US Stock Market returns for the first nine months of the year were significantly less than long term expectations.  Broad market indices were down roughly twenty five percent as rising interest rates, high inflation, and recession fears pressured valuation multiples for stocks. Rising interest rates have also led to double digit declines in fixed income portfolios, which are traditionally relied upon to offset riskier stock portfolios during down markets. For investors holding a combination of equities and bonds, the negative returns in both asset classes have made 2022 an historically difficult year.

Within equities, the correction has been broad based and hit almost all sectors of the market. Energy stocks which benefited from high oil and gas prices have had positive returns. Companies with negative earnings have been particularly hard hit, reflecting both rising recession risk and the increased discount rates for future earnings.

The S&P 500 index was down 4.88% in the third quarter, but that number fails to capture the significant volatility in the market during the quarter.  Major stock indices rose for the first half, a rally of over 17% from mid-June to mid-August, only to sharply decline in the second half of the quarter to end back near the lows of June.  

High volatility in a declining market does not make for a fun ride, but as long-term investors we remain encouraged that the outlook for returns over the next ten years has improved significantly. Valuation measures that correlate well to future longer-term returns, such as the equity risk premium and the implied cost of equity (up from 5.75% on Jan-1 to 10% at Q3 end), have become more attractive and we are looking to invest opportunistically.

The following is a summary of returns for the Shaker Fundamental Growth strategy and selected major indices for the third quarter, year to date, and the average annual returns for the one-, five- and ten-year periods, as well as the period beginning January 01, 2007, and ending September 30, 2022:

We have chosen to include the annualized average returns since January 1, 2007, as this time period includes recessions and expansions and is more representative of performance over an entire economic cycle.

Discussion of Third Quarter Performance and Positions

The first half of the year was dominated by broad selling, particularly of expensive, high growth names that were most impacted by higher discount rates. In the third quarter we began to see more differentiation driven by fundamental performance. Many growth stocks with negative earnings continued to deteriorate amid the riskier economic backdrop. Some of the more profitable growth stocks with higher margins and continued strong revenue growth began to exhibit better stock price performance. The largest positive contributors to returns during the quarter were Paylocity (PCTY), The Trade Desk (TTD), WESCO International (WCC), Paycom (PAYC), and Paypal (PYPL). Many of these benefited during the quarter from this shift toward more fundamental based stock performance, and away from all growth stocks being “thrown out with the bathwater” as seemed to have occurred earlier in the year. Our largest detractors during Q3 were Encore Capital Group (ECPG), Concentrix (CNXC), Alphabet (GOOG), Visa (V), and Fortinet (FTNT).

As economic growth continues to slow due to the lagged impact of higher interest rates and high inflation limiting real consumer spending, we expect investors to continue to focus more on the widening differences among company performance. The shifting economic landscape will make revenue and profit growth harder to come by for businesses. We believe companies that demonstrate strong fundamentals despite macroeconomic headwinds will benefit, and we have worked to position the portfolio accordingly.

Investment Outlook

The Federal Reserve continues to raise interest rates and shrink the real money supply in a concerted attempt to slow inflation.  Thus far it is not showing up in the Consumer Price Index (CPI) data, but it will.  The CPI is a lagging indicator, and actions by the Federal Reserve will typically not begin to impact inflation until 6 to 12 months in the future. High CPI figures in 2022 are the result of excessive stimulus by the Fed in 2020 and 2021. Because they are focused on lagging indicators like inflation, the risk is high that the Fed will err on the side of excessive tightening.

In contrast to the still elevated inflation measures, we are already starting to see the impact of rate hikes on leading indicators like orders for new homes, manufacturing orders, foreign currencies, and foreign economies.  Non-auto related retail inventories have increased dramatically in the last two years.  Shipping costs are sharply down relative to last year and are closer to normal.  The orders for new homes have crashed as mortgage rates have risen above 7%.  Home appliances are no longer in short supply. Whirlpool cut production in the third quarter by 35% due to increased inventories. 

While leading economic indicators are seeing rate hike effects, it will take more time to influence coincident indicators like employment, and, perhaps even longer to affect the lagging inflation indicators. As the Federal Reserve continues to raise rates, we are concerned that the economy will continue to weaken and will tip into recession in 2023 due to the impact of 2022 policy moves.

When growth in the economy and inflation meaningfully slow or decline the Federal Reserve will reverse course and stimulate economic growth with rate cuts and by increasing the money supply.  Those policy changes will similarly take a year or more before they stimulate economic growth.  While we understand the economic cycle, we can’t predict the timing of a Fed reversal (and the market’s discounting of the following economic improvement.)

We continue to be cautious in our investment approach and hold higher-than-normal cash balances in the portfolio.  We doubt the market correction is over, but stocks can have bear market rallies and we’ll try to take advantage of them through incremental adjustments in the portfolio. We will try to adjust the portfolio to hold a higher cash balance if there is greater risk that the fundamental outlook deteriorates further.  We do not expect the stock market correction to end until Fed policy changes and leading economic indicators such as the NAHB (National Association of Home Builders) index and the ISM manufacturing new orders index reach their cycle lows.

Difficult bear market periods are a time when great long-term opportunities arise in individual stocks.  Most stocks are on sale, but that does not mean that now is time to step in and buy any one stock, or that the future performance of companies and their stocks will be uniform.  We are very focused on understanding the current results of companies so that we can better predict future performance.  Some companies are going to be severely hurt by this economic downturn.  For others, it will be an opportunity gain market share and invest for the future.  Despite some differentiation in the third quarter, changes in the stock price of individual companies in a sector remain very correlated. While stock prices may be down a similar amount, it may not reflect the changes in the underlying value of the businesses. This creates tremendous long-term return opportunities to invest in businesses which have grown in value but whose stock prices have sharply declined. During downturns, we try to identify the companies that we think will do the best once the correction ends.  We have identified a growing list of such opportunities and are prepared to act as the environment improves.

Currently, 69% of stocks in the S&P 500 are trading below their 200-day moving average, a sign of the negative breadth in the market this year.  Equity valuations are more attractive relative to a year ago, and this has increased the long-term opportunities for positive returns. 

We hold a diversified portfolio of stocks in your account. Our largest holdings as of November 1, 2022, are as follows:

• Diamondback Energy (FANG), Energy
• Axos Financial Inc. (AX), Financial
• Dexcom (DXCM), Health Care
• Insulet (PODD), Health Care
• Paylocity Holdings (PCTY), Industrials
• Visa, Inc. (V), Industrials
• Wesco International (WCC), Industrials
• CoStar Group (CSGP), Real Estate
• Alphabet (GOOG), Technology
• Paycom Software (PAYC), Technology

The ten largest positions listed above are 31.7%, which remains a lower concentration than we typically have for the top-ten holdings partly reflecting our elevated cash balance and our desire to be more diversified at this point in the cycle. In terms of sector exposure, we are slightly overweight Industrials relative to the broader market index, roughly in-line Consumer Staples and Energy and our most underweight sectors are Technology, Healthcare, Consumer Discretionary, Financials and Utilities at 2-4% underweight. In general, the average cash position in accounts that we manage remains higher than normal. We are actively looking to take advantage of more attractive valuations in individual stocks and have begun to do so with the market pullback year-to-date.

We look forward to updating you in January and we are always available to assist in any way we can.

Sincerely,

The Shaker Investment Team

Disclosure: Past performance is not indicative of future performance. It should not be assumed that any investment or strategy discussed in this publication will be equally profitable in the future. Investment in this strategy carries risks, including loss of principal. There is no guarantee that any specific investment strategy will be suitable or profitable. Investments in smaller companies may be riskier, less liquid, more volatile and more vulnerable to economic, market and industry changes than investments in larger, more established companies. The strategy’s overall return is a composite of clients’ separately managed account returns. Some clients’ investment returns were more or less than the overall strategy return. Not all our client’s returns surpassed the benchmark and the strategy is more concentrated than the benchmark. The index performance information in the table is based on public information which we believe to be accurate but have not been verified.

The specific securities identified in this report does not represent all of the securities purchased or sold or recommended to clients. Holdings / sector weightings in any strategy are subject to change and should not be considered investment advice or a recommendation to buy or sell a particular security. Actual holdings may vary by client. A list of all the stocks selected for any of our strategies during the trailing twelve months is available upon request. This document is confidential and for the sole use of the intended original recipient. It is not intended as investment advice or recommendation, nor is it an offer to sell or a solicitation of an offer to buy any interest in any fund or product.