June 21, 2022
Ignore the Headlines
Recent headlines have been dramatic as “Inflation Soars to Highest level in 40 Years!” and “Stocks Plunge to 2022 Lows!” It sounds like the authors are all shouting, and we should really panic. It feels like we should “do something” but let’s take a step back from the headlines, and put today’s market in perspective first.
1. Stocks are in bear market territory if we use the standard definition of a 20% drop from market peak. In fact, the large cap growth sector tracked by Morningstar is down over 40% so far this year. On the other hand, the S&P 500 first reached current levels at the end of 2020, a mere 18 months ago, when the headlines said “S&P 500 Reaches New All-time Record High!” Again, these were delivered with shouting and exclamation points, inducing panic for Fear of Missing Out (FOMO) as people were bidding up the prices of Tesla, and Peloton, and crypto currency. As of May 16, the index is back to where it was 18 months ago, but the emotion is to bail out before it drops lower. Stock markets are volatile, we should expect these kinds of swings from time to time, and trying to predict them with any consistency is a fool’s errand.
2. Total Bond Market funds are now down about 11.5% year to date. This is explained by the dramatic and unexpected increase in interest rates, which are now about 2% higher than at the beginning of the year. The $1.00 you had invested at the beginning of the year was earning 1.25% per year. It is now worth $0.88 and earning 3.25%. The average maturity of the fund (measured by duration) is over six years. It is not surprising that earning 2% more over six years would earn back the 12% lost, and you would be back where you expected to be at the beginning of the year.
3. The odd sort of silver lining here is that the change in interest rates is primarily due to an increase in expected real returns, and not just due to higher inflation. In fact, despite recent record levels of inflation, the expectation for average inflation over the next five years is about the same as it was in January, so the expectation for higher fixed income returns is “real”. This signals a return to a more normal situation where long term savers earn something greater than inflation, which was not the case through much of the pandemic recovery period.
4. Things could get worse before they get better. In hindsight it is easy to agree with the people who said the economy was over-stimulated during pandemic recovery. It has led to record low unemployment, and resolved the Fed’s inability to push inflation above 2%. Unfortunately it is now WAY above 2%. Jerome Powell, Chair of the Federal Reserve is the person responsible for finding that just right balance between full employment and stable prices. Unfortunately, his tools are limited. “We don’t have precision surgical tools. We have essentially interest rates, the balance sheet and forward guidance and they’re … famously blunt tools,” Powell said at a recent press conference. It is quite possible that monetary policy pushes the economy into a recession in an effort to bring down inflation.
5. This is a good time to assess your risk tolerance. It is easy to take risk when it feels like markets only go up. We are now preparing to grit our teeth and rebalance by selling some fixed income securities and buying more stock. If that feels really scary, we should have a conversation about your investment time horizon, and appropriate risk tolerance.
In summary, it is a good time to ignore the headlines, reassess your investment horizon and appropriate risk tolerance, and continue to expect positive long-term returns for taking diversified investment risk.