Musings on investments - Q2 2022
The most recent downturn in stocks brought us to an official declaration that we have crossed the line denoting a 20% drop in the S&P 500 index and thereby entering an ‘official’ bear market. In truth we had been flirting with this number a few times already this year, but now it’s official.
We talked quite a bit about bear markets in the last communication we sent last month. In that letter we had described the frequency and severity of bear markets historically, how they develop over time and the sorts of concerns weighing on folks right now in this market downturn. The key takeaways from our last letter are that these sorts of markets happen with some frequency, they are not permanent but rather temporary by nature and, perhaps most importantly, it is why stocks have higher historical average returns than other asset classes. The reason we get to enjoy that higher return over time is that stock returns include a “risk premium”, an extra return above that enjoyed by other low volatility asset classes.
To receive that risk premium we have to earn it, and markets like these are the way we do that. If we can put up with the uncertainty and resultant market selloffs we can often enjoy higher average returns over time, important for most of us to help achieve a measurable “real” return, a return in excess of inflation.
Most portfolios contain more than stocks however. In the tradition of spreading our eggs to multiple asset class baskets our clients' portfolios hold bonds, real estate securities and often commodity securities as well. This market downturn has affected bonds as well as stocks, with the broad domestic bond index down 11.43% YTD as of the close on Friday, June 17 1. The downturn in bonds has been almost entirely caused by anticipation of how high interest rates may go over the next period as the Fed pushes up rates to combat inflation. Lower bond prices mean higher bond yields, and this will prove beneficial to bond investors over time as bonds mature and are reinvested at these higher rates.
As to real estate securities and commodity securities, often thought of in aggregate as ‘alternatives’ there has been some good news. While real estate securities (REITS), which held up well earlier this year, finally tipped over and headed lower along with most other traded stocks, commodity securities have marched to a different drummer, with strong returns last year and so far in 2022. Commodities respond well in an inflationary environment and have risen in price along with the prices of the commodity basket components and that has been helpful to diversified portfolios so far this year.
The reasons for the volatile markets this year have not changed since our last letter. Folks are worried about inflation and the higher interest rates needed to slow that inflation down to a reasonable level. While the economy is still moving along markets are always forward looking. As economists and market participants look forward there is considerable uncertainty about slowing corporate profits and the potential for a recession. There is also a lot of uncertainty about how high the Fed will have to push short term rates up to control inflation. This speculation about the final rate has had an outsize effect on the bond market, as bond holders try to incorporate those estimates into the price of various types of bonds, but certainly affects all sorts of stock prices as well, as the level of interest rates is a key input into the various calculations done to establish a fair value for stocks.
Looking forward it is clear that inflation is key to both the Fed’s actions and the trajectory of the market. It was thought last year that the higher inflation we were seeing was somewhat transitory and driven in large part by supply chain issues. Since then, we have started to see inflation become embedded to some degree in wage inflation and, more recently, in energy prices exacerbated by the Ukrainian war and the sanctions imposed by western nations on Russia.
In the end, for longer term investors, the whys and wherefores won’t really matter much. Eventually inflation will cool, supply chains will act more normally, and demand and supply will become more balanced. It may take a little longer to achieve this result than many thought earlier this year, but we’ll get there in time.
It is always tempting in times like these to try to earn our risk premium with none of the implied risk by ‘timing’ the market. Simply sell equities and bonds before the market starts dropping and buy them back after the decline is complete! The large and very real danger is “mis-timing’ the market, either sitting in cash long past the start of the rebound or getting whipsawed as market rise and fall, essentially being invested during most of the decline and missing most of the rebound. Numerous studies along with our own personal experience watching clients attempt this sort of maneuver indicate that the chances for success are very slim and we don’t recommend it.
In times like these it makes sense to stay diversified and to stay invested. We continue to look for values among the various asset classes in your portfolio and will under and over-weight asset classes to take advantage of mis-priced securities and classes. We’ve been able to take advantage of valuations in equities by emphasizing a shift to value stocks and in bonds portfolios have added value with shorter maturities and floating rate investments, a type of bond less affected by rising interest rates.
Looking forward, will we end up in a recession? It may be that rising rates will push the economy into mild recession later this year or sometime next year. It may also be that markets have already priced in most of that particular recession risk, it is always hard to tell without the benefit of hindsight. Sooner or later though we’ll move through this business cycle and on to the next. Over time companies will adapt to higher prices with price increases of their own and we’ll reach a new plateau of pricing. Equilibrium will occur and we’ll be able to move on from there.
It may be that some of the value in our portfolio at year end wasn’t ours after all. Valuations were calibrated for a perfect world and that isn’t the one we live in. It is important to remember though that the market levels of today should not be extrapolated indefinitely into the future either. In fact, the subsequent year or two after a decline like the one we have just witnessed is often quite robust from a performance perspective.
These are tough times to be an investor, and it is important to not let the inevitable worries distract us from our overall goals and objectives.
1 – Bloomberg data
This market commentary is provided for information purposes only and is not a complete description or analysis of the securities, markets or developments referred to in this material. There is no guarantee that these statements, opinions or forecasts provided will prove to be correct. All expressions of opinion are subject to change. Information has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance does not guarantee future results.
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