As we enter the historically volatile Fall period, it is hard to describe markets as anything but broken. With financial assets squarely in the crosshairs of policymakers looking to revert to 2% inflation, the S&P 500 Index has scored its worst year-to date performance in twenty years (-23.9%). Carderock Capital’s stock portfolios are down on average (-29%), with balanced portfolios weighted 55%-35%-10% (Stocks-Bonds-Cash) on average falling roughly (-18%).
When the dust settles, we will have an abundance of opportunities to buy great growing and profitable companies at much lower prices. As long-term Quality Growth investors, we believe that the fundamentals of our core holdings are still particularly strong, and markets this year have extrapolated a worst-case scenario from the Federal Reserve’s interest rate hikes.
How We Have Responded
Activity – On balance, we continued during the 3rd Quarter to be net sellers of stocks to defend portfolio values, rebalance overweight issues and cut positions with unattractive growth prospects.
Capital Gains – We have taken substantial profits in many of your stock holdings that gained nicely since the Great Recession in 2008/2009. Please review your attached statement with your tax advisor to avoid any surprises.
Equity Cash Reserves – We are at 40% as we patiently await more substantial evidence that rallies can be sustained, and the current cycle has bottomed.
Treasury Bill Purchases – We have been active buyers to augment yields on money market cash holdings.
What We Are Watching
Earnings Growth – Carderock holdings show higher earnings growth and returns on invested capital than the typical stock in the S&P 500 Index. And while earnings have been far more resilient for Quality Growth stocks this year, we believe markets have overreacted with prices falling more sharply on a relative basis which portends a catch-up period at some point in the near future.
Inflation – High frequency indicators show inflation is slowing down in major categories (housing, logistics, healthcare) that have yet to show up in headline news. This trend needs to continue for current Fed Policy to change and markets to stabilize.
Federal Reserve Policy – Signs of policy shifting from restrictive to neutral will occur when policymakers believe that the job of fighting inflation is complete. We see no signs of this now going into the New Year.
Our Expectations Going Forward
Supply Chain – Complications should continue to abate, offering stability to prices and compelling buying opportunities in our Quality Growth stock list.
Employment – Workers are still scarce while employment opportunities continue to grow. Companies with balance sheet flexibility will make the necessary capital investments to boost productivity and their prospects during the next recovery cycle.
Capital – With debt issuance, IPOs and Private Equity deals declining precipitously in 2022, we expect capital will be more productive and shift towards proven business models with sustainable profitability.
Fixed Income – We are still focused on the short end of the yield curve in both taxable and tax-exempt bonds, with the average current maturity of our bond portfolio coming in at slightly over 2 years. Short maturing bonds will continue to be favored by the market until inflation subsides and interest rates peak.
While extraordinary events in the form of war and monetary authorities have undoubtedly constrained markets this year, we see few signs that the competitive advantages of our core group of Quality Growth stocks have been upended. Now more than ever is the time to focus on remaining invested to ensure that your patience as a long-term investor is rewarded.
As always, feel free to give us a call to discuss any changes in your goals, circumstances or with any questions you may have.
Daniel A. Kane, CFA
James W. Mersereau, CFA
Stephen F. Knapp, CFA
Director of Research and Quantitative Strategies