The following is a Q&A with Jim Brogan and David Wagner, Equity Analyst & Portfolio Manager for Aptus Capital, and it took place on Jim’s radio show, More Living with Jim Brogan, on October 29th. They discuss some key areas that have the potential to impact your retirement savings in the current market and economic environment.
Markets are unpredictable and volatile. We know that in the short-term, markets are a toss-up. However, historically, over time, markets have delivered increasing returns. What is the importance of time when investing into the capital markets?
Warren Buffett is one of the most famous investors. He has always said “it’s your time in the market, not timing the market.” At Aptus Capital, we’ve done our own studies that show how important it is to stay invested during the periods of volatility. Because when you try to time the market, you not only have to be correct once, you have to be correct twice – when you sell and get out of the market, and then when you buy and get back in the market. In our study that went back to 1995, the average return of the S&P 500 per year is 9.5%. If you missed out on the five best days during the last 27 years, your return would be 8.2%. If you missed the 20 best days of the market during that same period, you return would be down to almost 5%.1 Interestingly, the best days in the market usually happen when you see the most amount of volatility. They tend to happen during bear market rallies.
Volatility can come from both downs and ups in the market. What is the cause of all the volatility we’ve seen over 2022?
Let’s put this in historical context. In an average year (dating back to early 1950s), the average drawdown from the peak-to-trough of the market is close to 15-16%. In 2022, the average has been about 24%.2 Even though it may have felt like an extremely volatile market, the average bear market tends to be down about 33% for large cap stocks and 36% for small cap stocks. A lot of the volatility that individuals are feeling or hear about isn’t coming from the stock side. It’s coming from the fixed income side, more specifically bonds. Bonds have been down 15% this year. Historically speaking, bonds tend to be considered a safe asset class with an average drawdown of 5%.3
When economic data is released, the market reacts. But the market is a forward-looking instrument that uses the data to predict the state of the economy and profitability of US companies 4, 6 or even 9 months into the future. What is the importance of that dynamic?
You tend to see stocks bottom 6-9 months before we as an economy head into a recession. Is there a difference between the economy and the market? Yes. The market is the mechanism where you have a lot more short-term volatility of investor sentiment regarding stocks and bonds. Over the long-term, the stock market is driven by economic data. The economy is quite strong right now. The US consumer is sitting on more capital than they ever have. The average US household has 30% more net wealth than they did before the pandemic. Certainly, inflation is impacting the amount we are spending on goods and services, and households are dipping into their accounts to purchase the same items they always have. This past year, the US household savings rate has fallen to a 20-year low. But just because we’re not saving as much today as in years past, most American consumers were somewhat prepared with a nest egg that could handle some stress in the economic system.
Is the Federal Reserve doing enough to combat inflation?
Many Americas would probably say that the biggest problem in the economy right now is inflation. You pay more to fill your car or to buy the same basket of groceries every week. The microcosm of what is happening right now from a quantitative tightening standpoint of raising the Federal Funds rate, the Federal Reserve is trying to slow down the economy. The economy was overheating due to the amount of stimulus that went into the market from Congress and the Federal Reserve throughout the pandemic. When the market starts to overheat, the Fed tries to put some type of restrictive policy in place to make sure we are not growing too fast. The Fed’s goal is to have stability over longer periods of time, whether it is price stability or some type of monetary policy stability. It’s a balancing act.
Everybody is feeling the impact of inflation. What do you think people can expect in the next six months in relation to inflation?
From a mathematical standpoint, inflation will come down. But that doesn’t mean that inflation will come down to historical levels. From 2000 to 2020, the average annualized inflation rate was 2.5%.4 That is much different from the 7-9% inflation rate year over year the past few months.
The wild card for inflation is wage inflation. When you increase the wages of one of your employees from $15 to $18 per hour, you can’t come back to them one or two years later and say inflation has come back down so I’m going to move your hourly wage back to $15.
Heading into the pandemic, the available job openings were about 7 million. Currently, there are about 10.5 million job openings. The Fed is working to bring down the number of job openings available as a way to combat inflation. The Fed doesn’t want people to lose their jobs, just reduce the number of available jobs. This will take some power from employees to bargain for higher wages, which then leads to companies having to increase the price of their goods or services.
As a borrower and investor, inflation affects us in different ways. Typically, when we’re younger in our lives we are doing things like buying houses, growing our net worth, and using debt to our advantage. That becomes more difficult with inflation.
Rising interest rates has been the genesis for a lot of the movement on the stock side or bond side of the market. On the stock side, rising interest rates have hurt stock valuations, which is a measure of investor sentiment to the market. Bonds have the inverse relationship with interest rates.
We can look at this from the mortgage interest rate spectrum and a 30-year fixed mortgage rate. At the bottom of the pandemic, you could get a mortgage for 2.5%. The 30-year fixed rates in the fall were over 6%. Home buyers can afford less now than just a year ago. Until the Fed pivots their monetary policy, mortgage rates will remain high.
The investment climate has changed. What are some of the dangers of the classic 60/40 portfolio?
The 60/40 portfolio has had the second worst year of performance next to 1931 during the Great Depression. This is due to the substantial rise in interest rates. That has hurt fixed income portfolios, the mainstay safety aspect of portfolios since 1981. Interest rates have been coming down since 1981, when the 10-year treasury was close to 16%.4 We have had 40 years of a bull market rally within fixed income in the bond market up until this year.
For investors that have a conservative portfolio, traditionally most have had a heavy allocation of fixed income assets. Fixed income assets like savings bonds and CDs were a cornerstone or price stabilizer for your portfolio that was garnering some type of guaranteed yield. Since 2007 and historically low interest rates, some of those assets like a 10-year US Treasury haven’t yielded more than 1-2 percent. In fact, in December 2021, the rate was as low as 1.44%.4 As the Fed has raised interest rates this year, fixed income assets are finally starting to get some type of yield. However, moving forward, the classic 60/40 portfolio may continue to be a kind of dangerous investment mix.
Key takeaways
- Be sure you are measuring the inherent volatility or risk in your portfolio.
- What can you expect in terms of the volatile movements of your portfolio as compared to the market?
- How long has it been since you rebalanced your portfolio?
- What does your diversification actually look like?
- Ask questions.
The current market landscape is changing, as market dynamics have continued to shift since this interview in late October. Inflation has continued to persist, the Fed has continued to raise interest rates, and the stock market has continued to be volatile. However, the fundamentals of wealth management amidst market uncertainties remains a constant.
Ultimately, at Brogan Financial we help our clients mitigate the impact of short-term volatility, and we stress growth of income over the longer term in order to fight inflation. We will continue to look for strategic opportunities while working to protect our clients from unnecessary risks.
