Below is an excerpt containing this quarter's market commentary. To download a copy of our full quarterly newsletter, click the Download Article link.

In his 1987 letter to Berkshire Hathaway shareholders, legendary investor Warren Buffett shared the timeless parable of Mr. Market:

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market, who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business…. At other times he is depressed and can see nothing but trouble ahead for both the business and the world….

Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.”

It is clear to us today that Mr. Market has been ping-ponging between bouts of euphoria and distress. On June 30th, the Wall Street Journal front page headline read “S&P 500 Posts Worst First Half of Year Since 1970.” Fast forward to the end of July, and the headline was “S&P 500 on Track for Best Month Since 2020.” Stocks continued to rise through much of August before reversing course in September to retest their 2022 lows.

Although Mr. Market is good at naming a price on any given day, it is debatable how good he is at determining the value of something. Price and worth are not always synonymous in the stock market, particularly in the short term. Because Mr. Market reacts to every piece of information big or small, his price moves all over the place – sometimes very quickly. Valuations, on the other hand, tend to move more slowly. Thus, for investors with a long-term focus, an investment’s day-to-day price is less important than its long-term value. The pertinent question is not, what is the price of Investment X? Rather, the better question is, what is the price of Investment X in relation to its value?

Any investment is worth the sum of its future cash flows, appropriately discounted back to the present. This begs the question, what is the appropriate discount rate? For many investors, the answer is, it depends. That is, it depends upon the current level of interest rates and the returns available from competing investments.

Stocks, which are risky long-term investments, must provide a return better than a “risk-free” asset of comparable duration. This has historically been recognized as the 10-year U.S. Treasury Note. U.S. Treasuries are the safest assets in the world, because they are backed by the full faith and credit of the United States government. Any other investment that is perceived to be riskier must compete with Treasuries by offering a better return. It is this relationship that serves as a reference point for investors to compare all other investment opportunities.

For more than a decade, we have witnessed an unprecedented distortion of this relationship. Beginning with the Global Financial Crisis in 2008, and seen again during the depths of the pandemic, central bankers around the world drove short-term interest rates nearly to zero. With risk-free rates near zero, any rate of return, no matter how minuscule, compares favorably. For example, with the risk-free rate below 1.5%, an investor could pay 50 times earnings, equal to an earnings yield of 2%, for a no growth, mature company and still beat the risk-free rate. This may be an extreme example, but it highlights the lack of alternatives available to investors until just recently.

These dynamics caused investors to bid stock prices to high levels, decreasing the likelihood that future returns would match historical returns. With money so cheap and returns on safer investments so low, investors poured enormous amounts of money into stocks. The economy was strong, inflation was low, earnings were skyrocketing, and the S&P 500 rose 31% in 2019, 18% in 2020, and 29% in 2021, more than double the average return over the past 100 years. As economist Herbert Stein said, “if something cannot go on forever, it will stop.”

And here we are. The investment landscape has transformed from one of stimulus and spending to one of inflation, tightening financial conditions, recession risks, and geopolitical instability. It is only natural for Mr. Market to be feeling the way he is feeling.

Consistent with Mr. Market’s ping-ponging between euphoria and distress, the quarter ended on a much different note than it began. At the start of the quarter, U.S. stocks had risen 18% from their June lows. Bond yields had declined amid hopes that inflation had peaked and the Fed could cool its aggressive rate-hiking path. A combination of unpleasant macro events, persistently high inflation, and continued hawkish rhetoric from the Fed caused stocks to finish the quarter solidly in bear-market territory, and bond yields – which move in the opposite direction of prices – were at their highest levels in years.

On the equity side of things, it remains to be seen whether the lows are in. Stocks are now trading at a discount to their 10-year averages in all major equity categories. Nonetheless, corporate earnings have been a key pillar of support, and analyst forecasts for 2022 have remained upbeat. While we feel more optimistic about where valuations are today, we see risks of downward revisions in corporate earnings estimates going forward given tighter financial conditions, persistent supply chain disruptions, bloated inventories, and squeezed margins. On the other hand, when inflation begins to cyclically fall again, one could expect to see stock prices increase materially.

In terms of fixed income, bonds are having their worst year in modern history, with the Bloomberg Barclays U.S. Aggregate Bond Index falling -14.6% through September 30th. The two-year U.S. Treasury yield ended the quarter at 4.22%, up from 0.27% just a year ago. The 10-year U.S. Treasury rose to 3.97% on September 27th, its highest level since 2010. The yield curve remains inverted, which is often seen as a precursor to a recession. It is too early to sound the all-clear on periods of volatility, but this year’s decline in bond prices has led to a significant increase in yields, making them more attractive than they have been in a long time.

While none of this is easy to digest, resets can be healthy for financial markets. Like the business cycle, markets have natural periods of ebb and flow. Peter Lynch, another famous investor, once said, “Far more money has been lost by investors trying to anticipate corrections than has been lost in corrections themselves.” Market corrections happen, especially during periods of economic uncertainty. It is no wonder then that markets have declined with fears of recession on the horizon combined with abnormally high inflation and a war in Ukraine. But as bad as things can feel in the moment, Mr. Market is coldhearted and usually moves past even the grizzliest of stories long before people do. Neither panic nor greed is an investment strategy. The best defense against the unpredictable is having – and sticking with – a long-term investment strategy. For perspective, stocks have posted positive returns in 42 of the past 52 years, despite average intra-year declines of 14%. Over this time period, the average annual total return for the S&P 500 was 12%. Market volatility is unsettling, but it is not historically unusual. It can be hard to sit and wait when markets are hurting. It is human nature to want to do something, anything other than waiting for markets to heal. Oftentimes, however, waiting is the best course of action, and it is the action with the lowest probability of self harm.

With an appropriately diversified portfolio that matches your time horizon and risk tolerance, the recent market drop will likely be a mere blip in your long-term investing plan. If you feel the need to do something, anything – harvesting losses, after many years of strong returns, can lower your tax liability. If your plan allows, continue making regular investments. And remember, bear markets don’t last – going back to the 1960’s, the average bull market ran for about 6 years, delivering an average cumulative return of over 200%. The average bear market lasted roughly 15 months and resulted in an average cumulative loss of 38.4%.

Though our relationship with Mr. Market can be challenging at times, he has proven to be a good partner over the years and will one day feel euphoric again.

Until next time, and may you enjoy all that Autumn has to offer.