Quarterly Market Letter, July 2022

By {{_embedded.author.0.name}} on July 11, 2022

When Markets Slide, Zoom Out, Not In

By Bruce Thompson

Happy Independence Day to you and your family!  A million salutes to America’s brave men and women as we celebrate our nation’s rich history.  In this quarter’s letter, we draw on market history to provide something in short supply — perspective and wisdom. 

Mostly, we want you to know that we understand market corrections can be as painful and worrying as they are inevitable, and that we care and are here for you.  The advisors at Lexington Wealth Management have ample experience guiding clients through a variety of investment environments, including seven bear markets.  Please, don’t be shy about reaching out if you want to review your portfolio or financial plan, or if you just want some insight on recent developments.

In case you missed it, our own Mike Tucci recently hosted the first in a series of podcasts on investment and financial planning subjects of interest.  Mike is joined by Bradford Long, CFA, of Fiducient Advisors, our outside investment research firm, for a discussion on Market Volatility and Outlook.  During the podcast, Mike alludes to a recent letter from Liz Ann Saunders, Chief Investment Strategist at Charles Schwab, which you might find of interest: Panic is Not a Strategy — Nor is Greed. 

That bonds and stocks have turned south this year will not be news to you unless you’ve been channeling “Rip Van Winkle” and have been sleeping through the last few months.  Amid concerns about inflation, rising interest rates, and a potential recession, the S&P 500 Index has retreated about 17.5% this year.  International stocks are down a like amount.  Bonds often have had positive returns when stocks drop, but this year bonds have taken an unusual elevator ride below ground.  The Bloomberg US Bond Index is down 10.5% and the Morningstar Short-term Bond Index is down 4.9%.  Below we explain why the jump in bond yields is a silver lining for clients and financial plans. 

Taking a Rip Van Winkle approach during market downturns is not such an unconstructive idea.  In fact, one of Vanguard founder Jack Bogle’s famous suggestions for getting through market downturns is don’t peak: “The daily machinations of the stock market are like a tale told by an idiot, full of sound and fury, signifying nothing.  Don’t let all the noise drown out common sense and wisdom.  Just try not to pay that much attention, because it will have no effect whatsoever, categorically, on your lifetime investment returns.” 

The intuitions that serve us well in other parts of our lives can be counterproductive when it comes to investing.  As Saunders points out in her letter, markets tend to overshoot on the upside and then the downside, and when that happens “our reaction mechanisms are heightened and that’s not necessarily to our advantage.”  When markets slide, investors tend to zoom in on recent data and worrisome headlines, which might lead us to think “the sky is falling.”  It’s critical to filter the information we consume because it is often slanted, by Wall Street which profits when investors trade, and by the media which uses hyperbole to sell “clicks.” 

For example, last week this headline appeared in the Wall Street Journal: Fed Raises Rates by .75%, Largest Increase Since 1994.  That sounds scary, but nowhere does the article mention that just three months later the stock market launched skyward!  The S&P 500 Index returned 37.5% in 1995 and a remarkable 27% per year from 1995-1999. An investment of $100,000 at the end of 1994 would be worth $1,481,300 through May 2022, an annual return of 10.3%, despite four bear markets.

Many are rightly concerned about inflation today and look back for clues to the early 1980’s when the Fed raised interest rates sharply to battle inflation.  This infamous Business Week magazine cover from 1979 warned of the “Death of Equities – How Inflation is Destroying the Stock Market.”  Indeed, there was a twenty-month bear market between 1980 and 1982 which resulted in a 27% drawdown in stocks. But stocks recovered sharply after that.  In fact, an investment of $100,000 at the end of 1979 would have grown to $544,000 in ten years. 

We don’t mean to imply that history is about to repeat itself, or that it won’t.  We don’t know what the future holds, no one does.  But it is helpful to realize that investors have always faced significant volatility and worries, and that uncertainty is what drives returns.  Because of “memory compression,” we tend to perceive current risks as somehow more serious than those endured in the past.  To help put today’s worries in perspective, we compiled this List of Concerns Since WWII.  Where would you rank today’s concerns on that list?

The stock market has provided excellent returns over time for patient investors despite fourteen bear markets since WWII and an ever-changing economic backdrop.  While it is important to be aware of what’s happening in the economy, maintaining a long-term perspective, and staying invested with a well-conceived, suitably balanced, and diversified investment plan gives the highest probability of capturing your fair share of those returns over time. 

We’d like to share this investment policy guidance from the folks down the street at MIT Investment Management, who may be the “smartest people in the room.”  Perhaps this will sound familiar.

Of course, we do not ignore macroeconomic factors as they play a key role in determining investment outcomes. Here, however, our approach is very different. We view it as very difficult and perhaps impossible for us to generate an edge forecasting macroeconomic events. As a result, we undertake no primary macroeconomic research. Instead, we seek to construct our portfolio with diversification and margin of safety in mind so that our portfolio will be resilient and perform well over time and under a variety of macroeconomic conditions. To remain aware of macroeconomic downside scenarios that could overwhelm our microeconomic work, we stress test the portfolio on a periodic basis to estimate the impact of extreme events.“

Wall Street makes lots of forecasts, most of which never come true.  The idea that one can trade deftly in and out of the markets around forecasts is a unicorn – with an exceedingly low probability of success.  That’s partly because timing the market requires two decisions — when to sell and when to buy back in.  If we generously assign a 50% chance of correctly timing each side of that trade, then the round-trip odds of beating a stay invested strategy are 25%… each time we attempt it.  Over an investment lifetime, following a market timing strategy would result in infinitesimally low odds of beating a stay invested strategy.  That’s something Wall Street doesn’t want you to think about too deeply, their bonuses depend on it!

It might “feel” like a relief to sell stocks during a downturn, but the odds involved in market timing are further reduced by the math associated with capital gains taxes.  For example, over the erstwhile 2009-2021 bull market, the S&P 500 returned 582% with dividends reinvested, and a $100,000 investment grew to $682,129.  After this year’s correction, through May 30, 2022, that investment would have pulled back to $624,625.[1]  But if you had been “smart” and sold at the end of 2021, after paying capital gains taxes at an assumed combined rate of 25%, the investment would be worth just $537,129.[2]  That’s worse off than the Rip Van Winkle investor.  Moreover, the taxes paid represent a permanent loss, while the market has always recovered eventually from downturns. 

Even without taxes, the odds associated with timing when to sell and when to get back into the market are fraught with problems.  How many times has the market gone up when you thought it should go down, and vice versa?  That’s because the market often turns before the news gets better (or worse), and because what we’re really doing is following other investors’ moods, which are unreliable, and which swing between optimism and pessimism like a yoyo.  Here’s the smoking gun.

[1] If you had been “unlucky” and invested $100,000 in the S&P 500 at the end of 2007, just before the financial crisis bear market, the investment would have grown to about $392,251 today, despite three trying bear markets. 

[2] The illustration assumes a taxable account.  If the stocks were half in a retirement and half in a taxable account, the after-tax value would be $609,379 – still below the Rip van winkle investor.

This chart compares the S&P 500 Index since 1987 against the weekly Investors Intelligence survey, which shows the proportion of bulls and bears among money managers.  We’ve circled the periods when market sentiment was at pessimistic extremes, like today.  What’s telling is that the periods of great negativity correspond with major upward turns in the market, revealing just how wrong investors collectively have been at key inflection points.

To understand this contrarian dynamic, it may help to think of the stock market like a bonfire on the beach, a welcome thought this July 4^th holiday.  How long the bonfire can burn depends on how much dry kindling there is to throw on the fire; how high a market rally goes depends on how much cash is on the sidelines.  When investors are overly optimistic, as they were late last year, it follows that they are mostly fully invested with little money on the sidelines to fuel a further advance.  When pessimism is high, as it is now, there’s a lot of money to fuel the next upswing.  Of course, the market needs a spark, which often comes in the form of news that is less bad than feared. 

This illustration points to how difficult it is to time reinvestment after taking money out of the market, yet the “opportunity costs” involved in missing out on market rallies represent a significant penalty on long-term returns.  This slide from our research partner at Fiducient shows the Impact of Missing a Rebound.  This slide shows that the Average Mutual Fund Investor’s Returns over the last twenty years came in at just 3.6% compared with 9.5% for the S&P 500, 4.3% for Bonds, and 7.4% for a 60/40 mix of stocks and bonds. 

When it comes to investing our intuitions can mislead us and our perceptions can trick us.  If you always zoom in, you’re apt to miss the big picture and tasty profits along the way.  I’ve often thought about this over the years when watching our beloved family beagle, Bono, during walks in the woods.  Beagles are captive to their incredible smelling instincts and Bono incessantly zigs and zags across the trail, nose pressed firmly to the ground, reacting to every scent.  Beagles aren’t great atmospheric sniffers, so they focus intently on what is right under their noses to the exclusion of what might be down the trail.  On one occasion Bono didn’t even notice a rabbit lopping thirty yards away.  Another time, someone had dropped a coveted Krispy Kreme donut on the trail, but he completely missed it!

The thing is, if you focus on shortsighted views of the market, you will be captive to that perspective.  The following two charts show the annual swings in US GDP Growth (left) since 1950, and monthly returns in the S&P 500 Index (right).  Dramamine anyone?

But if you zoom out and look at compounded growth in GDP and the stock market over the same period, you see very different pictures:

Despite twelve recessions and constant economic volatility, US GDP since 1950 increased from $2.1 trillion to $23 trillion today!  And despite numerous bear markets, $100 invested in the S&P 500 Index grew to $238,042 today.  That’s an average annual return of 11.3%, and 7.6% after inflation.  Again, we don’t know what the future holds, but capturing average annual returns requires staying invested.  Doing that is easier said than done, which is why the rewards for patient investors have been so great. 

What we do know is that following other investors’ “Cycle of Emotions,” endlessly zigging and zagging between greed and fear, is a losing game.  During bull markets, greed and excitement tend to skew perceptions of risk, which is always present whether we choose to see it or not, pushing many to over-invest in equities.  But risks actually are higher when stocks and bonds are priced for perfect outcomes, which has never been reality, leaving little margin for disappointment.  The economy is inherently  cyclical and, when gravity invariably asserts itself, investors who had downplayed risks have little choice but to react emotionally and sell coveted ownership of fabulously profitable American and global companies. 

This dynamic helps to explain why market corrections tend to unfold the way they do as investors who had been swimming naked scramble for cover when the tide goes out.  Their mistakes are your opportunities.

Your life preserver is always investing within your financial and behavioral ability to accept risk, structuring a properly allocated portfolio that you can stick with when other investors lose their heads, and then developing an equanimous long-term mindset that will help you stay off the deleterious rollercoaster of investor emotions.  You do not want to follow those investors; they aren’t smart, prudent, or prescient.  If you will excuse the shameless plug, this is the true value we bring as advisors at Lexington Wealth Management.  

A Word on Bonds

Bonds have often benefitted during periods of weakness in stocks, but this year the bond market has experienced an unusually big decline against the backdrop of rising rates and inflation.  We’d like to take a moment to explain why the drawdowns may be regarded as temporary and not permanent.  Moreover, looking forward, the shift to a more normal interest rate environment will result in significantly higher income for clients.  As a result, Lexington’s Investment Committee is in the process of raising expected fixed income returns in financial plans, which will boost planning outcomes. 

Current bond prices represent the market resale value at a point in time in the fixed term of a bond.  Upon maturity, bonds will be redeemed at face value by the borrower regardless of interim price fluctuations.  The so-called yield to maturity is locked in at purchase and will be realized over the life of the bond.  This holds true whether you own individual bonds or invest through bond mutual funds, which provide the advantage of diversification and professional management.  If you want to understand more about how bonds work, here is a great tutorial from PIMCO, Everything About Bonds.

It might help to think about bond prices like an elevator, which always comes back to the ground floor.  When interest rates in general decline, as they have for much of the last few decades, the elevator goes up.  But as a bond approaches maturity, the elevator gradually comes back down to the ground floor.  When interest rates rise, as they have over the last year, the elevator goes down below the ground floor.  But as a bond approaches maturity, the elevator will gradually return to the ground floor, to maturity value.

Therefore, negative returns in the bond market this year represent temporary declines, and you appropriately should view the performance of your bond portfolio over a period of years.

Your bond portfolio is structured as a “ladder,” meaning that bonds will be maturing continuously within the mutual funds owned, with the proceeds reinvested at higher rates of interest.  At this time last summer, a two-year treasury note paid under .5% interest, but today the yield is over 3%.  Three-year high grade corporate bond yields are now over 4%.  And a diversified portfolio of three-year “high yield” (lower rated) corporate bonds is suddenly yielding over 8%.  (High yield bonds are subject to the credit paying ability of the issuer and, therefore, most investors should own them through diversified funds).  Money market yields are now well over 1% and, If the Fed continues to raise rates as telegraphed, yields may soon approach 2%.    

A prudent mix of bonds diversified by maturity and type might now be expected to provide interest of about 4% vs just 1.5% at this time last year.  Therefore, a $1m bond portfolio might generate income of about $40,000 per year versus just $15,000 a year ago.  Over ten years that would produce income of $400,000 versus $150,000 just a year ago.  That’s a real game changer for income investors, and it’s something to keep in mind when you read scary recent news headlines like, “Bond decline continues with no end in sight!” 

Appendix: Slides for Discussion with Your Advisor