When each of us became an investor, whether we realized it or not, we entered into a deal of sorts with the market. It wasn’t a contractual obligation per se; it was more like a handshake deal with a friend we’ve known for many, many years. We trusted that based on our friend the market’s past behavior (since the 1920s, if you’re referring to the chart below), we had no reason to believe our friend the market would not keep up its end of the deal: to deliver us a return on our investment over the long haul. But in order for the market to do so, we needed to uphold our end of the bargain which was to not throw in the towel early; to not give up on it, despite it weaving off course at times. The handshake deal we entered is just that: we will get a return on our investment if we don’t cut the deal short. When the going gets rough, we have two very important things to rely on: trust and history. And therefore, in order to be fit for investing in the market, we need to in fact be people who are willing to rely on both and, therefore, uphold our end of the deal.
STOCKS RISE OVER THE LONG TERM
Sometimes, our faith and trust get tested, and this is one of those times.
The stock market is down over 25% at the time of this writing, and the bond market is down over 13%. To say this is tough to see and experience is an understatement. It causes investors to question why they ever became market participants in the first place. It causes investors to want to do just about anything to make the pain stop. We understand this more than anyone; we feel our clients’ pain always.
We want to take some time to answer the questions we’re hearing from all of you amidst this market volatility in order to offer some context to the current environment and remind you why you can and should have both trust in the market and hope for what the future holds.
Q: Why are both my stocks and bonds down?
A: It’s a good question, and you’re right—it’s probably been a long time since you’ve seen this in your portfolio. Bonds play an important role in portfolios for two reasons: their stability and their fixed income in the form of interest payments. Typically, stocks and bonds aren’t highly correlated with each other. When investors are feeling uncertain or even negative about the stock market, we usually see them take their money and run to what feels safer—bonds, which are the less risky or less volatile asset class. Therefore, it’s common to see the bond market rally when the stock market is down, and vice versa. However, this year has been unique with a combination of inflation and monetary policy to fight said inflation in the form of raising interest rates, and there has really been no place (or asset class) to hide. This year, to a historically notable degree, the stability part of bonds has been challenged.
Q: So why do bonds take such a beating when interest rates go up?
A: Bond prices and bond interest rates have an inverse relationship: when bond interest rates go up, their prices go down. Let’s think this through logically, starting with what makes a bond a bond. Bonds are loans to companies or government agencies or even the US government. In return for loaning money to a company or government agency, a bond investor receives a fixed rate of interest (on the bond’s par value or face value, not on its fluctuating market price) for the life of the loan that does not change. Because the interest rate on the bond is set, as interest rates at large change, that bond is stuck with its original rate. So, as is the case in the current environment, as interest rates at large have gone up, old bonds don’t look very attractive anymore because they have lower interest rates attached to them. Why would a buyer want an “old” bond that pays 2% interest when there are other newer bonds that pay 4%? Well, the only way to make that old bond paying 2% interest look more attractive to potential buyers is to lower its price tag. Maybe a buyer would be interested in that bond paying 2% if it can be purchased on sale because when the bond matures, the bond holder will get the full face value or par value back—not just the discounted price they paid for it. This makes logical sense. So, framing the same concept in another way, current bond holders’ bonds have taken a price tag hit at the moment, but it’s merely that: a reduced price tag that only matters if the bond is in fact sold. If you don’t sell the bond, it doesn’t matter what its price tag says—hold the bond to maturity and you will receive the full face value or par value back (and, again, you will have received all of the fixed interest income payments along the way). This is largely our strategy when it comes to owning individual bonds in our clients’ portfolios.
Q: Well it’s still really disconcerting to see my bonds down so much, so what are you doing about it?
A: Believe it or not, we design our bond portfolios with this exact scenario in mind. We design our bond portfolios with bonds of staggering maturities so that we are consistently in a position to be able to buy the new bonds coming to market (that are paying higher interest rates) with cash that’s just become available. And for clients with bond ETFs, ETF managers make sure to do the same thing. They take advantage of rising rates by buying, selling, and swapping positions all the time. Additionally, the bond ETFs we use are compiled in such a way for us to monitor their duration and cashflows, too. In other words, while this is a tough time to be a bond owner, it’s a great time to be a bond buyer, and one main way we diversify for bond investors is to always keep them in a position to act as both a bond holder and a bond buyer.
Q: So, when will the bleeding stop? Is a recession coming?
A: We wish we knew exactly, but unfortunately no one knows. But here is what we do know. We know that the market is down over 25% year to date. That’s some pretty serious blood loss already. It’s easy for all of us to say this now, but calling that loss ahead of time would have been impossible. The same goes for the future—it’s impossible to predict what’s going to happen and when. But we know that the market is a forward looking, discounting mechanism. That means that the market usually goes down in anticipation of a recession, not necessarily as a result of a recession. That also means that often, the market bottoms before a recession and then climbs as the economy falters. We also know that bear markets are shorter than bull markets. In fact, the average bear market lasts 289 days. The most recent one in our memory, which happened at the start of the pandemic, took only 33 days to recover all of its losses. Bull markets, on the other hand, are periods when the market is going up. Those last an average of almost three years! Bull markets are also more common: they’ve occurred for almost 80% of the last 91 years. And you know what else we know? We know that over the last two decades, more than half of the S&P 500’s strongest days happened during bear markets. All of this is to say that even if we have a bearish view in the short term (for the days and months to come) we would be silly to have anything but a bullish view in the longer term. But then why is it so difficult to be optimistic? Why is it so difficult to be bullish? Because stamina comes easy to folks when they’re riding the market up. When the market is going down, one day can feel like an eternity. Stamina, resilience, and hope are hard to keep when things are ugly, but stamina, resilience, and hope will reward us if we keep up our end of the deal and refuse to throw in the towel.
Annualized Performance of a $10,000 Investment between January 2002 & January 2022 ($)
Q: Is there anything I can do to help my situation?
A: Yes—you can do your very best to fight the urge to do what feels emotionally tempting. In the words of Warren Buffett, “Be fearful when others are greedy. Be greedy when others are fearful.” Resist the urge to follow the herd in this instance. In our experience (which is fairly extensive given that we’ve been doing this since 1930!), when you are feeling like you can no longer stomach further loss, this is typically an indication of a couple of things: it’s an indicator that your portfolio is already down quite a bit, and it’s an indicator that capitulation is coming and things will turn around soon. Keep in mind, too, that what feels emotionally tempting and easy right now (cutting your losses and selling in order to go to cash) becomes less tempting and less easy to reverse at some arbitrary date in the future. In other words, in our experience, folks who make that move don’t have the gumption to get back in when they should. Market timing isn’t just selling before things go down; it’s buying back in before things go up. If you’re tempted to sell when the market is down 25%, it’s hard to imagine you’ll be itching or even willing to buy back in when the market is down 30%. Or 35%. Or even 20%. And we already talked about how much price appreciation and growth happens during bear markets (see chart above again). We cannot afford to miss those crucial up-days in the market. This is why we aren’t market timers.
Q: So what is Howe & Rusling doing in this environment, then?
A: Good question. But first, let’s back up.
As “shoppers” in the marketplace, in theory, we should want to see stocks and bonds “on sale” sometimes. This is not the time to run out of the store; it’s the time to take advantage of the sale prices and possibly pick up some items we’ve had our eyes on for a while but are now a much more attractive price than they’ve been. This is especially true for clients who are still contributing to their portfolios, or those who are still earning and are able to add new savings to their portfolio. And remember: as market shoppers we aren’t just buying clothes or shoes or video games or cereal on sale. We’re investing in ideas that we believe are going to increase in value over time. So, not only is there a sale going on, but we’re investing at lower prices into ideas that we believe are going to continue to go up in value over time.
Now many of you aren’t contributing to your savings (portfolios) anymore; you are living off of your savings (portfolios). You are still able to benefit from market “sales” because we’re actively managing what you own, but because you aren’t in a position to put new money to work at lower prices, you face a different challenge. You are whom Howe & Rusling has spent its entire tenure trying to serve and protect. We see our job as protecting your wealth as best we can, and part of that is protecting you from having as much downside loss as you would have if you were exposed to the market at large. Part of our job, also, is to prevent you from making an emotionally charged detrimental decision, such as locking in losses that would otherwise recover with time.
Over the past couple of years, it would have been easy to “chase” the returns of those few large companies whose growth was unmatched in the wake of Covid (many investors did). In the wake of Covid, it may have felt stupid or frustrating to be diversified when it felt like you should have owned about 3-5 big tech names alone to beat the market. Fast forward to now, and we’re gravely reminded why we diversify. In an equal weighted portfolio of Meta, Amazon, Apple, Netflix, Microsoft, and Google this year, you’d be down about 42% year-to-date. Diversification can feel silly when the market is seemingly leaving you behind on the way up, but diversification feels like the smartest decision you ever made when the market is down.
In our Howe & Rusling portfolios, we have positioned ourselves more defensively this year which has helped our client portfolios hold up better than the markets. In balanced accounts of stocks and bonds, we’ve shifted to a slight overweight in bonds and underweight in stocks. And on a sector level, we’ve overweighted our positioning in the more defensive areas of the economy that tend to hold up better during economic downturns. Our portfolios, whether individual securities or ETFs, are always diversified across all 11 sectors of the economy represented by the stock market, but we make strategic decisions to tilt our holdings toward or away from certain sectors or styles at certain times. In this environment, we’ve overweighted our positioning in those areas of the economy that tend to be more shielded from recessionary pressures. To illustrate this point we’ll contrast two different sectors of the economy. Consider the healthcare sector: regardless of whether a person loses their job, they still need to go to the doctor, fill their prescriptions, etc. In contrast, consider the consumer discretionary sector: when a person loses their job, they might clutch their wallet a little tighter when it comes to going out to dinner or buying a new TV or upgrading their wardrobe. We’re thoughtful about this type of behavior—but rather than have a portfolio of 100% healthcare, utilities, and consumer staples names, we can consider individual companies’ exposure to recessionary pressures in order to remain diversified. We’re also overweight quality, value, and domestic exposure versus international. Economic downturns are going to hurt lower quality companies more—it is intuitive and true that solid, established companies with solid balance sheets are going to be able to withstand tough times better than companies on stilts or companies riddled with debt in order to grow like crazy. But above and beyond this sort of tactical portfolio positioning, we spend every day challenging the thesis on why we own the companies we own. We continue to own companies we believe in for the long term.
We are doing our job for you. It is never, ever lost on us how important your money is to you. We lose sleep at night over your portfolios so that you hopefully don’t have to. We work tirelessly to protect and grow your nest eggs. Down markets are part of every market cycle; the market cannot always go up. But over time, it does. As investors who are in this together, let’s have trust, let history be our guide, and hold up our end of the bargain.
Please do not hesitate to reach out to your Wealth Manager if you’d like to talk through our outlook or strategy in more detail or if you have questions you’d like to explore, and we will do the same with you. Thank you for the enormous responsibility that is managing your money for you; it is the most important part of our job.
