As we enter the second half of the year, investors continue to grapple with inflation, higher interest rates, the Fed, and the prospect of a recession. If historical bear markets are any indication, investors' decisions during this period will have long-lasting effects on their portfolios. Resisting the temptation to overreact to daily market swings, dwelling on the past, and losing sight of bigger factors has never been more critical. While it's difficult to imagine a market recovery today, more than a century of market history suggests that they can occur when investors least expect. Investors should consider what will matter to markets over the next several months as they position for the years and decades ahead.
We discuss in this episode of The Wealth Effect Podcast:
📉 Stock and Bond Market Returns
💸 CPI Inflation
🧮 Stock Market Valuations
🏦 Tightening Monetary Policy
💰 The Value of Cash
📊 The Benefits of Diversification
Matt Faubion, CFP®
Founder - Wealth Manager
Show notes and charts:
1. Stocks and bonds have both struggled this year
What has made this year particularly challenging is that both stocks and bonds have performed poorly. This is because the sudden rise in rates due to inflation has hurt all asset classes simultaneously, and this bucks the typical pattern of bonds supporting portfolios in difficult markets.
2. Bonds help to diversify portfolios except when rates rise
Of course, there are always reasons to believe that "this time is different." In this case, the situation is unique because the inflation story has evolved over the past year, and rising interest rates are the primary reason all asset classes have performed poorly.
3. Inflation has increased across many categories
Inflation can be a tricky subject since many factors can drive it. Rising energy prices due to strong demand and the war in Ukraine have only worsened matters, especially for consumers at the gasoline pump. The fact that all prices have increased adds insult to injury and hurts consumer pocketbooks, reducing discretionary spending on other items. Recent data show that retail sales and spending have, in fact, declined on a nominal basis (not adjusted for inflation). When adjusted for inflation, these metrics have been negative for most of the year.
4. Valuations present long-term opportunities for patient investors
Stock market valuations are at their most attractive level in years. Rather than being close to all-time peaks last seen during the dot-com bubble, the forward price-to-earnings ratio on the S&P 500 is now back to historical averages. As the above chart demonstrates, the P/E ratio tends to "revert to the mean" over the course of market and economic cycles, though hardly ever visits and stays at the average for very long. Meaning, the ratio tends to overshoot on both the upside and downside, resulting in increased volatility. Whether the ratio has further to shoot downward is uncertain, and time will tell. However, as written in this week's newsletter, lower stock market P/E ratios are highly correlated with long-term average annual rates of return. For patient investors with long time horizons, this presents an opportunity to benefit from this downturn in the years ahead.
5. The Fed is tightening monetary policy
Admittedly, the Fed has a very difficult job at hand in containing inflation while at the same time not choking off real economic growth. The narrative of inflation being transitory (a short-term blip that would not last) that The Fed perpetuated much of last year has proven to be false. Now The Fed is playing catch-up, which increases the risk of a policy mistake and tipping the economy into recession. Our view is that The Fed will ultimately decide to live with higher inflation over causing significant damage to economic growth. Though, not until they see tangible evidence that inflation has reversed its upward trajectory and is making headway in coming down.
6. Cash is less valuable in inflationary periods
While it is tempting to "hide in cash" during times of market stress, inflationary environments are perhaps the worst times to do so. This is because inflation, by its very definition, erodes cash value. The consumer price index has increased 9.1% over the past year means that cash buys that much less in goods and services today. Only through investing appropriately can the value of money be preserved, even if it involves short-term bouts of volatility. We prefer diversifying portfolios into assets that historically are "inflation-fighting" assets which include alternatives, hard assets, commodities, inflation-linked bonds, and dividend stocks.
7. Diversification has helped this year
The bottom line: While bear markets are challenging, astute investors understand that every challenge provides opportunity. This is why rooting perspectives with historical context is so crucial to positive investing outcomes. Through this lens, we can see that if inflation begins to ease, optimism may return to the market and economy. If the market continues on its downward trend, valuations will become that much more attractive - increasing the odds of higher expected long-term returns. By deploying capital incrementally and methodically over time, investors can take advantage of the current market and level out future volatility - an effective way of achieving long-term financial goals.
This content is developed from sources believed to be providing accurate information. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.