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5/19/2022

Markets and perspective update from DRW Financial

Hi!  It's been a little under a month since my last post about the markets and my foreword looking perspectives, and I thought it was time for an update.

On a personal note, I am in the recovery stages of my first COVID infection.  I successfully (luckily?) avoided the virus for 2+ years, didn't really suffer the vaccine hangovers that some did, etc, but apparently my number came up.  I think I will be ok.  We are currently waiting to see if I infected my family; it's been a couple of days and so far they seem to have escaped.

And if you want a summary of what's below, this is a simplified version: the markets are in a funk, I know and don't like it any more than you do, and I think there's a chance it gets worse for a while.  But ultimately, my clients and I are following an approach designed to weather the storm in pursuit of their financial goals.

The longer version tilts to the "nerdy" and relies on a lot of charts.

Interest rates

It may be my past life as a bond trader informing my perspective, but I still see interest rates as the primary metric to watch for insights into the health of our economy and markets.
First, I want to highlight some fairly straightforward relationships:
Picture
The Federal Reserve and the US Treasury are both meaningful actors in our economy, and their roles overlap.  The Fed's toolbox has two main options: they can essentially set a floor on bank lending rates, and they can buy & sell bonds (historically mostly treasury bonds) in the market to influence market yields.

The chart above shows the relationship between the "effective Fed Funds" rate and three others:
  • 2 year treasuries (these trade very tightly with the Fed)
  • 10 year treasuries (the relationship is clear, but there is more "spread" and variability between this spot and the Fed over time)
  • 30 year fixed rate mortgages (to my eye, these relate to the 10 year treasury pretty consistently at a +X amount of spread)
All of that to say, the Fed is on a course to raise their rate in an attempt to slow inflation.  They announce their moves one at a time, but we can look to the so-called "dot plot" that tracks each member of the Fed's current expectations about where rates will end up in the current cycle:
Picture
Without dwelling on this piece for too long, my main takeaways is that even the more aggressive members of the Fed see topping out around 3.5%.  This could always evolve, but let's take as a current premise that they are correct for now.
Flipping back to the comparison of the effective Fed Funds rate and the 10 year treasury:
Picture
The treasury market is "out in front" of the Fed at the moment; the market pushed yields at this spot as high as 3.12% on May 6 before falling back to ~ 2.8% as of this morning.
My current expectation is that the treasury market is going to trade sideways for a while, as the Fed "catches up", and absent additional inflationary surprises, I would expect the 10 year to end this cycle in the 3 - 4% range.  (I don't profess to know, just guessing based on the historical pattern).

Speaking of inflation, the market has an opinion about where we are headed:
Picture
The US Treasury issues both "regular" and "inflation adjusted" bonds; at a given maturity, the difference in market yields between those two informs a so-called "breakeven" rate that we assume approximates inflation over that period.  This seems to suggest the market things inflation over the next 5 to 10 years will average out to around 3 - 3.5%

The image above shows the breakeven rates at the 5, 10, and 30 year spots.  It is not unique over that history for the 5 year spot (shown here in blue) to exceed the 10 and 30 year spots, but the degree of excess in recent history is meaningful.  Here it is zoomed into the last 12 months:
Picture
To me, this suggests that the bond market (currently) believes that inflation will top out and reverse course within the next 5 years, or quickly enough so as not to impact values as much over the 10 year span.

All of this has implications for portfolios holding bonds or bond funds.  Most of my clients do have allocations to bonds, and those positions took a major hit as interest rates rose.  If interest rates continue to rise, the value of those positions will continue to fall...that is simply the nature of bond market pricing.
However, bonds and bond funds distribute meaningful cash flows to investors that allow for tactical reinvestment, and if the thesis about rates going sideways for a while is correct, the worst may be over for high quality bonds.

Stocks

Longtime clients and readers know that I have held concerns about stock market valuations since at least 2019.  By the end of that year, and using the price to earnings multiple for the S&P 500 index, stocks were overvalued by as much as ~ 50%; using an alternate valuation version that "smooths" the earnings part of the metric over a 10 year period made it look even worse at about 80% overvalued.

There were some structural changes to consider: the tax regime was very different coming out of 2018, and that resulted in a step-change in corporate profits that could potentially justify the growth in P/E.  And then, after the COVID shutdowns hit the markets and stimulus efforts began, all bets were off.  So many dollars hit the market and eventually found their way to risk assets (stocks, investment properties, cryptocurrencies...) that the S&P rose about 47% from the end of 2019 to the high point in December 2021.

Even after the recent sell-off, the S&P is still about 20% higher than December 2019.  Is this an interesting time to point out that the nominal compound annual growth rate of the S&P since 1871 is about 9.37%?

Projecting stock market valuations is fraught; one may Google recent headlines from big banks like JPM Chase, Morgan Stanley, Bank of America and get a sample of where they see the S&P closing out 2022.
My view has been that I won't be surprised if the index revisits levels seen at the end of 2019; that would represent another ~ 20% decline from current levels and approximately a ~ 40% decline from the highs.  My concern around the market falling that far has actually lessened a bit in recent weeks, but ultimately my intention is not to try to time the markets, but to prepare for range of outcomes based on relative likelihood...which is a good segue:

So what do you do?

For myself and clients who ask me to manage their investments, my process is rooted in study and experience:
  • Recognize that the nature of the stock market is volatile.
    This graphic from Capital Group / American Funds shows the historical frequency of different amounts of decline:
    ​
Picture
  • Understand that there are earnings underlying stock market valuations; the companies that we pay for streaming TV, gasoline, toilet paper, and smartphone services typically make a profit, and those profits are available to shareholders...that's those of us invested in the market
  • Choose to diversify among risks; this can mean avoiding the risk of a single company or sector imploding by buying index funds or limiting exposure to a fraction of the portfolio, or it can mean holding different types of assets (stock & bonds & cash & XYZ)
  • Dial in an individual's portfolio to their actual life situation; for those who expect to need access to a high percentage of their savings within a few years, we generally pursue a lower risk portfolio (with lower opportunity for growth and gains).  For those with years of employment income and savings opportunities ahead of them, we generally tilt towards higher risk portfolios
  • In taxable accounts, be tactical about "tax loss harvesting", which is a technique for lowering income taxes during a sell-off
  • Don't chase the fad (the possible exception being the Treasury's "iBonds" -- I have generally been recommending that clients with excess savings and who do not need liquidity to consider this option for the next 12+ months)
  • Stay the (appropriately decided) course.  I cannot quote performance data here, but will be happy to run numbers for my clients on request.  I looked at YTD returns across my client base this morning, and those generally align with expectations: younger people have more exposure to stocks and are down more than older people; those who expressed a greater sensitivity to risk are generally down less than those with a higher risk appetite.
  • Always check your premise, and update as necessary
Stay safe out there.  If you are a client, please feel free to reach out with questions about your investments and financial planning concerns.  If you are not a client and find yourself interested in an advisory firm that takes the time to nerd out on occasion, feel free to fill out our contact form here: ​https://www.drwfinancial.com/contact.html
This blog post is intended as market commentary and to be educational.  It does not imply certain knowledge of where any market or index is headed.  Past performance does not imply future performance.

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    Author

    David R Wattenbarger, president of DRW Financial

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