Unpredictable Times, Normal Cycles

October 14, 2022 – This quarter, higher than anticipated inflation resulted in additional rate hikes as the Fed worked to slow down the economy.  Despite a market rally this summer, both bonds and stocks turned lower for the third quarter of 2022. While the circumstances leading to our current market condition are exceptional, history serves as a guide for this market environment. Neither bear markets nor bull markets last indefinitely. According to the Schwab Center for Financial Research and S&P 500 data going back to the 1960’s, bull markets last an average of six years and deliver a cumulative return of over 200%. In contrast, bear markets average 15 months and deliver a cumulative return of  -38.4%. A review of returns in the table below offers reassurance that current market returns are not abnormal. Rather, they fit comfortably within a normal market cycle.

Considering the changes in the economy and markets over the past several years due to the pandemic and the federal response, the upcoming months will be difficult to forecast. As a result, the markets will likely remain volatile. The actions and words of the Fed are a dominant driver of the markets. The Federal Reserve must talk tough to combat any perception in the minds of market participants that the Fed’s rate policy may reverse in the near term. Consequently, until inflation significantly decreases, there will be additional talk and rate hikes intended to slow the U.S. economy and demonstrate that inflation will be controlled.

This quarter, we are taking a close look at fixed income. Bonds have always played a key role in reducing risk in client portfolios. They are fundamentally different than stocks: their value is based on periodic interest payments in exchange for lending money to the bond issuer. Stocks, on the other hand, are priced on the value in today’s dollars of profits to be generated in the future. Typically, having a mix of stocks and bonds in a portfolio provides diversification of risk.

The decline in the value of existing bonds results from rising interest rates. Investors can purchase a newly issued bond with a higher coupon interest rate. Previously issued bonds with lower coupon interest rates must then be priced lower to attract buyers. Long-term bond funds have suffered the most loss because they are the most sensitive to interest rate changes. While rising rates hurt bond prices in the short term, they can be helpful as older bonds mature and newer, higher-yielding bonds are added.

For clients with bond portfolios of laddered maturities, there is good news: there is finally some income in fixed income. With U.S. Treasuries recently earning around 4.2% for a 2-year, 3.8% for a 10-year, and corporate and municipal bonds north of 4%, there are many options that present a sensible alternative to higher-risk assets.

U.S. Stocks – We view U.S. stocks as on sale in this environment. While prices can always go lower, for the stocks that make up the S&P 500, current valuations are well below the long-term average. This improves return expectations for the future. Volatility in U.S. stocks is likely to continue due to the outsized influence of inflation and the Federal Reserve’s response. Adding to quality U.S. stocks incrementally over the next six months is an opportunity to take advantage of these low prices.

Foreign Stocks – Foreign stock investment presents a dichotomy. On one hand, global growth is expected to slow. Europe will likely continue to be hampered by the effects of the Ukrainian-Russian war and resulting sanctions on Russia, as well as rate hikes by central banks to counter inflation. But for U.S. investors, the decades-high in the U.S. Dollar makes foreign shares much cheaper and any easing in the dollar will benefit those investments. We see Japan as preferable to Europe at this point. The specialized management of an actively managed fund, as opposed to an index, is worthwhile for a portion of foreign allocations. Emerging markets still face a headwind, with higher borrowing costs and a slowdown in China. However, the currency factor should be considered for these shares as well.

Fixed income – Bonds and CDs offer opportunities with yields now higher than an average stock dividend yield. We are taking advantage of higher interest rates to move from defensive short-term and floating-rate positions to longer-term, high-quality bonds. At this point in the business cycle, we are cautious regarding credit quality, favoring higher quality with longer duration. We “ladder” portfolios of individual bonds with similar dollar amounts in maturities between two years and six years. As we discussed above, laddering gives us the opportunity to reinvest maturing bond proceeds in longer maturity bonds at the new, higher yields. We use tax-exempt municipal bonds in taxable accounts, which are increasingly attractive on a tax-adjusted basis. Corporate, taxable municipals, CD’s, government, and agency fixed income are our choice for IRA accounts. Since we hold bonds to maturity, market price changes during their term do not affect portfolio results.

While we review many areas of the market, our focus when managing your portfolio is on your personal goal and an individualized strategy to reach that goal. As always, your comments and questions are welcome. Please call us or stop by the office any time.