LVHD - 2023 May Be A Year Like No Other (Except Maybe For 2022)

Summary

• In earlier articles, I made recommendations for ETFs and mutual funds that one should consider given the unusual combination of conditions we don't often see.
• How successful were these recommendations made under very high inflation, the Growth fund collapse, steeply rising Fed fund rates, and bear market conditions?
• While my guess is that 95% of funds had negative returns in 2022, my recommendations had alpha, that is, they beat the major market indices.
• While the above four conditions persist, I present my opinion as to whether funds will break out of their slump in 2023.

Introduction

If you are a regular reader of my articles, you should be aware that they typically present specific suggestions as to funds (ETF and mutual funds) that investors may want to include (or exclude) in their overall portfolios.

How helpful were these suggestions made during the end of 2021 and the early part of 2022 will be explored in this article. And I present my perspective as to whether these suggestions will continue to be useful into the new year.

There appear to have been four major themes that influenced investment returns in 2022. Let's briefly review these themes and see what I said about each of them in prior Seeking Alpha articles.

Very High Inflation

In a Dec. 12, 2021 article , that is, even before the start of 2022, I examined the possibility that even a moderate amount of inflation above the Fed's goal of 2%, could have a damaging effect on stock prices. Since inflation was already running at 40-year highs, this appeared to be a highly worthwhile inquiry.

Here are two specific quotes from the article:

... "if by the end of 2022, it turns out to be another one of those above average full years [for inflation], many investors may now want to begin reducing their stock allocations, especially if they want to avoid a possibly poor performing year next year, or possibly even beyond, if inflation does not return to a level closer to the Fed's goal".

And:

... "overall stock prices [for Vanguard Total Stock Market ( VTI )] and many funds may be headed for a poor year in 2022."

At the end of 2021, you may recall the stock market was on a roll. Many analysts, at the time, were predicting another positive year. (See here .)

This turned out to be so wrong . The S&P 500 closed at 3,839, down 18.1% vs. the average prediction of 4,825. VTI ended the year with a return of -19.51%. So much for predictions made for 2022! As for me, I don't try to make exact predictions. Trying to "guess" (yes, really this is the most accurate word) general trends are good enough for me.

The Growth Fund Collapse

In a Jan. 20, 2022 article entitled " VUG: No Longer One of the Most Likely Vanguard ETFs to Outperform ," I discussed VUG , that is, the Vanguard Growth ETF, and Growth funds of all market capitalizations. I advised against an over-emphasis on Growth funds in a portfolio based on past returns and recommended a reconsideration of previously underperforming Value funds.

Here are three specific quotes from the article:

"It now appears that Vanguard Value-focused ETFs along with other Value-oriented ETFs/funds are likely to be superior choices to VUG."

"Value has a considerably higher post-pandemic potential than Growth."

... "investors who may have over-allocated portions of their portfolios toward Large Cap Growth funds, such as VUG, are encouraged to consider reallocating some of such funds toward Value funds of all capitalizations, such as Vanguard Value ETF (VTV), Vanguard Small-Cap Value ETF (VBR), and Vanguard Mid-Cap Value ETF (VOE)."

The emphasis on Value funds as opposed to Growth funds (or even any funds with a high percentage of growth stocks) has been one of my most profitable suggestions. According to the Wall Street Journal , Large Cap Growth funds returned -31.5% in 2022 vs. -6.9 for Large Cap Value funds. And specifically, for Vanguard index funds, VUG returned -33.15% while VTV, VBR, and VOE returned -2.07%, -9.36%, and -7.95%, respectively.

But, as one critical reader has asked, "Are we supposed to be aiming for negative returns?" Well, when it appears that at least 95% of fund returns were quite negative in 2022, a relatively low negative return can be considered a victory. And in the case of over a 30% negative return vs. a single digit negative return, I'd say the answer is yes.

If we look more recently, the tide does turn positive. In the fourth quarter of 2022, while VUG was down -0.14%, the above three mentioned Value funds were up 14.67%, 11.62%, and 12.11%. So perhaps, but not guaranteed, the tide has turned toward not only outperformance, but positive results.

Rising Fed Fund Rates

Even before the Fed's first interest rate hike in March, 2022, I wrote about categories of funds that tended to do well when the Fed had raised rates over a series of rate hikes. The article was published on Feb. 11, 2022.

The Fed has promised to continue raising rates, so this analysis remains incomplete until the Fed either holds rates for a substantial period or switches to lowering them. However, it is still interesting to see which categories of funds are outperforming the indices now and might do positively once that occurs.

Here are some relevant quotes from that article:

" ... the Energy category, as represented by Vanguard Energy ( VGENX / VGELX ), a commodity fund, seems like a good bet. Commodities are considered good investments during inflationary periods with rising interest rates.

"Other categories of funds are shown to have done particularly well during prior periods when the Fed was raising rates:

Real Estate funds, as represented by the Vanguard Real Estate Index ( VGSIX / VNQ / VGSLX) ...

Financial funds, as represented by the T. Rowe Price Financial Services Fund ( PRISX ). ...

International funds, including Emerging Markets funds."

... "Value funds, as represented here by VIVAX , are likely to outperform unmanaged Growth funds during periods of rising rates, due mainly to possible Tech underperformance in the latter and cyclical stock outperformance in the latter."

How have these categories and specific funds mentioned performed since the Fed first raised rates? Well, unfortunately, negatively in most cases. But "alpha" can apply to negative returns if they beat a benchmark that is also negative. So, as compared to the Vanguard S&P 500 ETF ( VOO ), VGENX returned about +14%, while a benchmark of VOO returned about minus -13%. VGSIX sank about 20% along with PRISX about -9%, while international funds about -10% and Emerging Markets about -15%. So, by comparison, these returns, except for Real Estate, held their own.

So, although most fund categories have done badly so far, if performance improves substantially as a result of a Fed downshift or pause , the above categories/funds may again show positive returns.

Bear Market Conditions

The current bear market for the S&P 500 was declared on June 13, 2022 although the NASDAQ started one a little earlier. A bear market is defined as a 20% drop in an index from a previous high. It is considered over when it rises 20% from a previous low. By these definitions, we are still in a bear market for the major stock indexes in 2023.

Even before the beginning of the S&P 500 bear market was declared, I tried to find specific fund investments that had been recommended by other authors during one. I then published an article on Seeking Alpha on May 15, 2022 on this topic.

I selected a list of nine funds along with their 2022 returns. They are shown below:

1. Legg Mason Low Volatility High Dividend ( LVHD ) -1.81 (Note now called Franklin U.S. Low Volatility High Dividend)
2. Utilities Select Sector SPDR ( XLU ) +1.42
3. Consumer Staples Select Sector SPDR ( XLP ) -0.83
4. Vanguard Short-Term Bond ( BSV ) -5.49
5. VanEck Vectors Gold Miners ( GDX ) -8.98
6. ProShares Short S&P 500 ( SH ) +18.07
7. Vanguard High Dividend Yield Index ( VYM ) -0.46
8. Invesco DB Commodity Tracking ( DBC ) +19.34
9. Vanguard Dividend Growth Inv ( VDIGX ) -4.88

When we compare these nine returns with that of the -19.51% of VTI, and even for the -13.11% for the Vanguard Total Bond Market ETF ( BND ), it is easy to see that each of these selections as contained in the article yielded significantly better results than investing in the broad market indices, even when they were negative.

Conclusion

It should be apparent that anyone who adopted some or any of these prior suggestions would have achieved some of the " alpha " they were seeking . As you can see, those following these suggestions likely would have experienced less of the much larger losses experienced by most investors.

And how about for 2023? Since high inflation, the Growth fund malaise, a Fed intent on continuing to raise rates, and a bear market still persist, it appears that the same recommendations for ETFs and funds with the best probabilities for beating the market, or generating alpha, can continue into 2023 and perhaps beyond.

For further details see: