The Entryway – 2023 Q3: Market Update & Outlook
Market Check-In
As we close the books on the first half of 2022 and look ahead to the second half of 2022 and beyond, inflation, interest rates, supply chains, and their impact on consumer confidence and behavior remain front and center for policymakers, business owners, and market participants.
Global markets continued their downward decline from recent highs made in late 2021 and early 2022, with the S&P 500 having its worst start to the year in more than 50 years (down 20%), the Dow Jones having its worst start since 1962 (down 15%), and the Nasdaq composite and Russell 2000 experiencing their worst start to the year on record (down 30% & 23%, respectively). In addition, traditional bond investments have not provided the typical safety they do during times of market volatility as that asset class has also experienced an abrupt sell-off with the Barclays Aggregate Bond Index, Corporate Bond Index, and Long-term Index down roughly 10%, 14%, and 23% respectively year-to-date. In short, traditional stock and bond investments have sold off in concert with a typical investor’s 60/40 portfolio down approximately 17% year-to-date.
While the war and humanitarian crisis in Ukraine and China’s continued zero-tolerance COVID-19 policy are broadly impacting supply chains and input costs, the main drivers continue to be surging inflation and the Federal Reserve’s recent resolve to significantly fight it by raising interest rates and shrinking their $8.5 trillion balance sheet. As a reminder, the Federal Reserve (“Fed”) has a dual mandate: maximum employment and price stability. In other words, their stated job is to influence monetary policy to find an equilibrium between a healthy economy/labor market and stable prices. Currently, the Fed is more focused on the latter as the latest inflation rate is running at 8.6% year-over-year (according to the Consumer Price Index – CPI), with the real inflation number likely twice that amount for most consumers.
Prices are simply a function of supply and demand. Unfortunately, the Federal Reserve is stuck in a tough position in that it cannot control the supply side of that equation and can only influence demand. In other words, the Fed cannot stop the war in Ukraine, reopen their ports, fix supply chains, change demographics, or legislate energy policies. However, what it can do is materially increase the cost of capital (i.e., increase interest rates) and shrink the overall amount of money in the economy (through “quantitative tightening”) to influence behavior. The goal is to stifle demand by making it more expensive for consumers to buy houses, cars, invest in their business, etc. without destructing demand so much that we tip into a mild or more severe recession. To date, the Fed has raised the federal funds rate in March (0.25%), May (0.50%), and June (0.75%), with the expectation of another 0.75% increase at their upcoming meeting in late July. This would put the federal funds rate at 2.25-2.50% after its July meeting with the stated expectation to get the federal funds rate to the 3-3.5% range by year’s end.
Starting June 1, the Fed also stopped reinvesting maturing bonds from its balance sheet (i.e., Treasuries & Mortgage-Backed Securities) to the tune of $47.5 billion per month. This “runoff” will increase to $95 billion per month starting in September and is meant to further tighten monetary policy and push up the cost of capital as it is removing a “buyer” from the market.
In short, the Fed is trying to thread the needle where it increases the cost of capital just enough to water down demand but not completely destroy it and throw the country into a deep recession. Erring on the side of caution, we assume a recession is unavoidable – only time will tell how moderate or severe it will be. As we always remind our clients, the market is a forward-looking machine and has likely already priced in a significant amount of the recession risk.
How can we protect ourselves and what’s next?
As we mentioned in our last quarterly letter, we have systematically reduced our exposure to the growthier part of the market and increased our exposure to value. This has helped families as evidenced by the growth index being down 30% year-to-date vs. the value index down 13%. In addition, we continue to believe in our alternative investments, which have significantly outperformed traditional fixed income investments and provided our families with the typical counterbalance and protection during times of enhanced volatility. Lastly, the increase in interest rates has allowed us to reduce our exposure to bond funds and once again purchase high quality, investment grade individual bonds. We are now able to lock in 3-4% yields on very short-term bonds. While we cannot avoid these broad market sell-offs, we are working day in and day out to further protect your hard-earned dollars the best we can.
While the asset management side is extremely important, the biggest impact we can make is on the investor psychology side. Stated simply, money and investing can be very emotional. However, letting emotions dictate your behavior can be disastrous. Therefore, one of our biggest jobs will be to continue to have detailed conversations with you, help keep things in perspective, tailor your investments to your specific needs, ensure you have enough short-term liquidity to allow you to persevere and get to the other side of this market downturn.
History has shown us that if we do the proper planning and design your portfolios around your goals, we can stay disciplined and wait for bear markets to turn into bull markets. And history also shows us that bull markets tend to be much longer and stronger than the downturns that precede them. In fact, since 1950, the average bear market has returned -34% and lasted about 13 months, while the average bull market has returned +167% and has lasted about 3.8 years1 (see chart).

Keep in mind that economic downturns, wars, varying administrations and policies are a natural part of any business cycle, but over time, innovation and productivity gains tend to lead corporate earnings and market returns higher. While bear markets are painful, they offer an opportunity for long-term investors.
If you have any questions or want to discuss things in more detail, please do not hesitate to call or email us.