Stock and bond markets continued their drop in lock-step from the second quarter, as both contracted to end Q3. In addition, the economy shrank in July to officially place the U.S. into recession. Most Americans already felt the effects of persistent inflation, rising 8.3% in August, driving housing and food costs higher throughout the quarter, as the U.S. endured the highest cost of living increase in 50 years. The Fed again pushed interest rates higher by 75 basis points in September, the third consecutive increase, leaving the benchmark rate at 3.00%-3.25%. How these increases will effect inflation are yet to be determined, but as we mentioned in last quarter’s review, the historical “neutral rate” of 3.50% to 4.00% will likely need to be reached before we can affectively begin to see inflation start to come down. In addition, our calculation of the Taylor Rule, used as a yardstick for the Fed Funds rate, gave us a reading between 6.50% and 7.50%, as the proper rate given current levels of inflation and GDP in America today. With that said, we could still see several increases in the rate before levelling off. What that means for our portfolios is twofold. First, equities will continue to be under pressure, as the money supply begins to shrink and secondly, cash and short-term bonds will begin to be more attractive, as rates rise. Rebalancing portfolios will be a priority in the coming months to capture some short-term yield. Effects of the current cyclical bear market that we should see accompany the rising rates, will be an increase in layoffs and unemployment, a decrease in earnings due to the shrinking U.S. economy and a continuation of the recessionary environment.

Major stock and bond indices posted losses for investors and deepening their losses year-to-date. For bonds, it was as bad as Q1 and Q2, with the U.S Aggregate Bond index losing -4.8%, bringing the yearly loss to -14.6%. The S&P 500, DJ Industrial Average and NASDAQ Composite Index posted losses of -4.9%, -6.2% and -4.4% for Q3 and -23.9%, -19.7% and -32.4% for the first three quarters of 2022. Internationally, the EAFE lost another -9.3%, leaving it down -26.8% for 2022 respectively. All sectors were undervalued at the end of Q3, with 78% being the average discount. Communication Services at 56%, and Consumer Cyclical, Technology and Basic Materials all at 74% represented the most discounted. Utilities at 95% and Energy at 94% were the closest to fair value in Morningstar’s universe1. From a Price/Earnings (P/E) standpoint, the S&P 500 ended Q3 overvalued by 19.4%. With prices coming down significantly from the beginning of the year, risks remain high as we navigate the recession. Once again, considering the headwinds to corporate earnings and economic conditions worldwide, we are urging extreme caution when putting new investable money to work. There are pockets of value in individual high dividend paying stocks, as well as some great yield to be captured in cash, short-term treasuries and short-term investment grade bonds, while the recession plays on.

We’re honored to help our clients understand these challenging economic times, continually searching for opportunities, as well as earning your business, your trust and your respect.

Jack A. Kennedy

Chief Investment Officer