The Markets	12/31/22 Close	09/30/22 Close	4th Qtr. Change	12/31/21 Close	12 Mo. Change	YTD Change
Dow	33,147	28,725	+15.39%	36,338	-8.78%	-8.78%
NASDAQ	10,466	10,576	-1.04%	15,645	-33.10%	-33.10%
S&P 500	3,840	3,586	+7.08%	4,766	-19.43%	-19.43%
MSCI EAFE	1,944	1,661	+17.04%	2,336	-16.79%	-16.79%
10-yr Treas. yield	3.88%	3.80%	+0.08%	1.51%	+2.37%	+2.37%
Fed funds rate	4.25-4.5%	3.0-3.25%	+1.25%	0-0.25%	+4.25%	+4.25%

(stock indices are before dividends; yield and rate changes are absolute changes)

The curtain came down on a year that, simply put, was very rough for investors. Despite a decent recovery in the fourth quarter, the broad US stock market had its worst calendar return since 2008. So did the Dow and the tech-heavy NASDAQ, even though the Dow beat tech by the largest margin in 20 years. (In a year like this, falling less is a welcome result.) Energy was the only positive sector for the year, up a sizzling 59%, with other sectors like consumer discretionary and communications down as much as 40%. With interest rates increasing steeply, bonds had their worst year ever by some measures, with the investment grade aggregate index down nearly 12%. Higher interest rates began to weigh on real estate values, bitcoin was down another 60% after beginning its fall in 2021and gold, considered a safe haven in turbulent markets, was flat but was up considerably through October. International stocks posted a strong final quarter, primarily because the US dollar index fell 8%, which boosts investments in non-US assets. After a number of lagging years, a leading hedge fund index finally beat the S&P 500, with winning bets on interest rates, the US dollar and falling stocks.

Interest rates were the focus of markets across the globe. Although backing off from its string of four 0.75% hikes in December, the Fed still raised short-term rates 0.5% to their highest level since 2007. While the Fed noted that indicators point to modest growth, it anticipated ongoing increases, with no pause, to curb inflation. The market does not seem to believe the Fed can keep its pace of rate increases, with the steepest yield curve inversion (intermediate interest rates lower than short-term rates) since 1981, and the inversion has now lasted nearly a year. An inverted yield curve is considered a sign of an impending recession. Except for Japan, the other leading central banks were also raising rates, with the European Central Bank also acknowledging the need to raise rates “significantly”. In a stunning reversal, the UK backed off announced tax cuts that nearly led to a collapse in their government bonds, and the new prime minister resigned after just six weeks in office. The US dollar index, which was up 19% through the first three quarters, slid in the fourth quarter but still closed up over 8%, reflecting the strength of the dollar and US economy.

The consumer was on the ropes with higher interest rates and high inflation, and spending and retail sales softened but were till positive. Wages and income are increasing nicely, but the savings rate is extremely low at 2.4%. Credit card balances jumped 15% over the past year, the most in 20 years, and delinquencies were up but still at manageable levels. Existing home sales fell for 10 straight months, down 35% to 2011 sales levels, and price increases are easing, still up 3.5% from the prior year. Inventory is increasing but still low, and housing starts and permits are slumping, despite a widespread housing shortage. Through it all, the latest consumer confidence readings were up, largely due to erasing gas prices.

Manufacturing indicators slowed considerably, with a global index at a four-month low and a US index at a 31-month low. Non-defense capital goods, a proxy for business investment, remained positive. The job market stayed strong, with unemployment flat at 3.7% and more job openings than unemployed workers, but the latest weekly jobless claims were slightly up and the labor participation rate is still below pre-Covid levels. Social Security recipients will see a huge 8.7% increase in benefits in 2023, which is welcome as the core consumer price index was up 6.0% in November for the prior 12 months, the lowest reading in 2022. All told, third quarter GDP was revised upward to +3.2%, driven by consumer spending and non-residential investment, following two quarters of decline.

Looking Forward

Self-dealing, opaque or nonexistent reporting and disclosure, hype, intertwined entities, hubris, misappropriation of funds, inexperience, speculation – these are all typically part of the story of ventures that collapse or, even worse, are exposed as a fraud. This is certainly true of the cryptocurrency exchange FTX and its affiliates, which looks like a huge fraud. Much of it was also true of the collapse of cryptocurrency Terra, which may not be a fraud but was fundamentally flawed in its design to maintain a value of one US dollar and was wiped out in a matter of days.

The larger question is whether and how regulation will become part of the cryptocurrency world. It is ironic that a vehicle that was designed to be decentralized and beyond the control of governments is in the regulatory crosshairs, but crypto has morphed from its original use into a method to raise funds for other ventures. And over 1 million customers of FTX face an uncertain, and lengthy, road to getting their funds back.

The argument for regulation hinges on crypto being similar to other innovations that promised big rewards but ended in ruin. Too many people have been either cheated or enticed into investing in something that carries huge risks. There are too many undisclosed insider deals, and the lack of customer disclosure or transaction tracking is ripe for money laundering. As FTX so clearly illustrated, the lack of restrictions on related entities (that is, when the entity holding customer funds uses those funds its own investments) leaves customers totally unprotected. All these shortcomings are regulated for banks, stock exchanges and brokerage firms. The SEC contends that cryptocurrencies are securities and should be treated as such.

The crypto industry, of course, counters that crypto exchanges are so different from securities exchanges that the SEC rules are impossible. There are already laws against fraud, and those can be enforced without subjecting crypto to unnecessary and impractical rules. Despite investor losses from FTX, Terra and huge market volatility, crypto will mature and weed out abuses on its own.

It could also be argued that the old saying “a fool and his money are soon parted” is appropriate with the crypto rise and fall, and that it is regulatory overreach to try and control what the market eventually fixes. Much of the volatility in crypto has been pure speculation, and nothing fixes speculation like a 70% loss (bitcoin) and a multi-billion-dollar bankruptcy (FTX).

Crypto is unlike “innovations” like nonfungible tokens (NFT’s), where gains and losses are mostly isolated to buyers and sellers. The sheer size of crypto and its integration into mainstream financial institutions make it likely that regulation will be implemented, whether under current rules or some now guidelines that recognize the unique nature of crypto. If blockchain technology, which is the foundation of crypto and has an ever-growing array of applications, has the potential to disrupt and upend the movement of capital, it must “mitigate risk and build proper controls”, as noted by David Solomon, the CEO of Goldman Sachs. Like it or not, regulation and relationships with policy makers are the best ways to accomplish those goals.

If crypto is not regulated, it could be “separated as completely as possible from the traditional financial system”, as suggested by Todd Baker in an opinion piece in the Wall Street Journal, because of the gambling behavior of crypto traders and its lack of transparency. Traditional, regulated entities would have to choose whether to have any exposure at all to crypto, and there should be no mixing of crypto and traditional finance in any entity.

Robust regulation or relegation of crypto to being a sideshow – there is probably no middle ground.

Our Portfolios

As long-term investors, it is easy to accept the volatility of stocks in return for potential growth. Our balanced portfolios have always used a bond allocation as the “ballast” to stock volatility, and we have always felt that even though bonds can fall in value, their potential loss is far less than the potential short-term loss of stocks. (A local advisor is advertising that “investors have been told for years that bonds can’t go down”, which is not only false but would be malpractice for an advisor.)

So, it is particularly painful when bonds are down nearly 12% when stocks are also down significantly; the two markets typically move in opposite directions, but since rates were already historically low as the economy started to slow, there was no option other than to raise rates to dampen inflation. Our bond allocations have for years been of a shorter “duration”, or sensitivity to interest rate changes, than the overall market, but there was no avoiding the pain in bonds. Going to cash, or significantly altering the characteristics of the bond allocation, would be akin to market timing, which we eschew.

The good news is that, while a recovery in the stock market is unpredictable, the mechanics of bonds make us confident that the losses will be gradually, but steadily, recovered over time. Consider how an individual bond works. When interest rates increase, the implied market value of that bond drops immediately. However, that bond will continue paying its income and will repay its face value when it reaches maturity. (It is a different story if a bond “defaults” or is unable to pay either its income or its maturity value, but our portfolios contain only investment grade bonds with a very small risk of default.) This combination of income and repayment will recoup the market value loss caused by the higher rates; selling a bond after it has dropped in value eliminates this recovery. If the bond is sold at a loss before it matures, the proceeds can be reinvested at current rates, so the income component is higher and will still recoup the losses over time.

A bond fund is nothing more than a bunch of individual bonds, and the mechanics of recovery are the same. The abrupt “step down” in market value is slowly recovered by a “ramp” of income and bond repayment and reinvestment. While interest rates could certainly increase more, they will eventually level off and the ramp will accelerate. If rates are later decreased, the recovery will happen even faster.

Our portfolios have suffered the brunt of the rapid interest rate increases, but now is no time to bail out. We will hold our bond allocation in anticipation of the recovery in value.

A Lump of Coal

Both traditional mutual funds (which are “open-ended” and have a five-letter symbol) and exchange-traded funds (ETF’s, which have symbols of four letters or less) are “pass-through” investment vehicles. This means that each year the funds must distribute to investors nearly all the income from investments and the net capital gains generated by the fund’s transactions. Because of this pass-through, the investors are taxed while the funds are not, so double taxation is avoided, and the distributions are taxable whether or not they are reinvested in shares of the fund. (This all applies only to nonretirement investors, which are either tax-free or tax deferred.)

The structure of ETF’s allows them to avoid almost all capital gains distributions. There are two situations, however, where capital gains distribution from traditional mutual funds are a nasty surprise. In their own defense, mutual fund managers maintain that their job is to generate strong long-term investment results, and many fund investors are retirement investors anyway, so the tax implications of the fund’s investment activities are not the manager’s concern.

The first lump of coal is when an investor purchases shares of a mutual fund in, say, September and then receives a large distribution at year-end. This happens because all investors in the fund receive the same per-share distribution, regardless of how long they have owned shares. While it may take some digging, one way to avoid this surprise (and the accompanying tax bill) is to look at the unrealized gains in the fund’s financial report, which is known as “overhang”. Those gains will eventually be realized by the fund, and distributed to shareholders, and can be especially large in funds that hold stocks for a long time. (Ironically, low turnover in a fund, or infrequent trading, is a good thing for investment returns but can generate these large distributions.)

The even more painful lump of coal is when mutual funds make large distributions in a year when their returns are negative. This is another result of holding stocks for a long time and is particularly common in a down year following several strong market years, and with big market shifts, which is exactly what we have seen in 2022. Investors can usually take these distributions in stride, but there can be extreme examples. For example, 26 mutual funds had capital gains distributions of over 30% of their share value, while 39 funds had distributions of over 20% of their share value. Some of these funds are repeat offenders, like the T Rowe Price Real Estate Fund, which distributed 18%, 12% and 28% over the last three years. The worst example this year was the Delaware Sustainable Equity Income Fund, which distributed a capital gain that was 60% of its share price, while the fund’s total return was down 8.5%.

The silver lining to these lumps of coal is that although mutual fund distributions create a tax bill in the current year, they reduce the long-term tax bill. The investor’s cost basis is increased by the amount of any reinvested distribution, decreasing any gain when the investor ultimately sells his shares. If the distribution is not reinvested, the investor receives cash and the market value is decreased by the distribution amount, also reducing the future gain.

ETF investors have greater control over when they want to take gains by selling their shares, but they face a larger tax bill when they do. Like most tax issues, traditional mutual funds compared to ETF’s is a “pay now or pay later” situation, and investors are best served by first and foremost determining how any fund, traditional or ETF, fits in their overall strategy and allocation.