Investment Strategy

Interestingly, the stock market rose in six of the twelve observances of economic contraction.

So even with perfect economic foresight at the start and end of a recession, selling stocks at the beginning of a recession and buying them back at the end would have resulted in being better off (by preserving capital) only half the time.

In the other half, the investor with prescience regarding economic events would have foregone stock market gains.

The historical record is worth knowing, especially if you’re prone to worrying about your portfolio when the economy slows down. One interpretation is that market timing can work – if you’re lucky.

But a better approach for long-term investment success (and one that doesn’t require luck to yield satisfactory results) is determining an appropriate asset allocation plan for your individual circumstances – and sticking to it.

The stock market gains so far in 2023 have been pleasing, with the S&P 500 index of large-company US stocks gaining 9.7% through the end of May and advancing further during the early days of June.

Investor enthusiasm about the potential benefits to companies from Artificial Intelligence (AI) has been the main driver recently of the S&P 500’s gain.

According to research from Goldman Sachs, the seven largest technology-company constituents in the index – Apple, Microsoft, Alphabet (owner of Google), Amazon, Nvidia, Tesla, and Meta (owner of Facebook) currently make up about 27% of the S&P 500 index. These ‘tech seven’ have surged 53%, compared with a net zero gain for the remaining 493 stocks.

While this very sizable outperformance of just a few stocks may be unusual, a wide divergence in performance among sectors of the market is typical from year to year. Also, market leadership tends to rotate on a sector basis over time.

While many investors find it helpful to have some perspective on evolving market trends, it’s important to keep in mind that a diversified portfolio is a time-tested way to participate in the positive market trends of today, and limit downside when the market leaders of the moment eventually fall out of favor.

On Wednesday, May 3, the Federal Reserve delivered the 10^th interest rate hike since beginning its fight against inflation in earnest in March 2022. The latest action pushed the Fed Funds short-term interest rate above 5% for the first time in 15 years.

In his press conference following the rate hike announcement, Fed Chair Jerome Powell indicated that he expects the economy to slow down and inflation to continue to decline in 2023.

This implies that the Fed likely will be able to take a break from boosting short-term interest rates soon, and that we may be in for an extended period of Fed inaction.

In this note I share some perspective on what a pause after a period of interest rate increases means for investors holding bonds and bond funds.

In the months and quarters following the pandemic, Wall Street people often used the acronym TINA (There Is No Alternative) when referring to stocks.

After interest rates dropped to the floor in 2020, and stayed there for some time, bonds offered little by way of returns, while many stocks and stock funds paid dividends and appreciated in price, especially in 2020 and 2021.

In 2022, the financial markets turned from TINA to TONR (There’s Only Negative Return) as investors suffered through high inflation, rising interest rates, and stock and bond bear markets.

However, the change in the interest rate environment, which started in 2021 and accelerated in 2022, brought a benefit, by way of higher yields, that improves the long-term outlook for bond fund holders.

In 2023, we’ve got BANANA – Bonds Are Now A Nice Alternative. In some cases, bonds and bond funds now present compelling yields with satisfactory total return potential.

The chart below compares where yields were for different types of bonds two years ago (in early March 2021) with where yields are today, following a period of inflation-fighting by the Federal Reserve.

The sharp yield increase resulted in a steep decline in bond prices in 2022. What does this mean for investors going forward?

DoubleLine, the bond fund manager, has done some research on this topic. Their analysis shows that the prospects for positive returns from bond fund holdings, in years following sharp yield rises (and corresponding price drops) is quite good.

The average price of bonds in the Bloomberg US Aggregate Bond Index (a broad measure of High Quality Corporate and Government bonds) going back to its inception in 1977 is $100. Today, the average price is in the low $90s.

According to DoubleLine, investing in High Quality bonds when the average price of the index is between $90 – $100 has typically meant returns of between 5% – 10% during the next 12 months. In years following sharp yield increases, bond returns historically have been positive.

While 2022 was painful for bond fund holders, the next several years (assuming the average bond price remains below $100) may be more pleasurable for investors who have significant bond allocations in their portfolios.

As the bank tempest was hitting full force in March, a few clients did reach out to me to inquire about how the money that we manage for them is kept safe. Below is a summary.

Client assets managed by Moore Financial Advisors are typically custodied at Pershing LLC, and Shareholders Service Group is a broker that also acts in an administrative capacity for client accounts.

Client assets are kept safe through the following:

• Segregation of Assets: client assets are segregated from Pershing’s (custodian) and Shareholders Service Group’s (broker) assets. Unlike with checking and savings accounts at your bank, which are obligations of the bank, the assets in brokerage accounts, Trusts, and IRAs are legally separate from the assets of the custodian and broker that oversee them on clients’ behalf
• Financial Strength: Pershing is part of BNY Mellon. The stand-alone financial strength of BNY Mellon is high. Two of the major credit rating agencies, Moody’s and Standard and Poor’s, assign a “AA” credit rating to BNY Mellon. (The highest ratings tier is AAA.)
• FDIC Insurance: uninvested cash in client accounts is typically held in the Dreyfus Insured Deposits program. Dreyfus is a subsidiary of BNY Mellon. Dreyfus Insured Deposits benefit from the $250,000 Federal Deposit Insurance Corporation (FDIC) guarantee.
• SIPC Insurance: Investments in Pershing accounts are protected by Securities Investor Protection Corporation (SIPC) coverage of up to $500,000. Pershing also provides coverage in excess of SIPC limits from commercial insurers.
• About SIPC Insurance: this covers investors if Pershing were to fail and client assets cannot be located due to theft, misplacement, or destruction.

If you have additional questions regarding the safe-keeping of your assets, please send a message to Susan or me and we’ll gladly address your inquires.

The fact that the US government acted quickly and in a coordinated fashion gives me a degree of comfort that today’s problematic situation regarding US banks may be reasonably contained. At the root of all financial crises is a widespread loss of confidence. We don’t seem to be at that juncture yet.

However, a lesson learned during the 2008 financial crisis was that it is hard to know what comes next and when the danger has passed.

We are in a period of high uncertainty now where systemic weakness has come to the fore and many banks may be in precarious positions. If losses mount at other banks because of poor risk management practices, regulators may need to do more.

The good news is that regulators understand how to fix liquidity crises at banks. They have a Global Financial Crisis Playbook from 2008 and a Pandemic Crisis Playbook from 2020 as reference guides, along with a willingness to use them.

Fast-acting and knowledgeable regulators can help boost confidence when cracks in the financial system appear.

Also, the US economic machine continues to drive forward.  Jobs are plentiful, wages are growing, and the consumer is spending. While a downshift in the economy is possible, and perhaps even likely, there seems to be enough momentum and resiliency to maintain growth in 2023.

And interest rate increases, which have put pressure on stock and bond prices, may soon be viewed as ‘yesterday’s policy’ by the Federal Reserve. Policy makers meet next on March 21-22 to decide on the direction of interest rates.

While it’s not a foregone conclusion that they’ll change the policy path and hold off on hikes, the Federal Reserve needs to be considering this in light of last week’s developments. A lower interest rate environment would alleviate pressure and should support higher stock and bond prices. 

The bottom line for clients is that maintaining your long-term asset allocation strategy, even when it’s uncomfortable to do so, is a time-tested approach that tends to produce the most satisfactory results.

By saving and investing today, most investors expect that they will be better off tomorrow. This is a reasonable premise. For this to happen, investments must, at a minimum, outpace inflation.

Stock returns have done a great job at outpacing the rate of inflation over time –generally speaking, by about 6 percentage points per year.

Bond returns also have outpaced inflation over time, but by a significantly smaller margin than stock returns. Treasury bond yields have exceeded inflation by about 2 percentage points, on average, going back to 1958.

Sometimes the relationship between inflation and bond yields gets thrown out of whack.

In high-inflation environments, it’s possible that bond yields might not keep pace with inflation. Today, we are in this type of abnormal environment – illustrated by the chart below, courtesy of JP Morgan Asset Management.

The blue line shows the yield history of the 10-year Treasury bond yield. The peak yield of nearly 16% was reached in 1981, which came during a period of very high inflation.

The average 10-year Treasury bond yield since 1958 has been 5.7% (blue line), and the yield at the end of January was 3.5%. This yield, referred to as the ‘Nominal yield’, is what the 10-year Treasury has paid bondholders in interest before taking inflation into account.

The grey line shows the same 10-year Treasury with its yield adjusted for inflation. The after-inflation yield is called the Real yield, and it has averaged about 2.1% over time.

However, with inflation running north of 5.6% today, and with the 10-year Treasury providing a Nominal yield of 3.5%, the Real (after-inflation) yield is negative, by about 2.1%.

This situation of bond yields failing to keep pace with inflation is unusual and unlikely to persist indefinitely.

Eventually, Nominal yields will move above the rate of inflation. But the adjustment process can be painful for bondholders.

This was apparent in 2022, when the US bond market fell by 13%. The steep decline was a function of the yield / price relationship for bonds. When interest rates move up quickly, bond prices and bond returns fall.

A significant course correction for bonds occurred last year. Even still, the bond markets and the path of inflation remain in flux today. It likely will take time to revert to a normal bond yield / inflation relationship.

Because of this uncertain environment, proceeding with caution in managing bond allocations is advised. 

Emphasizing short-term bond funds, which carry less interest rate risk than longer-term bond funds, and inflation protected bond funds, are two ways to mitigate the negative effects of higher inflation on the bond portion of a portfolio.

The corollary to “What Comes Next?” is “What Happens Years from Now?”

This is not an academic question. Big banks and investment firms typically invest a lot of time and money when trying to figure this out.

JP Morgan Asset Management, for example, compiles a comprehensive set of forecasts each year. More than fifty researchers are tasked with this project, and the report they recently produced runs more than 120 pages

These forecasts are commonly referred to as “Long Term Capital Market Assumptions”. This is a mouthful. It translates to researchers’ best guess on how stocks and bonds will perform over the next ten to fifteen years.

The good news is that updated long-term forecasts for 2023 have improved very significantly compared to a year ago. This holds positive implications for long-term financial planning purposes.

I’ll share with you a snapshot of the changes, then use an example to illustrate why this development is so significant for individuals’ financial plans.

The table below compares long-term return expectations at the start of 2022 with long-term return expectations at the beginning of 2023, based on JP Morgan’s data.

At first glance, the percentage changes for the long-term assumptions might appear to be modest, at 3-ish percentage points for stocks and 2-ish percentage points for bonds.

But seeing how these adjustments play out, and how the higher return assumptions enhance wealth over the long-term, are noteworthy.

Here’s an example.

Say a family has $500,000 to invest in a well-diversified portfolio. They select 60% large company US stocks and 40% US Treasury bonds for their long-term asset allocation and decide to rebalance at the end of each year. They will neither make additional contributions nor take withdrawals during the next 10 years.

Under this framework, how much should they expect to have at the end of the 10-year period?

Using the 2022 return assumptions, they would expect to earn 3.3%, on average, per year. To keep things simple, let’s say they earn 3.3% each year for the next ten years. This translates to $692,000 at year 10—for a cumulative gain of $192,000.

Using the 2023 assumptions, annual return expectations rise by 2.9 percentage points to 6.2%. This higher annual return assumption means their portfolio would grow to $912,000—for a cumulative gain of $412,000.

The 2.9 percentage point difference means the family’s gain is more than twice as much in 10 years’ time.

While an actual financial plan has far more variables that what was presented above, you can see from my example that an upward adjustment in return assumptions (similar to changes JP Morgan has made for 2023) can have a very meaningful impact on total wealth over time. 

The Economist magazine summed up the situation well, in a non-statistical way, in the Leaders section of their December 8, 2022 issue:

“This year’s capital losses, however, have a silver lining. If the downside of higher asset prices was lower expected returns, then by symmetry, future real returns have now gone up…

The new regime of higher interest rates and scarcer capital may seem like a shock, but for much of history these were the normal conditions for investors. It was the era of cheap money (that is now behind us) that was weird.”