Invest As If There Will Be A Tomorrow

October 8, 2021 – The U.S. stock market has gained 91% since the March 2020 low and is up 31% compared to highs just prior to the COVID pandemic sell-off. These large gains can be credited to many factors including the strong economy going into the pandemic, extreme measures taken by Congress and the Federal Reserve, along with a generally successful reopening of the economy.

For the past few months, we have been hearing concerns about inflation due to factors such as supply chain disruption, labor shortages, and very strong demand for goods and services. In response, the Federal Reserve has signaled the gradual withdrawal of the stimulus measures enacted in early 2020. The likely effect of inflation and the Federal Reserve’s response is higher interest rates across the board; exactly how high and how quickly the increase will be is still unknown. This is a headwind for stocks, and that has the market on edge. Nevertheless, these expectations are already priced into stocks and are not likely to be the trigger for a bear market.

What if we flip the narrative and ask: what if things go right? What will the market look like if inflation settles at a healthy rate of about 2%, if Congress passes a reasonable infrastructure bill, if the Delta variant runs its course, if people are able to return to work, and if the supply chain resumes normal function? This presents a very compelling upside scenario for stocks as well.

Watching the rollercoaster of news —including a pandemic, concerns about government spending, and rising inflation—can cause any investor anxiety or excitement, followed by an inclination to act immediately on that news.

Keep in mind the future course of economic factors such as interest rates, inflation, and economic growth – and the market’s reaction to them – are not knowable. We manage investment portfolios as though we do not know the near-term future of the markets. Because we don’t—no one does. Recall that we have designed your portfolio to withstand the ups and downs of the market. We’ve created with you an investment policy to accomplish your objectives, with a level of risk appropriate for your individual needs.

There are several “rules of thumb” in finance. One is that a market cycle tends to last approximately seven years. One simple exercise you can do is to compare the amount you currently have invested in safer, low risk investments (cash or fixed income) with your current or expected annual withdrawals.  Using the formula below, you can determine how many years the amount you currently have invested in safer, low risk investments will last.

If the result takes you through a full seven-year market cycle, you should feel confident that your portfolio will weather whatever the markets have in store. The risk and the higher returns of stocks over the long-term are tolerable because the low-risk assets provide stability and a source of funds for withdrawals. As a result, there is no need to sell stock in a down market. Portfolio allocation between stocks, bonds, and cash is essential to reduce risk and protect your current or near-future needs for cash.

We view U.S. stocks as fairly-valued given continuing low interest rates and still-strong corporate profits and balance sheets. There are still areas of opportunity in most sectors. Leadership in the market has alternated between large technology stocks, when interest rates have declined, and less volatile value stocks when rates have risen. These recent rotations among style and sector performance demonstrate the importance of stock diversification.

In foreign markets, we expect corporate profits to strengthen as a result of above-average global economic growth. Higher interest rates and commodity prices are particularly helpful to emerging markets. The U.S. dollar has continued to strengthen and is now near a 12-month high. A strengthening dollar makes foreign profits less valuable in dollar terms, which can be a drag on returns for U.S. investors in foreign denominated stocks.

We continue to expect bonds to have lower returns than normal due to still historically low interest rates. The benchmark 10-Year Treasury Note ended the quarter at a yield of 1.53%, up from 1.44% on June 30^th and up from 0.91% at the start of the year, reflecting an increase in inflation expectations. We view current bond yields as remaining too low to be consistent with a strengthening economy, given the increasing supply of bonds coming into the market and the risk of inflation. Even in this low-rate environment, a fixed-income allocation is important for most portfolios for risk reduction and income when needed as we demonstrated above. We prefer to build core positions in individual municipal bonds, or high-quality taxable bonds with shorter-than-typical maturities. For diversification and added yield, we supplement these with small allocations of lower-rated bonds, convertible bonds, preferred stock, and specialty bond funds.

Although we provide an overview of many areas of the market, our focus when managing your portfolio is on your personal goal and an individualized strategy to reach that goal. We welcome your feedback and questions.