It’s Been an Ugly Year for the Markets, There Is No Sugar-Coating It
Let’s take a step back and put things in context to better understand what’s going on.
The current stock market drop is the third 20%+ decline in the past four years.
In the bond market, interest rates shot up from barely above 1% last December to above 3% on 10-year Treasury notes. Step back in time to 2020, and the U.S. 10 yr rate was about 2.5% before plunging to 0.32% at the worst of the Covid Crash that March.
Safe-haven bonds posted irrationally high returns during the first few months of that fateful year. It’s important to recognize that bonds should usually be used not for price appreciation bets, but for diversification benefits. Hence, interest-rate-sensitive bonds went on to fall in price in a big way.
A Bond Battering, But Could That Be a Good Thing?
That’s what has happened since early December. So far this year, our core bond positions are down roughly 6-10%, a mirror image of what we saw back in 2020. If you are rattled by seeing your bonds endure losses, I have good news. With lower bond prices comes much better yields today. In some cases, we expect to earn 5.5% or more. Wouldn’t you rather earn 5.5% instead of, say, 2-3% on your bonds in the decade ahead? I sure would!
The Powell Play
You might hear about how the U.S. Federal Reserve, led by Chair Jerome Powell, plans on continuing to hike interest rates through year-end. It’s well telegraphed. The market knows it. While the Fed’s current policy rate is just 0.75%, it will likely head up toward 3% by December. But that does not mean the bond market will continue plummeting. Traders have discounted higher rates ahead. Moreover, the 10-year Treasury yield has already dropped back to under 3% due to economic worries. Investors are finally flocking to fixed-income again.
Rates on the Rise: Fed Targets ~3% by Year-End
A Rough Year for Stocks
Turning to the stock market, the S&P 500 is down due to slowing economic growth in the U.S., inflation concerns, the ongoing Russia conflict (and its impact on the commodities markets), supply chain bottlenecks, labor shortages, and (just recently) China shutting down due to Covid. That’s a lot of negativities permeating through investors’ minds.
Given that bleak macroeconomic backdrop, we are finally starting to see impacts on corporate earnings. In their Q1 reports, both Walmart and Target shocked Wall Street with some of their inventory management numbers and weak profit margins. It wasn’t so much of a demand problem, but high costs to get products on the shelves.
These stock market drops are a feature of investing, not a glitch
That does not make it easy, but it should help serve as a reminder that being long-term focused is a winning mindset. I’ll never forget talking with one of our wisest clients in March 2020 when the 34% stock market crash was fully-fledged. After talking about the sharp pullback, he calmly said, “Well, I’m not stupid; I’m not going to sell now.” Wise (and frank) words!
That is the tact of a well-seasoned investor who has studied and experienced normal market drops over the decades. We don’t build portfolios to avoid all the big drops—that's impossible—we build portfolios designed to withstand them instead. That’s an evidence-based approach based on humility and pragmatism—not the panic of the day that is unfortunately so common in the news cycle. While it might feel necessary to take a risk-on, risk-off approach, it is not a wise strategy. Market-timers quickly learn their foibles. If you need to hear them, we can tell painful stories of people we have seen trying to buy the bottom and sell the top. Wall Street sees the same stories, too. As I write this, another failed hedge fund is closing down.
Understanding Asset Allocation and Your “Safer Money”
To underscore the point, the strategy is to set our target allocations ahead of time before big drops even as we know they will happen from time to time. As we’ve outlined before, if you are retired or close to retirement, I urge you to have enough money in reasonably safer assets vs stocks. Bonds and perhaps some alternative investments with downside hedges can be used for money you might need to last you 10 to 20 years.
That way, when (not if) we have another market crash that takes five years from which to recover, like 2008, or seven years like in the wake of the Dotcom collapse, we don’t have to sell your oversold Microsoft stock to buy groceries.
While not everyone can have such a wide moat of “safer money” on hand and still earn upside returns from equities, the same investing rules apply if your cushion is lighter.
Selling after a panicked time is too late to de-risk.
If the stock market drops are still too painful and you are losing sleep at night, please make a note of it, let me know, and we should revisit when times are better. We can consider making portfolio adjustments then.
U.S. Stocks Cheaper Today
Source: J.P. Morgan Asset Management Guide to the Markets
What Lies Ahead?
So, what’s the outlook? Where are we headed from here? We have some good news to share:
1. Bond yields are up again, so we are paid to take less risk with our safer money. In wealth management parlance, the tax-equivalent yields on tax-free bonds are at fresh 15-year highs. We have even bought some in the 6% range. And some of our favorite bond funds now yield over 5.5%!
2. Stock market valuations around the world are much more attractive today. Analysts like to use the “price-to-earnings" ratio as a gauge of value, and those metrics are now in-line with historical averages. Certain stock markets are even downright cheap. Those valuation readings are not nearly as elevated as they were right after all that stimulus money was sent out last year.
3. Dividend yields are also approaching their historical norms. So, we are getting paid more real income vs just relying on the recent price appreciation.
4. Corporate earnings forecasts continue to be strong in future years. We will certainly see the impacts of lower economic growth and inflation go through earnings in the coming months, but that’s just part of the process. Firms should be able to weather that storm. There are more risks in Europe, but we might also face a mild recession late this year or in 2023. A recession is defined as two consecutive quarters of negative GDP growth. Don’t think “2008”, though. It won’t be the end of the world. Recessions usually happen every five to 10 years, and they used to be even more common than that.
5. Beanie Baby-type investment fads like AMC movie theaters, cryptocurrency, and NFT tokens are all reverting to where financial nerds like us thought they should.
While it’s painful and can be horrible for those impacted, the return of fundamentals and rationality is ultimately a good thing for most investors. Another set of stocks hurt by this unraveling, the “stay-at-home" names, have given back all their Covid gains. Think: Peloton, Zoom, DocuSign, and the like.
6. Value stocks are back en vogue. We always favor a balance between owning growth companies and shares of value stocks, and it’s nice to see the benefits of diversification come through. Surely the Facebooks and Netflixs of the world got a bit ahead of themselves, and they are now coming back down to reality. In the long run, profits and dividends still matter. Those firms must focus on cutting costs. Netflix, for example, was spending upwards of $3,000 per viewing household per year! As illustrated below, growth equities are still pricey vs historical averages, but today’s technology is as revolutionary as ever. So, we definitely want to keep some ownership there.
Source: J.P. Morgan Asset Management Guide to the Markets
Stocks Do Drop on Occasion
Finally, it’s always good to remember that markets drop about 14% each year, on average. This year’s 18% dip, while nothing to downplay, is close to the long-term norm, though much bigger than some recent years. Some reversion to the mean is probably warranted given the stellar run U.S. large-cap stocks have had over the last 13 years. As I have said to many people lately in risk modeling meetings, things could get worse from here.
Remember it was just 27 months ago when stocks began plunging 34% over just a few weeks.
Unnerving world events and volatile stock market reactions can be surprising but are very much anticipated and expected from a big-picture perspective. They are part of how the sausage gets made in the long-term investing process, so to speak.
Buffett Buys the Dip
We believe great investors like Warren Buffett and others would agree with most, if not all, of these perspectives. Moreover, many of them have been aggressively buying into the market during this current decline, as cash becomes available. They are not selling when prices are down.
Thanks for Taking a Look
Please let us know if you would like to discuss your specific situation and, maybe more importantly, if you are still on track to meet your important financial goals. We would love to talk with you and brainstorm about your situation.
-Your ISC Team