I own Berkshire Money Management, and recently investors have called us because their financial advisors appear to have messed up this year (their sentiment, my words). It is possible the financial advisors couldn’t open their worldview and only thought “in the box”; the box was broken.
The clients’ investment goals were “income with capital preservation.” Their advisors placed the bulk of the clients’ money in municipal bond mutual funds (Eaton Vance, Nuveen, Western Asset) and some in U.S. Treasuries (Franklin). Neither asset class preserved capital in 2022; their portfolios experienced declines, some as high as double digits.
In the context of the goal of “income with capital preservation,” this portfolio was an unmitigated disaster in 2022. All the while, the clients had the privilege of paying the mutual fund and the advisor management fees.
In 2019, I wrote about the death of 60/40 (the “40” being the percent of bonds many in-the-box advisors target for investment clients). I said, “be careful of…false promises of ‘safety’ from bonds.”
Maybe this advisory group didn’t steal their clients’ money in the traditional way (as it seems FTX did). Still, their stupid decision to do what everyone else does stole peace of mind and perhaps a comfortable retirement from those clients.
For those unaware of the FTX collapse, our friends at the Wall Street Journal are covering it well. But the gist is that the previously heralded wunderkind, Sam Bankman-Fried, allegedly stole customer money from his company, FTX. He then allegedly bet it on risky investments at his other company, Alameda Research. The $32-billion company imploded in the span of about a week once someone with a brain actually looked at the books of this house of cards.
Before the unraveling, well-regarded venture capital firms like Sequoia Capital, SoftBank, Tiger Global, Paradigm, Blackrock, and nearly 80 others invested $1.9 billion into FTX over the last two years, as recently as January 31, 2022.
So maybe I shouldn’t be so angry at those advisors for losing so much of the clients’ money even though it was mandated to provide “income with capital preservation.” Although I warned investors to avoid investment-grade bonds, these advisors were just doing what everyone else was. It’s wrong, but humans often use the social proof of “everyone else doing it” in place of good old-fashioned research. Think about it: I bet you know someone who has bought a stock just because it was going up in price.
In April 2022, Bankman-Fried opined in the “Odd Lots” podcast about how venture capital firms picked investments.
Bankman-Fried said, “You get a bizarre f—ing process that does not look like the paragon of efficient markets that you might expect. [Venture capitalists] see what all their friends are chattering about, and their friends keep talking about this company …and they start FOMOing [feeling the fear of missing out] and then [they] find a way to get into that … And all the while, you’re like, ‘How do we justify: Is this a good investment?’ Like, all the models are made up … You’re valuing [companies] off a model built by a person who owns the thing that’s being sold. So, like, of course, the number’s going to go up between now and 2025, right? It’s going to go up an arbitrary amount. And you can justify anything.”
Fortunately, or unfortunately, little guys and gals like us don’t typically have the opportunity to invest directly in the next hopeful unicorn. However, many people are going to use financial advisors. I am admittedly biased, but you should use an advisor. Advisors are important because they do more than invest. (Although, admittedly, I write a lot about investing. Why? I find that people act on investment advice but require an advisor to implement financial planning advice.)
Berkshire Money Management can’t take on every investor that needs an advisor, nor, quite frankly, do we want to. (We have a client selection methodology, which is more of an art than a science). However, you can and should add the “Capital Ideas” column to the agenda when you schedule portfolio reviews with your own advisor. We’re all human; we often do what others do because it feels safe. This weekly column is a tool for you, and it’s perfectly ok to discuss my advice with your advisor. Maybe my advice won’t be good for you (because I don’t know you personally), but it might help your advisor save himself from blowing up your “capital preservation” portfolio.
Upside Down You’re Turning Me, Again
In 2019, I warned that there would be a U.S. economic recession in 2020 because, in part, the yield curve (the spread between yields on 10-year and three-month U.S. Treasuries) inverted. As a refresher, an inverted yield curve is an interest rate environment in which long-term debt has a lower yield than short-term debt instruments of the same quality. And that is not how it usually works, as long-term rates are supposed to be higher than short-term.
The 3-month Treasury ended the week of November 18, 2022, at 4.13 percent, while the 10-year Note yielded 3.82. This inversion first occurred on October 16, 2022, and has since persisted. It’s the first inversion of this part of the curve since March 2020.
An inverted yield curve is considered a predictor of an economic recession. When people believe there is an increased risk of a crisis, like a recession, they shift their money into the world’s safest and most liquid investment asset, the 10-year Treasury note. This is an indication of negative sentiment regarding the direction of the economy. Even if the belief was misplaced, how we think dictates how we act, and it can become a self-fulfilling prophecy that bad times are coming.
There’s been much debate about whether the inverted yield curve predicts or causes a recession. For example, one standard theory is that banks are disincentivized to provide capital when the yield curve is inverted. Banks make money by borrowing at short-term rates (typically lower) and lending at long-term rates (usually higher). But when the yield curve inverts, that money-making mechanism evaporates. And so, too, does the lifeblood of corporations: access to capital.
That is a significant concern, but I don’t believe that’s it. I contend that an inverted yield curve indicates that the economy is sufficiently fragile such that the next shock will push the U.S. into a recession. In a way, that’s good news because even if the yield curve does invert, there’s still a possibility that we can escape a recession—unlikely though it may be.
Following the 2019 yield-curve inversion, there was a recession in 2020. It could be argued that the 2020 recession only occurred because of the response to the COVID-19 pandemic. It’s impossible to prove the counterfactual—that there would have been a recession otherwise. However, anticipating a different 2020 recession, I had begun to allocate more defensively in my investment portfolios. That is to say, I had (and still have) the conviction that the yield curve inflection is ominous.
Once the inversion starts, it could take well over a year before an economic recession begins. Or it could take a few months. However, as we know, the stock market can sniff out an economic downturn well before the downturn begins. Investors need to pay attention.
What am I doing about it? Mostly just paying attention for now.
The historical performance of the S&P 500 after the yield curve first inverts has been weak. Bespoke calculated that one year after the inversion, the median decline has been -20 percent, with positive returns only half the time.
The anomaly this time is the performance of the S&P 500 leading up to the inversion. Historically, the index’s median performance one year before the inversion was a gain of 7.9 percent, with a positive return 80 percent of the time. In this instance, the stock market declined 18.5 percent in the year leading up to the inversion. That is the most significant 12-month decline before any other inversion since 1966. I am always loath to invoke the most dangerous words of the investment world, but maybe this time, it is different. This time, the yield curve inversion may better predict the economy than the stock market.
Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
