Charting the Course

If asked to write a script to describe a really terrible year in the investment markets, I’m not sure many could have written one that was worse than 2022.

After beginning January at an all-time high, the S&P 500 rode a roller coaster through war in Europe and fears of recession in the U.S. to finish 18% lower by the end of December. Investors tried to get out of the way by jumping on bonds, but they were sinking too.

There was simply nowhere to hide in 2022, but the tides appear to be turning as they eventually do in markets, and 2023 offers some glimmers of hope for those who are paying attention.

The outlook for returns going forward has improved, especially for bonds, and here’s why. At the end of 2021, a one-month U.S. Treasury bill had an annualized yield of 0.06%. Today, investors can make that same investment and earn an annualized yield of more than 4.3%.

This is a significant advantage that investors have not seen in a long time. Consider a typical investor who might have a 60% stock/40% bond portfolio with an 8% return objective. If bonds can only produce 2% returns, the stock portion of that portfolio must produce 12% to hit the 8% return, and that was the challenge coming into 2022.

This year, investors can reasonably expect to earn 5% or more from a diversified bond portfolio. To hit that same 8% return, the stock portfolio needs to earn only its historic average of 10% per year.

While 2023 might look better, we are still not out of the woods because stock returns are much more difficult to predict over short time horizons. And if you don’t believe that, look back at the December 2021 Reuters poll of Wall Street strategists, which suggested the S&P 500 would gain 7.5% in 2022.

But there is reason for optimism when it comes to stocks. Given that earnings grew but stocks fell, math tells us that stock valuations must have come down. Indeed, the price-to-earnings multiple on the S&P 500 has declined from about 22 times earnings at the end of 2021 to less than 18 times earnings today.

Ultimately, stock market returns for this year are likely to be driven by interest rate changes and economic growth or contraction relative to what is already priced into the market. While there is always a chance stocks underperform again, risks and prospective returns are better in balance today than they were a year ago.

So, for patient, long-term investors, a return to a more normalized interest rate environment and reasonable stock multiples should be a good thing.

Unfortunately, the temperature outside is about the only thing that’s hot this summer. We know there’s not much heat coming from financial markets with the S&P 500 turning in its worst first half since 1970. That’s enough to make you want to find a swimming pool and leave it all behind.

And there’s no fault in that, but remember that markets can’t go up forever, and after the post-COVID spending spree of last year, the market may have been due for some dark clouds.

But rain eventually ends, blue skies return, and history tells us financial markets recover. So, enjoy your day in the sun because there are things you can do to make that blue sky even brighter when clouds finally clear.

Here are some silver linings to think about. With the market now in bear territory, the risk to earnings outlook for both stocks and bonds is more balanced than it was when bulls were in command.

Today’s earnings multiple is now below average, leaving the market cheaper than it used to be, and there’s a case for optimism in bonds as well. After more than a decade of ultra-low interest rates, the Fed’s efforts to bring down inflation have pushed interest rates up, which correlates well with higher bond returns over the long run. There are still risks associated with protracted inflation and economic recession, but even with those considerations, the bond market is more attractive than it’s been in years.

So, even though markets are down, we can still make the most of the situation. If we have cash that’s been on the sidelines, we can invest it at more attractive valuations. We can also use these favorable market conditions to rebalance portfolios, and we can reduce our capital gains tax liabilities by selling underperforming investments. That is called tax-loss harvesting. Tax rates are historically low, so this also may be a good time to convert your traditional IRA account into a Roth IRA.

But this is the time to be careful because bear markets can sometimes scare us into making costly mistakes. Watching portfolio values decline is stressful, and studies suggest we can feel twice as much pain from a decline than pleasure from an increase.

So, in times like these, resist the urge to sell because those who bail out of the market are likely selling to buyers who have long-term, patient approaches to investing, and history shows that markets reward those with the courage to buy during bear markets.

Just keep in mind that storms aren’t always as bad as they appear, and despite the dismal performance of stocks year-to-date, the S&P 500 has still returned more than 10% a year over the last three-, five-, and 10-year periods. And while it may feel like the market has given up many years’ worth of returns, the S&P 500 currently sits at the same level as it did in March of last year.

So, enjoy the pool and the cool water because the summer is likely to get even hotter. And rest assured that your investment prospects aren’t as cold as they might seem.

Remember when we were kids, spending the day at Six Flags or some other amusement park, binging on roller coaster rides and any number of other thrilling adventures?

At the end of the day, we were disappointed that the fun was over and a little bummed that we were walking back into a calmer, more mundane reality. We were kids, so our post-park depression may not have been mollified by what was ahead, like summer camp, our family vacation, the scout trip, or some other big adventure.

That may be how a lot of investors are feeling today, as we watch the stock market move into what is shaping up to be a tumultuous 2022. Last year’s market was one of those wild rides that left everyone laughing and high fiving all the way to the turnstiles. The S&P 500 gained 29% on the year and posted 70 record closes while 88% of stocks in the index posted positive gains. Indeed, there was plenty to smile about.

In comparison, 2022 may seem more like that long walk back to the parking lot with our parents. We can feel the exuberance wearing off as we consider an economy beset by inflation and interest rates poised to go up. The S&P started January in a pretty good mood, hitting another all-time high before slumping into correction territory later in the month.

But let’s remember that parking lots are not the end of the world and going home is much better than spending the rest of your life in an amusement park. How long can the market keep powering higher at double digit rates, anyway? After all, the S&P was up more than 18% in 2020, despite the pandemic.

As we’ve seen in January, the market is not going to respond well when the Fed starts raising interest rates in March, but even with the expected increases, rates will still be low relative to historical norms.

Speaking of history, S&P 500 returns have been quite good in years following market gains of 25% or more. On average, second-year gains have been 14% with only three instances of negative returns. Corporate earnings are also expected to grow in 2022, with analysts predicting a 9% jump in profits.

While trying to predict returns over a one-year period is little better than a dart-throwing exercise, it would be safe to expect 2022 returns to be lower than they were in 2020 and 2021, so wise investors will control the things they can control. They will maintain portfolio diversification to reduce risk, rebalance portfolios in a disciplined way, contain costs to increase net returns, and harvest tax losses when appropriate.

This year may seem like the ride home from an amusement park, but remember, the next big adventure could be right around the corner.   

Inflation is not something we have had to talk about much over the past few decades. In fact, many of us weren’t even born the last time the Consumer Price Index, or CPI, peaked to levels that shook the economy.

Those who were around in the 1970s may remember watching staples like a loaf of bread double in price along with the average price of a new car. Gasoline led the inflationary charge, tripling in price from 36 cents to $1.19 per gallon.

Fortunately, the Federal Reserve Bank has used monetary measures to help keep inflationary pressure under control since the CPI hit 13.5% in 1980. But those days left a lasting impression.

Inflationary alarm bells began ringing louder this summer when the CPI rose to 5.4% in June, the highest it has been since the global financial crisis battered the economy in 2008. So, there is no wonder all eyes are on Fed Chairman Jerome Powell.

“Transitory” is the word Powell is using to describe the current run-up in consumer prices, but market watchers worry inflation could be more stubborn, prompting interest rate hikes, slowing the economy, and dragging down stock prices.

Inflationary pressures abound. A worker shortage and an abundance of cash in consumer bank accounts means there are a lot of dollars chasing a constrained inventory of products and service, leading to higher prices. The price of lumber is one well-known example, but prices are going up on everything from fast food to cars and trucks.

For an explanation, look no further than the size and scope of government stimulus. Between the Trump and Biden administrations, more than $5.3 trillion was allocated to shore up the economy during the pandemic. The fiscal response, combined with the Fed’s multitrillion-dollar monetary response in 2020, has led to the largest ever annual increase in money supply.

There is simply no historical guide to show us what inflation may do in response to such unprecedented government action. Chairman Powell could be right, and inflation may well fade as the economy reaches post-pandemic equilibrium. But investors are looking for ways to protect their money from a potential return to the 1970s.

Obviously, cash is out, and investors should also be cautious about fixed-rate bonds, which are particularly at risk in inflationary periods. For example, the 30-year U.S. Treasury bond currently yields about 2%. If inflation runs at 3% over the next 30 years, investors will lose about 1% a year in purchasing power.

For bond investors, there are alternatives. Inflation can lead to higher interest rates, so bonds with shorter maturities are better suited to take advantage of higher rates when maturities are reinvested. Perhaps the most straightforward way to protect a bond portfolio against inflation is to use Treasury Inflation-Protected Securities, which are bonds that receive an increase in principal value that is equal to the rate of inflation.

Stocks have a mixed record when it comes to inflation. On the downside, inflation usually forces interest rates higher, which can push earnings lower, leading to lower stock prices. On the other hand, companies can adjust prices in response to higher costs or higher demand, which is a built-in protection against inflation.

Remember that mild inflation is not necessarily a bad thing. The Fed would like to see inflation settle at 2%. The economy and markets seem to be comfortable with that, and historically, the market has delivered its highest real returns when the rate is between 2% and 3%.

If you like hyperbole, this is the election year for you. Strong feelings abound on both sides of the political spectrum, and heated passions have spilled into many facets of society that are usually benign to politics.

In our office, we talk about politics almost every day with clients concerned about who might be our next president. It does not really matter whether they are liberal or conservative. The fears are the same.

“If Donald Trump wins, I’m pulling out the market,” some say. Others say they’ll make for the sidelines if Joe Biden becomes president. But jumping off an emotional ledge just because of an election is a serious mistake.

Political tides ebb and flow, and presidential administrations come and go, but markets continue to gain value over the long term and reacting to an election cycle is not a winning investment strategy. Successful investors stay focused on long-term goals and resist making short-term decisions based on politics.

We can look back at history and assess how markets have performed under various leadership configurations, such as a Democrat in the White House and a Congress split between the two parties. Historians have documented trends, but those trends are not necessarily predictors of future performance.

For example, look at the current configuration. The Dow Jones Industrial Average has an abysmal record when there has been a Republican in the White House and a Congress split between the two parties, averaging 1.1% in the first two years after the election, according to Fidelity Market Research. That is the worst performance of all possible configurations.

Historians might have advised investors to jump ship when the Republicans lost the U.S. House of Representatives in 2018, leaving President Trump to work with a split Congress. But those who ignored history are glad they did. The Dow gained nearly 6,000 points before the bottom fell out in February. Even with the coronavirus selloff, the index is still ahead of where it was in January 2018.

History can be intriguing to study, but election outcomes and future market performance do not necessarily align, so it’s easy to see why experienced investors don’t react to political outcomes. Instead, investors focus on interest rates, corporate tax rates and earnings.

For example, today’s markets are largely driven by a low 21% corporate tax rate and historically low interest rates.

The outcome of a presidential election would not necessarily change either of those variables. A Democratic president might attempt to raise the corporate tax rate, but it is safe to assume a Republican majority in the Senate would thwart that attempt. Even if Democrats take the Senate majority, a corporate tax hike could face strong opposition from Republicans and even some Democrats.

As for interest rates, the Federal Reserve has demonstrated a strong commitment to keeping rates low for the foreseeable future, and it’s important to remember that the Fed functions independently from the president.

There are many arguments and counterarguments about public policy from Washington, but the fact is our government is well-balanced, and it has functioned effectively for 244 years. As divided as society seems to be right now, the historic fundamentals of our government remain the same.

So, it is important for investors to set politics aside and remember that elections have short-term effects. Meanwhile, they will be investing through many different presidencies and Congresses, and despite all of the hyperbole out there right now, the best investors follow a long-term path to their financial goals and avoid drastic moves based on an emotional response to the political season.

Zac Reynolds is chief investment officer at Oklahoma City-based Full Sail Capital, and he is one of the firm’s founding principals.