First Quarter 2022 – TINA (There Is No Alternative) Until There IsSubmitted by Alsworth Capital Management, LLC on April 20th, 2022
It has certainly been an eventful first three months of the year. Most noteworthy has been Russia’s jarring and brutal invasion of Ukraine. The daily reports of the atrocities of war are agonizing and depressing, much like the violence in Syria in recent years. The attack on a neighboring sovereign democratic nation with strong ties to Europe has caught the world’s attention and it stirs up our notion of the settled world order. Combining this news with still rising inflation and the apparent realization that the Federal Reserve will need to aggressively raise interest rates, has made for a difficult quarter for both stocks and bonds.
The S&P 500 Index of large US stocks ended the quarter down 4.6%. The Nasdaq Composite Index of large US growth stocks was down 9.1%. Developed international markets declined 5.9% (MSCI EAFE Index) and Emerging Market (MSCI EM Index) stocks fell 7%. The relatively mild declines for the full quarter masked the intra-quarter volatility, where peak-to-trough declines were much larger. Rising interest rates upset the bond market, causing the Bloomberg US Aggregate Bond index to decline 5.9%. This was the second worst quarter for the bond market in history and conjured up memories of the late 1970’s and early 1980’s war on inflation. Gold was our only positive asset class for the quarter, with a gain of 5.8%.
Our allocation to non-traditional bonds, like floating rate bonds, helped our bond portfolio relative to the benchmarks. Our tilt to US large cap value stocks at the expense of US large cap growth stocks, benefited the portfolio. However, our allocation tilt toward foreign stocks was a relative drag on performance. Our Gold position was a positive contributor to relative performance in the quarter.
The old adage that a market loss is not realized until you sell, holds true. If the estimated value of your home declines 20%, would you feel compelled to sell your house? Similarly, the value of a stock can fluctuate wildly, but you don’t need to buy or sell just because daily market values changed. Sometimes we don’t have a choice and you are forced to sell stocks that are down in value to meet a cash need. We can mitigate this risk by making sure we have enough in cash, short-term bonds and alternatives to avoid having to sell stocks that are down. Sometimes fear takes over and you may feel compelled to sell stocks to avoid further declines. We can try to avoid selling out of fear by extending our mental time horizon. If you believe that the companies you own are likely to grow over a longer time frame, like ten years, then continuing to own those companies, despite recent declines, likely makes financial sense.
The next question is how much do you realistically expect an investment to grow and are you earning enough to justify the risk. The higher the price you pay today, the lower your expected growth will be. At historic high prices, rational estimates of even ten year returns on US growth stocks yields a historic low expected return. However, investors have rationalized the investment by comparing it to the returns you could get on a bond investment. This has been referred to, in recent years, as TINA (There Is No Alternative). Last year, the 10-year US Treasury Bond was yielding only 1.19% at its low point and in 2020 it hit a low of 0.54%. Locking in those low returns for ten years is hard to stomach, especially if inflation forces you to take a loss on your purchasing power. Even if technology stocks are priced to earn only 5% over ten years, it could be enticing to take on the higher risk, especially when things have been going well. However, life is dynamic and ever changing. With high inflation and geopolitical risks coming into the forefront from unpredictable events, that 5% return no longer feels like enough, relative to the risk. Making matters worse, the yield on bonds have come up, with the 10-year Treasury Bond currently yielding 2.7% (more than double last year’s low). Historically, they average around 4.3% and I fully expect that we will end up getting back to something closer to that long-term average. As such, I expect that high priced stocks are going to have a challenging period ahead, as investors realize that there is in fact an alternative.
This past quarter was rare in that both stocks and bonds sold off at the same time and in the same magnitude. However, the downside risk for bonds over longer periods of time is quite different from stocks. Unlike stocks, bonds have a defined term to maturity when we can expect to get our original investment back. On average, the bonds in our portfolio mature at around four years out, with some that are shorter and some that are longer. When we bought our bonds, the yield they paid was very low and it is locked in for the full term. Now that newly issued bonds are yielding a higher rate, our old bonds look less attractive and the price someone would pay us today for those old low yielding bonds has declined. That is a problem if we have to sell these bonds now. However, if we can hold them to maturity, we simply accept our lower yield, and wait to get our money back. At maturity, we can reinvest the cash into new bonds paying higher yields. This same dynamic does not exist for downside protection in stocks.
Markets and consumers have been fixated on persistently high inflation impacting nearly every corner of the global economy. This price inflation is not unique to the United States. Eurozone inflation just hit 7.5% and over 60% of the developed world has inflation running above 5%. The war in Ukraine has put even more strain on the system, as it has taken already constrained supply out of the global economy for materials like oil, natural gas, wheat, neon gas, and wire harnesses for electronics, which are produced in large quantity in both Ukraine and Russia. Similarly, COVID related lockdowns in China are again disrupting the supply of many goods. The market had been anticipating a sharp slowdown in inflation in the second half of 2022, but expectations are now for inflation to remain higher longer. The longer it persists, the more likely it becomes endemic and built into the psychology of consumer expectations. However, as pandemic related factors subside and supply catches up, there should be relief. The Federal Reserve has signaled that they will be aggressive in raising interest rates to slow demand and arrest an overheating economy. The 30-year consumer mortgage rate has reacted and now exceeds 5%. Ultimately, we expect that higher borrowing rates will lead to less spending and a slower economy to further combat inflation. Currently markets are pricing in expectations that inflation will be 2.45% five years from now and the Fed still has a policy target rate of 2%. It may be hard to grapple with these low expectations, considering recent headlines of 8-9% month-to-month inflation rates. We anticipate a higher probability that inflation runs closer to the long-term average of 4%, but we do expect it to subside from current levels in the coming quarters.
The overall level of uncertainty has gone up and investors are grappling with many changing factors. This makes for more volatile investment markets, and we expect that this higher volatility will persist through the remainder of the year. However, with volatility comes opportunities. We have positioned the portfolio to be relatively more conservative with respect to valuations and overall exposure to the more volatile asset classes. We anticipate having the opportunity to make tactical investments, if valuations become more compelling.
As always, we appreciate the trust you have placed in us to help navigate through uncertain times. Please reach out with any questions or concerns you have regarding markets or your personal financial planning.
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
The views and opinions presented in this article are those of Shane Alsworth only
Sources: Morningstar/ Ibbotson data, Ned Davis Research, BCA Research, Litman Gregory Research
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