the prior year. For the three-year period, large US companies (8.09%) and small US companies (7.34%) had positive returns. Important to note, 1-yr real estate, (-16.20) and 1-yr bonds (-18.47) has similar loss percentages to US companies.

Statistics are from Morningstar Advisor Workstation which are considered reliable.

The market correction – The market is in a correction. The main culprits are interest rates, post-Covid recovery issues and high valuations. The Fed has been increasing interest rates at a strong clip, and the market has priced in two additional large interest rate hikes. The market has reverted to the mean for valuation, meaning prices for company stocks have decreased. A simple example may help explain a correction. An investor in prior periods paid $18 for $1 of earnings. The normal price is $15 for each $1 of earnings. When the market corrects to $15, the result is a (-16.7%) decline ($3 decrease/$18)

Patience and Covid – This is the time for investor patience and perspective. The market has gone through the Covid pandemic and post-Covid recovery. Neither phase has been smooth. Covid reduced company capital spending, in effect reducing the future supply of goods and services. The quick Covid recovery produced supply chain snarls with demand exceeding supply, resulting in the first phase of inflation.

The miracle is the Covid vaccine was produced in one year rather than a typical ten. Most Americans were inoculated in a relatively short period. A million lives have been lost to Covid in the US. It is unfathomable to comprehend tens of millions of lives lost, but that could have been the scenario. This catastrophe was avoided with the vaccine, and behavioral changes like social distancing and wearing masks. As the holidays approach, we should be grateful where we are in our country.

Sales and Profits after Covid – The S&P 500 companies make substantial profits. In most cases sales and profits are growing. The market was overvalued prior to Covid and due for a correction. The low interest rates for prior years added to the inflated market pricing. Covid exacerbated the problem. Sales and profits are not growing as fast as in prior periods and this has an adverse effect on market prices.

With all we’ve been through for the last three years, we look at privately owned businesses like our clients. For an established privately owned company, an average return of 7.34% per year over the last three years, a small company return above, would look wonderful compared to the outlook at the beginning of the pandemic.

Inflation – The causes of inflation are widely reported. The Covid recovery created supply chain issues with demand exceeding supply. Russia invaded Ukraine, disrupting energy and food distribution. The Fed response to inflation is to increase interest rates, and reduce their investment in US Treasuries. The strategy, rarely achieved, is to bring down interest rates with mild disruptions to employment. In other words, the coveted soft landing. A more usual result is a reduction in interest rates but also a recession.

Most economists are predicting a mild recession. Some signs are showing with reduced capital spending and slower wage growth. Some commodity prices are decreasing. Employment remains strong at present. As a company’s profits decrease, the inevitable layoffs will come and unemployment will increase.

The Elections – Midterm elections are here. This time the ballots encompass more than candidates running for office. This election may be a referendum on the future of our country. There is an old saying, you can have your opinion, you can’t have your facts.

Our democracy is a fragile experiment. Our basic tenants are fair and free elections, limited government, and access to health care, employment and education for all citizens. Our country has many issues today, but they are solvable. We need both conservatives and progressives to execute solutions.

The polls show the Republicans will gain control of the House while control of the Senate is still a toss-up. We will have a Democrat in the White House with veto power and with a roughly split House and Senate, overriding a veto is unlikely. The market prefers a split between the Presidency and Congress with less regulation forthcoming.

The future – The future is unknown and unknowable and the best long-term strategy has been wide diversification. Investments in your portfolios are from world class managers at Dimensional, Vanguard, and PIMCO, and stocks from blue chip companies with wide moats.

Bonds and Preferred Stocks – Every market presents opportunities. Following are three investments that have been added to certain accounts.

Preferred Stocks – $25 par value bank preferred stocks are priced below $20. They have a current yield of 5.75% to 6.25% and a yield to call exceeding 10%. The call provision is an option for the issuing company to redeem their preferred stock at the $25 par value price. A call provision is usually within five years of the original issue date. The maturity date for preferred stocks is beyond the optional call date.

If the preferred stocks are called, the $25 call price becomes the sales price. Bought at $20, a $5 per share gain results. This 25% gain ($5/$20) is taxed at long-term capital gains rates if the stock is held a year or more. If the preferred stocks are not called and held, the investor continues the 5.75% to 6.25% return. Another scenario is as the call date approaches, the market price increases in anticipation of being called. In that case, if the price is close to the $25 par value, the stock can be sold for a capital gain on the difference between the sales price and the $20 paid for the stock.

TIPS US bonds – Treasury Inflation Protected Securities (TIPS) are treasury bonds with an inflation feature. These bonds do better than regular US Treasury bonds during times of high inflation like now. The 0-5yr TIPS bonds had a 12-month yield of 6.86% according to Morningstar. These bonds have been added to many accounts and will remain a good investment during high inflation.

Bonds – For some accounts, individual company bonds have been added. Like the preferred stock example above, the bonds are trading below their $1,000 par value. This means when they mature, the difference between purchase price and redemption price is a capital gain. These investment grade bonds have yields to maturity of 7% to 8%.

Bond pricing on statements – An investment point on bonds. Available bonds in the market have a buy price and sell price (bid and ask). The buy price is higher than the sell price. The difference or spread is the compensation to the bond market makers. Bonds purchased are intended to be held to maturity, three to nine years in future. Bonds are purchased based upon the yield to maturity. When listed in an account statement, the sales price appears. The day after purchase, this price will be lower than the purchase price. This sale price is insignificant since the bond will not be sold, it will be held until maturity.

Highlights from Jessica’s Desk

IRS scams – The IRS will not call or email you demanding payment. If you get a call from someone claiming to represent the IRS, just hang up. If you receive an email, delete that email. If you receive a notice by mail, you can call the IRS at 1-800-366-4484 to determine the legitimacy of the notice. If your returns are prepared by Handy & Reagan, let us know of any such notices as well.

E-mail Phishing – It is important to determine the legitimacy of any email you receive, not just from the IRS. Common ways to spot phishing schemes include email addresses and domain names that don't match, grammar errors and misspelled words, or a sense of urgency being created.

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