“In Bear Markets, Stocks Return to Their Rightful Owners” -J.P. Morgan

– by Chip Sawyer, CFA , Chief Investment Officer

On May 11, the S&P 500 closed 18.3% below its all-time high, which was hit near the start of the year, back on January 7.  If you thought bonds were a place to hide, think again.  Risk-averse bond investors have lost almost 9% since then.  January 7 seems like a LONG time ago.  At the low point today, the market was 19.9% below that high, just a whisker shy of an official bear market.

The bill has come due.  We are finally paying for the extreme generosity of the Federal Reserve and Congress when they flooded the economy with money in response to the COVID pandemic.  But unfortunately, that payment is coming in the form of the highest inflation rate in 40 years and a miserable start to the year for investors with balanced (60% stock/40% bond) portfolios.  They have watched the value of their portfolios drop by 15%.  That’s one of the greatest disappearing tricks since Harry Houdini made an elephant vanish from a New York stage.

The Federal Reserve’s change in interest rate policy has two significant effects on the stock market.  First, it reduces the multiple investors are willing to pay for stock earnings, which is why we’ve seen such significant damage to high-multiple growth stocks.  Famed investor Cathie Wood’s ARK ETFs are the poster children for this issue.  Her largest ETF is now down 76% from its high.  They’ve aged as well as the leisure suit.

We are finally paying for the extreme generosity of the Federal Reserve and Congress when they flooded the economy with money in response to the COVID pandemic.  But unfortunately, that payment is coming in the form of the highest inflation rate in 40 years

Rising interest rates also increase the likelihood of a recession, hurting the low-multiple value stocks in the financial, industrial, and discretionary sectors while helping the utilities and staples sectors.

Our Response

We have repositioned our client portfolios in response to this challenging investing environment.  As a result, on a percentage basis, they now hold more cash, more non-equity alternatives, and fewer stocks and bonds than our traditional WCA model targets.

Here are five steps we have taken: To hedge against inflation, we bought one ETF that holds gold bullion and a second ETF that owns a diversified basket of commodities. Third, we have shortened the average maturity of our bond portfolio.  In addition, we have added holdings in floating rate debt and inflation-protected Treasuries.  These two actions have helped our bond portfolio only lose about 6% versus almost 10% for the index.

Finally, there have been dramatic moves in the currency markets, with the dollar index reaching its highest level in 20 years.  In anticipation, we significantly reduced our exposure to international stocks last month.

Volatility Likely to Continue

The market’s volatility is likely to continue as the Fed raises rates and the war in Ukraine drags on.  So don’t get mesmerized by the ups and downs of the markets.  Those day-to-day shifts are no more informative than the meanderings of a squirrel.

This is not the time to panic.  A well-diversified portfolio is an investor’s best defense against market volatility.  Holding cash allows us to buy good companies at lower stock prices.  That strong dollar that has hurt international stocks’ value will eventually enable U.S. investors to buy very cheap international assets.

Much of the damage is already behind us, as the market’s multiple has declined from 23x to start the year to 17x today.

The quote from J.P. Morgan reminds us that patience is an investor’s best friend.  Another great investor put it more plainly when Warren Buffet explained, “The stock market is a device for transferring money from the impatient to the patient.” There are still great companies with outstanding long-term prospects in the market.  And impatient investors are putting those stocks on sale.

As we do our best to both safeguard your portfolio and find attractive opportunities, we’ll be sure to stay patient.

Take care,

-Chip Sawyer, CFA