“Wealth isn’t primarily determined by investment performance, but by investor behavior.”
–Nick Murray, Simple Wealth Inevitable Wealth
The first few months of 2022 have been difficult and unnerving. Back in January, many of us were eagerly anticipating the first “normal” year since 2019 as the world emerged from the dark days of the COVID-19 pandemic. However, we were quickly brought back to reality by rampant price inflation, Russia’s invasion of Ukraine, and upheaval in financial markets worldwide. Considering the challenging state of today’s world, we’d like to provide a mid-quarter investment update.
Several challenging crosscurrents have combined to punish asset prices in the first few months of 2022. First and foremost, starting in the back half of 2021, it became apparent that price inflation could no longer be considered “transitory” and was likely to remain a pesky, ongoing issue for the economy. The Federal Reserve—still hyper-focused on its full employment mandate as the U.S. economy recovered from the pandemic—was admittedly late to the game in addressing rising prices. Even in the best of times, monetary policy is a tricky business because of the lag effect between a central bank acting, like increasing a key interest rate, and accurately discerning any real economic impact. Markets now fear that the Fed will need to be hyper-aggressive in raising rates and transitioning from quantitative easing (buying bonds) to quantitative tightening (selling bonds). This shift to much tighter monetary policy, if not exquisitely choreographed and communicated to markets—the so-called “soft landing”—could easily send the broader economy into a recession this year or next.
On top of inflationary forces, Russia’s unprovoked invasion of Ukraine in late-February added geopolitical uncertainty to the mix. Assumptions that have underpinned the world order since the Cold War ended in 1991 are now being called into question, and countries are rapidly taking sides. Understandably, when countries start shutting down energy pipelines and rattling nuclear sabers, investors reevaluate their risk tolerance, and asset prices tend to suffer.
Beyond those themes, the world economy continues to deal with pandemic-related issues. Supply chain shortages and bottlenecks, most recently due to China’s zero-tolerance policy toward COVID-19 infections, remain a stubborn issue and a key driver of inflation. Likewise, the price of a barrel of oil, which had been increasing steadily as the world reopened for business in 2021, surged well past $100 after Russia’s invasion of Ukraine. While high oil prices may be great for energy companies, they are an increased input cost for every other sector of the economy.
Even novice investors understand that stock market selloffs are nothing new. Since 1980, the S&P 500 Index has experienced an average intra-year drop of 14.0%, despite positive annual returns in 32 out of 42 years.1 Historically, during these drawdowns, high quality bonds have often been the beneficiary; in a flight to safety, investors sell stocks and stash the proceeds in Treasury bonds and other “safe” assets. This demand for safe assets generally results in higher bond prices and lower bond yields. What is so unusual this year is that both stock and bonds have experienced significant declines; there has been nowhere for investors to hide. Through Monday, the S&P 500 Index had declined 15.5% year-to-date, while the Bloomberg U.S. Aggregate Bond Index was down 9.5%.2.
In the stock market, certain types of companies have been hit particularly hard. Growth stocks (particularly those companies for whom profitability is still years away), technology issues, pandemic “stay-at-home” stocks like Zoom and Netflix, and cryptocurrencies like Bitcoin have experienced extremely tough sledding so far in 2022. Conversely, energy stocks (up 49.4% year-to-date through Monday), value stocks, and defensive sectors like consumer staples, utilities, and health care have been relative bright spots.3
Each crisis we have faced over the past few decades was different than the last. Yet, the market response proved similar in nature (see chart below). After just a year, the cumulative total return of a balanced 60/40 portfolio was mostly positive. After three and five years, even more so.
Source: Dimensional Funds Advisors
Yes, there are silver linings for those ready to ponder what the future may look like. For bond investors, yields have quickly adjusted to much more attractive levels. The yield on the 10-year U.S. Treasury bond, which last summer was 1.2%, is now around 2.9%.4 Short-term bonds have seen even more pronounced yield increases, with the 2-year Treasury moving up from 0.2% in September 2021 to 2.6% today5. The municipal bond market has also seen dramatic yield increases from 2021’s paltry levels, with tax equivalent yields now close to 6% for intermediate-term municipal bonds.
For stock investors, valuations in the U.S. are now very close to historical averages. The S&P 500 Index currently trades at 16.91 times earnings, compared to a 25-year average of 16.85.6 By many measures, including price-to-earnings multiples and dividend yields, foreign markets look downright cheap. While valuations make for poor market timing signals, today’s levels suggest that investors can reasonably expect solid long-term returns from a diversified stock portfolio.
Finally, we are encouraged that the Federal Reserve is taking the initial steps to return to more “normal” monetary policy. For almost 14 years now, starting with the Global Financial Crisis of 2008-09 and culminating with the COVID-19 pandemic, the Fed has exerted enormous influence over the real economy, not just through its control of short-term interest rates but also by buying bonds for its own balance sheet (quantitative easing). While we agree that these actions were necessary and appropriate during times of crisis, the Fed’s long-term, massively accommodative policy has distorted, and likely inflated, asset prices. While extracting itself from direct involvement in markets will likely be a bumpy road, we believe it is the right thing to do to restore accurate price discovery and disciplined risk taking to markets.
First and foremost, it is worth remembering that volatility is inherent to investing. Attractive long-term returns don’t come without risk. Risk can be nearly invisible during prolonged, tranquil stretches, but it is always lurking under the surface. Right now, we are in a stretch when the risk is obvious the moment you glance at the news. And attractive returns seem elusive and unlikely.
Often in times like this, the best answer is to do nothing. If you feel compelled to act, rather than acting rashly, you might start by rationally contemplating whether your overall asset allocation is still aligned with your financial goals. Don’t panic. You may want to reduce your daily consumption of financial news, since that may drive negative emotions and the compulsion to take actions you may later regret.
Evidence also demonstrates that market timing—predicting when to sell risk assets and when to buy them back—doesn’t work. You must be right twice, which is nearly impossible. As an example, few thought the 34% plunge in the S&P 500 Index March 2020 would turn around so quickly—or correctly selected March 23rd as the bottom.7 If you miss a handful of the huge market recovery days after a bottom, long term portfolio performance will be permanently impaired (see chart below).
Source: Dimensional Fund Advisors
As our longtime clients are aware, D&Y’s typical discipline in times of market turbulence is to rebalance client portfolios. This time, because both stocks and bonds have declined in roughly equal measure, many client portfolios have stayed closely in line with their asset allocation targets. Of course, the stock and bond markets will eventually diverge, perhaps substantially, and we will continue to monitor for rebalancing opportunities. For those clients with taxable accounts, our portfolio management efforts this year have focused on tax loss harvesting—both stocks and bonds—to deliver the highest after-tax return possible for a given risk level. Some clients were surprised by a higher-than-normal level of taxable capital gains in 2021; as we continue to harvest losses this year, that seems very unlikely to repeat at year-end 2022.
Here are a few financial planning ideas that may be appropriate in today’s market environment:
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Maintaining poise and discipline during difficult market environments is perhaps the most critical skill for successful long-term investors. It is an honor and a privilege to be your partner in that journey. Please do not hesitate to reach out to your D&Y advisor with any questions you may have about your finances and the current market environment.
Dowling & Yahnke Wealth Advisors