Three Thoughts

Following are three summaries of items that interested me over the last week or so.

First, I am an ardent follower of the think tank and investment advisory firm Research Affiliates and I found their recent comments and analysis very interesting.  Following are the thoughts put forth by Vitali Kalesnik, PhD, Director of Research, Europe, of that firm where he expresses a cautious view of multiple recession indicators that he believes are currently present:

o   Higher interest rates

o   The prolonged Russia-Ukraine war, where sanctions are pushing energy prices higher and increased military spending will constrain other fiscal stimulus

o   Increased public infrastructure spending on renewables and, likely, nuclear power, further diverting governments away from other fiscal stimulus.

Secondly, Research Affiliates recently updated their Asset Allocation Interactive model and it suggests risk/return profiles for the major asset classes over the next 10-year horizon (see the chart below).  As shown, it indicates that investments in International Developed markets (EAFE), Emerging Markets , U.S. Small Cap and Europe are likely the highest returning AND highest risk asset classes.  U.S. Large Cap equities are forecast to underperform those asset classes, but still exhibit high risk.  The lower return (and lower risk) assets include broad U.S. Core bonds and U.S. high yield bonds.  So, no surprises here but interesting to see a model supporting a popular consensus and historical view.

And thirdly, you have all heard it from me many times to hold tight since no one can time the market, no one rings a bell when it is time to get back in, and based on history, long-term investors will be rewarded for sitting tight.  Echoing this thesis is a recent post from Fidelity investments titled, “Three Reasons to Stay Invested Right Now” with these thoughts:

1.      Market volatility is normal and stocks have historically recovered even from major downturns and delivered long term gains

2.      The best returns often happen when everything feels the worst

3.      Holding cash may also be risky due to inflation

In this environment it is best to ensure that your portfolio has some inflation protection built-in, that your bond exposure is appropriate, and your tolerance for risk is matched with your investment strategy.  At Dattilio & Ash we consider all these thoughts for all client accounts.

A "Sea of Red"

There are not too many good things to report for the second quarter of 2022.  In fact, the media reported that Q2 ended the worst first half of the year since 1970!  In a highly unusual occurrence, both stocks and bonds declined due to a confluence of shocks including heightened inflationary pressure, higher interest rates, risk of a slowing economy, and continuing supply chain disruptions, as well as fallout from the Russia/Ukraine war.  Though the sea of red numbers in 2022 is discouraging (see table below), it is encouraging to note that a longer term focus shows that the equity year-to-date total returns do not negate the positive values of the prior two years (except NOT for fixed income, though!).

The table shows large negative returns across all the major asset classes for Q2 and for the first half of the year.  Large cap U.S. equities (IVV) bounced off its low in mid-June but is still down -16.16% during Q2 and -20.00% YTD.  Small- and mid-cap equities (SCHA and SCHM) did worse during Q2 being down -17.36% and -16.92%, respectively.  Likewise, intl. developed and emerging market equities (SCHF/SCHE) were down but only a bit less.  Bonds also were down during Q2, but not as much as equities with core bonds (SCHZ, -4.79%), inv. grade corporates (LQD, -8.40%), and high yield bonds (HYG, -9.48%) continuing to be victims of higher rates/widening credit spreads due to inflation and a tightening Fed.

I wrote 11 blog posts during Q2 and they all dealt with weak market performance and how to cope with it.  As I have said many times and in my recent blog post, Spinning Wheel,

 “If you are employed, have a long time horizon, and have sufficient income/net worth to support your desired lifestyle, it is in your best interest to stay invested.  The trouble with getting out of the market now is that it will be harder to recover lost value when the market turns up again.  Also, we will then need to agree on the correct re-entry point (very difficult!)”

Spinning Wheel

 What goes up must come down
Spinning Wheel got to go 'round
Talkin' 'bout your troubles
It's a cryin' sin
Ride a painted pony
Let the Spinning Wheel spin

The lyrics from the Blood, Sweat & Tears song Spinning Wheel indicate a metaphor for the cycles we all go through.  Such is the experience we have seen in the capital markets recently.  Only a short week ago it appeared that all was lost and there was no hope, but this week the market delivered a rebound!

The chart below shows the cumulative value of the S&P 500 (IVV, the blue line) and its weekly returns (the orange bars).  As you can see, The S&P 500 has been in a volatile downward path since the beginning of the year.  In fact, before this past week, over the past 24 weeks the S&P 500 has had negative weekly returns 17 times and 10 of the past 11 weeks!   This week, however, we saw a nice +6.6% rebound.  The S&P 500 is still down -17.3% YTD, but the recovery did offer a pause in the negative market psychology.

Most of the recent market commentaries have bemoaned the troubling economic situation we are in; but it will not last forever!  When you have a long time horizon, this moment in time is simply a blip.  If you are employed, have a long time horizon, and have sufficient income/net worth to support your desired lifestyle, it is in your best interest to stay invested.  The trouble with getting out of the market now is that it will be harder to recover lost value when the market turns up again.  Also, we will then need to agree on the correct re-entry point (very difficult!)  As said by my peer in the industry:

 Scott Clemons, Chief Investment Strategist, Brown Brothers Harriman

“We’re trying hard to keep nervous investors in the market, reminding them that no one rings a bell at the end of a bear market, and that the recovery can be both swift and counterintuitive. In fact, the average return of the S&P 500 from the date of a bear market entry (not the trough, but the 20% trigger) is 23%. You don’t want to miss that.

 However, for nervous investors, we do point to the benefit that dividends offer, not just for cash flow, but as a market of a company with plentiful free cash flow and a strong balance sheet. Quality wins over time!”

 The prior week was the worst we have seen this year and this week was tied for the best (with May 27, 2022)!  All D&A client portfolios are made up of many core holdings of high-quality investments and are well-positioned to recover when the market recovers.  

No Zig

2022 has been a bust from almost the very beginning of the year.  Most telling has been the almost total lack of diversifying positions helping to smooth performance.  For example, bonds have performed almost as badly as stocks.  There has been no “zig” to offset the zag!

I have shown charts all year long showing the path of all major asset classes trending down.  The S&P 500 (IVV) hit a new low for the year yesterday, down -21.06%, while core bonds (AGG) were down -12.52%.  Naïve diversified portfolios tracked down in a similar fashion with the iShares Core Growth (AOR) ETF down -16.96% and the iShares Core Moderate (AOM) ETF down -15.51%!  No respite for the weary!

The causes for the weak capital market performance can be tracked to several things all occurring at the same time.  The external effects of the Russia/Ukraine war are most significant with impacts on oil and grain/food prices and the consequent impacts on inflation and global supply and demand.  Also, thought leaders point towards the lagged effect of excessive fiscal stimulus and Fed easy money policy in the wake of the global pandemic as another contributing factor to high inflation; with the Fed now “tightening” to try to slow the economy and quell inflation.  Again, with the consequent potential impact on economic growth and corporate earnings, we are seeing stock valuations and prices drop.

As bad as it has been, if you have a long time horizon (10 plus years) and capacity for risk (employed, with no need to tap your investments), history shows that “sitting tight” will reward the patient investor.  No guarantees, of course!

Smooth or Bumpy?

The metaphor of a “roller coaster” is often used to describe the capital markets.  Ups, downs, quick turns; they all apply to the gyrations we see in the markets.  This year is no exception!

Most surprising this year, though, are the gyrations we have seen in the bond markets.  A newly-turned “hawkish” Fed has put all parts of the yield curve at risk with targeted increases in the Fed Funds rate and planned selling of bonds from Fed inventory impacting the long end.  Moreover, the potential for a weakening economy begs the question of corporate credit strength and the widening of credit spreads.

Nowhere have we seen this more evident than in the recent performance of short corporate bonds (SLQD) versus intermediate term corporate bonds (LQD).  As seen from the chart below, the recent performance since May 3 shows increased volatility and varied performance.   SLQD (the green line) has been decidedly “flattish”, whereas LQD (the blue line) shows a nice “trough/peak” profile; core bonds (AGG, the gold line) is somewhere in the middle.

These profiles looks something like a classic risk versus return tradeoff; SLQD is less risky and delivers less return, whereas LQD has shown more risk and more return.  No one knows if rates will continue higher or revert lower due to potential for impending recession or other causes; no one knows!  Consequently, if you have an aggressive risk profile you would opt for the “blue line” in lieu of the “green line”, and vice versa.  Or, as I prefer, regardless of your risk profile you would opt for “some” green line exposure to smooth your return profile and provide well-diversified exposure to the bond markets.

Now or Later?

For Star Trek fans, you may remember the movie Star Trek: Insurrection that dealt with immortality. The plot doesn’t really matter, except that it portrays the thought that living forever is a good thing.  This reminds me of the “nows” or “laters”. 

If you could live forever, would you do everything you possibly could do “now” as quickly as you could, or would you delay doing anything since you could always do it “later”. In other words, would you be a doctor this year, a lawyer next, a construction worker the time after, etc., etc., or simply delay any of these things until “later”?  More importantly, what does any of this this have to do with investing?

Let’s assume you came into some cash, either from an inheritance, a bonus, or some other “liquidity event”.  Given the market environment today, what would you do?  Of course, it mostly depends on what your investment goals are, but even if you know what your goals are you still need to decide on the timing, i.e., “now” or “later”?

I wrote a blog post way back in February 2020 that dealt with this topic in some detail and is worth a re-read (https://www.dattilioash.com/our-blog/2020/2/24/invest-all-at-once-or-over-time), but given today’s market dynamics it makes sense to think about this again.

After the trouble we have seen in the market since January, it seems like everything is oversold and there is the potential for a rebound.  For example, per the chart below, since the beginning of this year almost all the broad indices are down – a lot, including bonds!  S&P 500 (IVV) is down -16.0%, small cap stocks (SCHA) are down -18.7%, emerging market equities (SCHE) are down -14.4%, and investment grade corporate bond (LQD) are down -12.8%! And also, near term volatility is high at over 20%!

Though there are no guarantees, putting money to work in this environment due to the pullback certainly feels like a good entry point.  We must remember, though, that risks in the economy still exist with the potential for continued inflation, supply chain disruptions, rising interest rates, and a weakened slower growth economy impacting corporate profits.

Even if you have a high tolerance for risk and have a long time horizon, there continues to be a large amount of risk in the markets that is prudent to avoid.  For a lump sum of new money that is significant to your overall wealth, I recommend entering the market slowly over a 6-month time frame. Operationally, we can identify the lump sum amount and we will initiate a transfer of 1/6th from your bank into your investment account over the next six months to get invested.  For smaller sums we can get invested more quickly.

"Black Swan of Black Swans"

This has been a great weekend for reading investment news.  Starting with Barron’s and ending with the many newsletters I get via email, there are a vast dichotomy of opinions.  I say opinions because no one can predict the future!

Let’s start with the thoughts of Michael Gayed, CFA, a leading portfolio manager and tactical asset allocator at Toroso Investments.  He has been fairly successful and makes his living by going risk-on and risk-off depending upon the triggers indicated by his models.  His investment strategies have been pummeled this year by markets that are exhibiting anomalous behavior.  As he said on Saturday,

At precisely the time when many investors would likely be turning to Treasuries for safety, government bonds posted one of their sharpest and steepest declines in history. Treasuries should be behaving like a risk-off asset, but they’re not.

He terms this situation the “Black Swan of Black Swans”; the worst case of when highly unpredictable events occur beyond what is normally expected with potentially severe consequences.  He goes on to say that his model is not wrong, it is simply the environment that is wrong, per below:

This is not a situation necessarily where it's the signals that aren't working depending on the Fund. It's the opportunity set that isn't.

Consequently, his funds that are supposed to immunize investors from these kinds of weak markets have lagged significantly year-to-date with one fund being down -37.42% (ATAC US Rotation ETF, RORO).  He does go on to say,

 All I can say with confidence is that this is an incredible dislocation happening in markets, and that generally, the best returns tend to come from buying after a large drawdown.

So, he offers hope and a belief that we all live in a small “sample” of a much larger universe of investment performance.  He closes with the final thoughts:

I believe everything is about to change in a way that at least allows for the potential for the funds, and opportunity set, to revert to historical behavior.

With an ominous caveat, 

At some point.

Special Blog Post: "Vortex of Downward Misery"

Tom Lee of Fundstrat Global Advisers, a frequent guest on CNBC financial news and persistent bull, had some interesting comments during his appearance yesterday on CNBC.  His positive comments were a telling counterpoint to the “vortex of downward misery” we are all seeing in the markets.

He correctly pointed out that the market declines have accelerated downward over the past week, but bonds have been fairly stable and the volatility index has risen and stabilized, but not “spiked”.  Also, he felt for this market to deteriorate further, he would expect high yield bond spreads to widen and get “crushed”, but that has not happened [yet, that I need to note here!].

He also put forward an interesting set of statistics.  Since 1940 there have been 16 occurrences of markets down 16% in 4 weeks; of these 16 occurrences, 12 of the 16 were higher by double digits 6 months later, and 14 of the 16 were higher 12 months later with an average return of 20%.  We shall see!

So, though there are plenty of reasons to be bearish not the least of which is heightened inflation and the Russia/Ukraine conflict, as I have highlighted ad nauseum in previous blog posts this year, there are some reasons to have a positive view going forward.  As we all know, though there are no guarantees, the markets have always rebounded to new highs given enough time.  In fact, don’t forget that our most recent all-time high was not too long ago on January 3, 2022!!

Update Your Retirement Plan Now!

Last week’s blog post, “Do or Die” Redux, recounted previously posted thoughts to consider during weak markets.  As I said then, “As long as we are comfortable with your time horizon and risk appetite, I do not recommend selling now.  If you sell now, it will be more difficult to recover the lost market value. Given the recent weakness in the markets, this is a good time to evaluate your lifestyles and to do more planning for the future…”

To that end, please see my short 5-minute video blog from last November where I quickly preview the investment planning for retirement that I do for Dattilio & Ash clients.  In it, we model projected income, expenses, goals, and investment assets across 1,000 different investment scenarios to calculate your personalized “probability of success”. We are happy to create or update a plan for you as needed.

"Do or Die" redux

As I have reported to clients, this is the worst beginning of a year since 1942!  Of course, that is no solace to me or you or anyone who has lost money in the market!  As I have been reporting in my recent blog posts, there is a culmination of economic and political events all converging at the same time to increase “fear” and cause caution in the markets.  From the “hawkish” Fed, increasing interest rates, heightened inflation, still-disrupted supply chains, and the Russia/Ukraine conflict, there are many reasons to be cautious.

S&P 500 large cap equities (IVV) are down -12.5% YTD (with small cap, international, and emerging markets down more) and investment grade corporate bonds (LQD) are down -15.0%, a highly unusual relationship that is fostered by the Fed threatening to move too fast with its tightening cycle.  As bad as this feels, the beginning of the Covid pandemic during March 2020 saw stocks lose -35% (but bonds did provide some negative correlation at that time, unlike now).  Over time, I do expect bonds to recover and produce a long term rate of return equivalent to its current yield of about 4%.  Likewise, stocks are struggling now, but unless we all start to live in caves, have upside in the future.

As long as we are comfortable with your time horizon and risk appetite, I do not recommend selling now.  If you sell now, it will be more difficult to recover the lost market value. Given the recent weakness in the markets, this is a good time to evaluate your lifestyles and to do more planning for the future, as recounted in the following D&A blog post “Do or Die” from July 20, 2020:.

The New York Times published a book review on July 12, 2020 that bears noting.  It has an ominous title, “Die With Zero”, but it does highlight an interesting perspective on retirement planning.  As the review states, the book covers important concepts on “why you save and how you live.”

Most financial and investment planners will tout the benefits of tax-deferred saving.  The benefits of compounding of returns within tax-deferred accounts are well-documented and, everything else being equal, tax-deferred accounts always beats taxable accounts on an after-tax total return basis over any time horizon.  So, if that is the case, keep the money invested in tax-deferred accounts as long as you can.  But, for what purpose??

Certainly, as I have indicated in previous blog posts (“Is there a Number for You?”, https://www.dattilioash.com/our-blog/2020/4/30/is-there-a-number-for-you), cash flow testing of expenses and income overlaid with your investment portfolio is important to help you determine your probability of retirement success.  If you have a high probability of success and a good amount of excess “cushion”, then you owe it to yourself to think about how you want to deploy the excess – whether save it for your heirs, gift it currently, or spend it currently on something that you value.

These are very personal decisions and only you can decide on the best answer for you.  My role, as an investment planner, is to bring this point to your attention and identify the pros and cons.

Strategic Bond Math Explained

It seems obvious now!  Hawkish Fed, huge fiscal stimulus, big pickup in inflation; everyone knew interest rates were going to go up and short bonds were going to outperform long bonds!   But, it wasn’t obvious!  The Fed is moving to control inflation and simply getting interest rates closer to a “normal” level, the fiscal stimulus simply replaced private sector economic activity that was diminished by the global pandemic, and the pickup in inflation, though serious, is simply catching up to a 2.25% long term trend line from its sub-2% levels of the last 10 years.   

Bonds with a short “duration” have less interest rate risk, i.e., the risk of prices going down when rates go up, compared to long bonds.  For example, a bond with an effective duration of 2 years will fall in value by 2% when rates increase 1.00% (e.g., from 2% to 3%), compared to a bond with an effective duration of 9 years that will fall by 9%.  This is simple bond math.

But, just like in the stock market, no one can predict the bond market. Per the table below, though short bonds (NEAR) have outperformed long bonds (LQD) on a year-to-date and 2-year time horizon, over longer 3- and 5-year horizons long bonds have outperformed short bonds.

Underweighting long bond exposures was a prudent strategy over the last two years given the risk-return tradeoff when rates were at historic lows, but re-targeting bond exposure to shorter bonds over a longer time horizon would have missed some of the longer-term positive return.

So, going forward there is plenty of risk in the market, but as I am known to say, best to stick with a long-term strategy attuned to your risk profile and targeted to help you achieve your goals.

What's With Bonds?

Like I wrote last week, so far during 2022 bonds have generated large negative returns.  Bonds are supposed to be less risky alternatives to stocks, so what goes?  Following is a brief discussion.

Bonds are financial obligations of a legal entity, either a government (e.g., the U.S.), a corporation (e.g., Verizon), or some other structure.  In the most basic form, they are analogous to a bank certificate of deposit in that they have a fixed principal amount upon which interest is paid over a set term.  In bond parlance, the par value of a bond earns a coupon rate that is accrued and paid periodically over a set term.

For a bond that pays a fixed 3% coupon on a fixed par value for a term of 10 years to yield 3%, any change in the general rate of interest will impact the value of the bond; either up or down!  A bond yield has two component parts:  the risk-free rate (e.g., the U.S. treasury yield) and a spread over the risk-free rate termed the “credit spread”.  Since the coupon is fixed, any increase/decrease in the general level of rates will cause the value of the bond to go down/up, so that the obligation continues to offer a yield that is competitive with the general market.  Complicating things further, if risk-free rates are rising AND the bond is issued by a corporation with a weakening financial condition, the underlying credit spread (as a proxy for risk) would widen (i.e., go up) compounding the rate increase so that the bond value would go down ever further. This is what we have seen happen so far this year, per the chart below.

As seen from the above chart, the 10-year constant maturity U.S. Treasury (the red line) started the year at a yield of 1.52% while the credit spread for a common investment grade bond index (the blue line) was a tame 0.98% implying a total yield for an average corporate bond at 2.50%.  During the year the 10-year treasury rate trended higher increasing by 1.31% to peak recently at 2.83% while credit spreads similarly increased by 0.28% to 1.26% implying a total increase in yields of a whopping 1.59% and a total corporate bond yield of 4.09%!  Historically, this is a large jump in rates!

Looking over our shoulder, it is easy to decipher the cause; a hawkish Fed tightening monetary conditions to help slow down heightened inflation and cool down an economy that may be overheating.   Other factors like the Russia/Ukraine conflict, persistent supply chain issues, and technical aspects also had an impact.  Higher interest rates caused the value of bonds to decline; in fact, investment grade corporate bonds (LQD) with a duration of 8.9 years are down -12.7% year-to-date through April 14, 2022.  Correspondingly, U.S. equities (IVV) are down LESS at only -7.5% over the same time horizon, but other diversifying equities like small- and mid-cap, international developed and emerging market equities are down more.

The Fed has telegraphed that more monetary tightening and rate increases are in the plan, depending upon how things develop over the near-term horizon, so more pain could be in store.  For clients with a long time horizon and higher risk tolerance, D&A has been underweighting bond allocations by up to 10% over the past year and on a narrow basis this was the right thing to do.  No one knows how the future will emerge, but sticking with a long-term strategy to achieve your goals is still the prudent thing to do.

Most Interesting to Me

The drumbeat since the beginning of the year has been loud and strong.  Run for the hills!  As I have reported since January, the news has pointed consistently to dire straits.  After two years of huge fiscal/monetary stimulus to protect the economy from the effects of the pandemic, we see a hawkish Fed telegraphing a new monetary tightening cycle to cool an overheating economy, increasing inflationary pressures, persisting supply chain issues, and the Russia/Ukraine conflict; plenty of reasons to be a bear!

But, running for the hills is not the answer!  No one can outguess the market!  As you can see from the chart below, except for bonds that have been on a consistent downtrend from the beginning of the year (the black line, AGG, and the red line LQD), despite the downtrend, there have been pockets of recovery that elicited some hope for a recovery.  In fact, if you were clever (or lucky!) enough to have bought the S&P 500 (IVV, the green line) at its low on March 8 and sold it on March 29, you could have garnered an +11.3% return; such is the nature of volatile markets!   

What continues to be most interesting to me is how the bond market (AGG, -8.2%) has “underperformed” the stock market (IVV, -7.1%) on a year-to-date basis.  For accounts with a long-term focus that could tolerate more risk, D&A took a position to underweight core bonds by up to 10% of target and it has worked out on a narrow basis, but other equities (e.g., small cap, international developed, and emerging market equities) have taken a bigger fall leading to some total portfolio underperformance on a year-to-date basis. As always, we expect a long-term focus will reward those investors who stay the course with the diversifying equity sectors that are currently out of favor.

Still, Relatively Well-behaved!

My Feb. 2, 2022 blog post, titled It’s Always Something!, highlighted the fact that it is always something!  No sooner did we begin to emerge from the grasp of the global pandemic then plenty of fiscal stimulus combined with Fed easy money and supply chain disruptions finally caused inflation to begin to accelerate.  And then, we watched as global geopolitical turmoil surfaced with Russia invading Ukraine; all while interest rates started to perk up and touch multi-year highs!  Consistent with these troubling situations, the markets have been volatile and down pretty much across the board, but still relatively well-behaved; especially when compared to the -35% drawdown that accompanied the beginning of the covid pandemic!

As seen from the table below, large cap U.S. equities (IVV) are only down a bit at -4.57% during Q1, though they we down as much as -12.9% during the quarter.  Small- and mid-cap equities (SCHA and SCHM) struggled a bit more, down -7.37% and 5.46%, respectively.  Likewise, international developed and emerging market equities (SCHF/SCHE) were down about a relatively well-behaved -6%; surprisingly tame given the turmoil overseas!  Bringing up the rear were core bonds (SCHZ, -5.84%), inv. grade corporates (LQD, -8.38%), and high yield bonds (HYG, -4.73%) as victims of higher rates/widening credit spreads due to fears of a weakening economy.  So, the traditionally LESS risky bonds underperformed MORE risky core equities.

Strategically, and mathematically(!), underweighting bonds was the right move during Q1, but bonds continued to be a drag on total portfolio performance.  A slow rise in rates will hurt bond returns in the near term, but will normalize over time; over a long time horizon, bonds should be less risky than equities and serve as a ballast when equities fall.

As I wrote in my Feb. 2, 2022 blog post, It’s Always Something!,

If you have a long time horizon and can tolerate market volatility, a larger equity content has been shown to reward investors.  D&A strives to ensure that client accounts are carefully managed to the appropriate level of equity content and risk suitable for each client.

When to Sell?

It is natural to get worried when the value of your investments goes down; no one likes to lose money!  But, as we all know, that is part of the process; markets go up and markets go down.  So, assuming you have a long-term investment strategy that is attuned to your risk profile, when do you sell, if ever?

Every down market is different, but our most recent experience with the market reaction to the COVID pandemic in 2020 is telling.  At its worst, from the chart below, the global equity markets (VT, the green line) tumbled -34.2% due to fear and the economic effects of the pandemic.  However, as we all know, markets recovered strongly once the situation got under control and became normalized and markets reached new heights in January 2022.  U.S. markets (IVV, the blue line) had a similar drawdown, but reached higher highs than the global equity markets.  Core U.S. bonds (AGG, the gold flattish line) meandered aimlessly during this time frame to a mostly flat-line profile.  In the context of the pandemic, this latest Russia/Ukraine crisis has a long way to go with global equity markets (VT) showing a recent drawdown of only -13.2%.

So, when do you sell, if ever?  It is really two decisions, when to sell to get out and when to buy to get back in; each decision is critically important, and no one can outguess the market.  Clearly, selling did not make sense during the pandemic since the market recovered and reached new heights.  Yes, you could have sold at the recent high and bought back at the recent low, but that is all market timing and study after study shows that no one can consistently outguess the market except by luck. 

I sound like a broken record (for those who remember what a broken record sounds like!), but best to stick with a long term investment strategy that matches your risk profile to achieve your goals.

Special Guest Blog Post - The Fed's Next Move: Ukraine Changes the Picture

As all of you know, I usually write weekly blog posts on the Dattilio & Ash Capital Management web site.  These blog posts are usually about 3- or 4-paragraphs long and reflect my views on current investment topics including investment strategy, retirement planning, economic events, etc.

However, this week I read a thoughtful market commentary from Charles Schwab & Co., Inc. titled “The Fed’s Next Move:  Ukraine Changes the Picture” that I agreed with and felt it would be appropriate to share it this week. 

The article highlights the patience shown by the Fed to head off inflation with a slow and methodical tightening of monetary policy, only to have the Ukraine-Russia conflict complicate matters with a shock to the economic outlook.  War in the Ukraine has caused a surge in some commodity prices that potentially could slow growth and financial and other sanctions could disrupt financial markets. The article ends with a familiar refrain that sounds like something I wrote: “Despite the uncertainties in the outlook for the economy and Fed policy, we believe investors should continue to hew to their “best-laid plans”.  Those with a long-term strategy that suits their risk tolerance and capacity should stick with their plans”.

What Next?

January was a tough month due to Fed tightening and inflation fears and February deteriorated further as the Russian invasion of Ukraine rattled global markets.  My blog post on February 2, “It’s Always Something!” highlighted the fact that managing risk is part of the investment process and as long as your risk profile matches your investment time horizon and goals, your chances for success are improved.

Per the table below, most every asset class (including bonds!) was down for the first two months of 2022 with the only major exceptions being gold and energy; gold as a traditional safe harbor and energy due to potential supply disruptions causing an historic price spike.

Going forward, there continues to be significant risk in the market.  Financial sanctions imposed on Russia from the western countries can pose a serious threat to economic growth and financial market stability around the world. This is mostly due to Russia’s large energy exports to the European markets and global supplies but also due to the curtailing of money flows through SWIFT and other systems.

From a portfolio management perspective, the turmoil has caused most asset classes to move into negative territory and diversification, once again, leading to underperformance. For example, key diversifiers like emerging market bonds, REITs, and factor exposures in momentum and minimum volatility (of all things!) have been a drag on total portfolio performance. Over time, of course, we expect these exposures to revert to a more normal profile.

Inflation Risk

My last two blog posts dealt with “risk” and justifiably so given the collective psyche we all face.  Of all the risks, perhaps inflation is the most concerning.

“U.S. Inflation hit 7% in December, fastest pace since 1982” (Wall St. Journal, Jan. 12, 2022) and “Red-hot Inflation Data Headlines Volatile Week for Wall Street” (NASDAQ, Feb. 11, 2022) are two recent headlines prompting fear in the capital markets and on Main Street!

But, alternate views are starting to show up!  The New York Times, perhaps with a clearer head, reported that possibly a “duller” and more reasonable headline could read “Inflation Remained Stable, Well below its October Peak” in “Inflation May Have Already Peaked.  The Fed Needs to Step Gingerly.” (New York Times, Feb. 11, 2022).  This is due to the fact that the monthly rate was up only 0.6% in January and over each of the past few months, down from the recent high 0.9% monthly rate in October 2021.

As shown in the table below, over the past 9 years prior to 2021, inflation was quite subdued with an average inflation rate of only 1.6%.  Including the large 7.1% inflation rate in 2021, the 10-year average inflation rate is still only 2.12%; a number that is quite benign and at the Fed long term target.

None of this is to imply we have nothing to fear from inflation since we all see it in food, energy and almost everything we buy every day and large inflation is disruptive to a normal functioning economy. The supply chain problems due to the pandemic and the huge Fed and fiscal stimulus have been well-documented triggers to the current heightened inflation.  Going forward, we are hopeful that market forces can help solve the supply chain issues and the Fed can ease slowly to a more “normal” interest rate environment with a complementary dose of fiscal restraint.  

In the meantime, there is no benefit trying to time the market!  As I ALWAYS say, best to ensure that your investment strategy is consistent with your risk tolerance and matched to your objectives to help you achieve your goals.

It's Always Something!

Many years ago I recall an advertisement by a major insurance company with the tag line, “It’s Always Something!”  The ad was accompanied by a picture of the earth with earthquakes, blizzards, hurricanes, and other natural disasters causing calamity.  The financial markets have a little bit of that now with inflation fears, rising rates, dropping stock prices, not to mention the turmoil in the Ukraine, all contributing to a discouraging January!  But, how bad is it?

Last week I posted a blog dealing with drawdown risk, the amount of value lost from a recent peak to trough.  The drawdown for the S&P 500 (IVV) through January 26 was a notable -9.3% (that recovered somewhat through today).  Given that the S&P 500 was up +28.8% last year, it took only less than one month to give up about 32% of last year’s gains!

Based on a statistical analysis over the last 10 years, assuming a normal distribution for stock returns, the S&P 500 index delivered a monthly standard deviation of return of 3.77% and average monthly return of +1.19%.   This means that for a 1 standard deviation (SD) event, there is a 68% chance of a monthly S&P 500 return being between -2.58% and +4.96%, for a 2 SD event a 95% chance being between -6.35% and +8.73%, or for a 3 SD event being between -10.12% and +12.5%.  The S&P 500 January 31 monthly return of -5.3% turns out to be a -1.41 SD event; not common, but certainly not a crazy extraordinary “tail” event.  

Per the table below we can see other returns and standard deviations of return for different investment strategies. For investors wanting, or needing, a lower risk strategy, the Dow Jones Moderate Portfolio Index with a 60% equity and 40% bond allocation delivered a historical average monthly return of +0.71% and a standard deviation of 2.44%; less return, but also less volatile than the 100% S&P 500 equity strategy.   The Dow Jones Moderately Aggressive Portfolio Index shown with an 80% equity and 20% bond allocation produced commensurate level of return and risk between the 60% and 100% equity portfolios.

So, no surprises here!  The risk/return tradeoff is alive and well; more risk has produced a higher level of return over the past ten-year horizon.  If you have a long time horizon and can tolerate market volatility, a larger equity content has been shown to reward investors.  D&A strives to ensure that client accounts are carefully managed to the appropriate level of equity content and risk suitable for each client.

Risky Business

The recent market volatility and decline has been disappointing and has highlighted the problem with “drawdown” risk; the risk of a decline in portfolio value from a recent high.  Other measures of risk like standard deviation of return measure the statistical volatility of returns, but drawdown risk is more easily understandable and observable (and hurtful!)

As seen from the bottom half of the chart below, we have seen a recent drawdown in the S&P 500 (IVV, the green line) of -8.3% drawdown from a recent high and a maximum drawdown experienced during the last twelve years of -33.8% due to the COVID outbreak in March of 2020!  But, the offset to this is that IVV has also shown a cumulative total return over this 12-year period of +390.5%; one could argue that is a fair tradeoff of return versus risk.  Other less risky portfolios that include varying allocations to bonds, like the iShares Core Aggressive ETF (AOA), iShares Core Growth ETF (AOR), and the iShares Moderate ETF (AOM) have shown less drawdown and a commensurate lower total return.  The portfolio with the least risky profile, the iShares U.S. Aggregate Bond ETF (AGG, the blue line towards the bottom) as a 100% investment grade bond portfolio, has shown very low risk and the lowest return.

As I have recounted many times, for clients that have a long time horizon with sufficient income and net assets to cover their lifestyle and can tolerate the potential for large drawdowns, a portfolio with a large allocation to equities has proven to be an effective strategy to earn higher total returns during this time horizon.  Clients with a shorter time horizon or unique circumstances are better off maintaining a portfolio with reduced equity exposure to target a “smoother” ride shown by the portfolios with reduced equity exposure (AOA, AOR, or AOM).