After an enthusiastic start to the year driven by an accelerating global economy and optimism about a large corporate tax cut, the stock market gave back some of its gains last week. The S&P 500 finished January with a 5.7% advance, including dividends. After a shaky finish, January’s returns were still one of the best starts for stocks since our firm’s founding in 1987.
Through Friday, stock prices continued to decline, with the S&P 500 losing 2.2% to start February, leaving it 3.8% off its all-time high reached on January 26. Stocks have not experienced a noticeable decline since nervousness intensified preceding the US presidential election.
The strength in the overall economy and employment is finally showing up in higher wages, potentially foreshadowing an inflation uptick. Interest rates rise as the bond market prices in the prospect of higher inflation. The benchmark 10-year US Government bond yield now stands at 2.85% after bottoming in September at 2.04%. Rising interest rates can also negatively impact stock prices as the expected return on future dividends must also increase.
Why, with the economy strong and corporate earnings growing, should the markets pullback at the smallest whiff of inflation? Uncertainty surrounds the Federal Reserve’s policy as Jerome Powell takes the reins today. Will the Fed be forced by resurging inflation to increase the pace of monetary tightening and withdraw liquidity faster than previously expected? The financial markets have a history of testing the resolve of new Fed Chairs early in their term.
Stock investors should always be prepared for a 10-15% correction at any time. Given the largely uninterrupted bull run for stocks over the past 15 months, this sudden selloff feels jarring. Short of a more drastic change or unanticipated hit to the economy, we see this as a normal reassessment of the recent enthusiasm for stocks and not necessarily the start of a more serious downturn. It is important to keep in mind that economic strength is often the cause of bear markets in bonds, but that same strength also should support stocks and other pro-growth assets through the volatility.
What We Are Doing
We have been busy rebalancing stock/bond allocations since late last year. We started with retirement and other non-taxable accounts in December and then moved to taxable accounts earlier in January. Resetting allocations is one of the most effective risk controls for a long-term investment strategy. As stocks have done well relative to bonds, stocks have become an increasingly larger part of balanced portfolios. Regular rebalancing is akin to a tune up on your car – it keeps your portfolio running as it should and helps mitigate overall risk.
We sometimes encounter resistance in the rebalancing process, and we try to be sensitive to clients who want to capture every last morsel of bull market returns or avoid tax implications. In our experience, trying to finesse an exit at the top or time tax gains runs the risk of the market taking your gains before you do. Regular rebalancing avoids committing these mistakes.
Our rebalancing process often results in paring back positions that have performed the best over the past few months. Some of the best stocks in technology, for example, have become outsized positions. Generally, we want to cut losses quickly and let winners run, but that approach holds merit only to a point. Rebalancing in this sense can be viewed as a nod to the old adage to “buy low, sell high.”
We continue to focus on shorter-term, higher-quality bonds that perform better in the face of rising interest rates. Our bond portfolio has a target duration of 4 years, or approximately 60% of the duration of the broad US bond market as measured by the Barclays Aggregate US Bond index. As noted in previous letters, we continue to shift away from corporate bonds into US government issues.
Traditional bonds, by nature, are more at risk from higher inflation as their fixed coupons buy fewer goods in the future. Prudent portfolio management is about preparing for a range of possible outcomes. While high inflation may not seem like the most pressing issue today, the potential it has to erode purchasing power warrants preparing your portfolio for that scenario. We continue to hold inflation-linked bonds as part of our core fixed income strategy. These bonds perform better when unexpected inflation weighs on the broad bond market and help insulate a portfolio from one of the biggest risks fixed income investors face.
The More You Know
For investors with new funds to invest, a correction in stocks presents an opportunity to enter at lower prices. In the meantime, we are holding new funds in an enhanced cash strategy while we use the volatility in stocks to average into long-term positions. Historically, we held new money and cash needed for ongoing client distributions in traditional money market funds. But money market funds are not what they used to be.
Money market funds pay regular interest and, up until recently, the net asset value (NAV) of all money funds was always $1. Historically, this worked well until an extreme credit or liquidity crunch like the one experienced in 2008 impairs money fund assets. In 2008, a large fund “broke the buck,” meaning the NAV dropped below $1, causing major panic in one of the perceived safest investments.
As a result of this stress, the SEC adopted new rules on how money funds can operate. Now, funds are required to impose gates that restrict the withdrawals and impose costly redemption fees if certain liquidity thresholds are broken. The new rules also required certain funds to have a floating NAV as opposed to the traditionally stable $1. While the aim of this reform was to make the whole financial system safer, these regulatory changes could make it harder to get your cash in certain situations.
Aside from regulatory issues, money funds have struggled to generate income while short-term interest rates have been near zero. Many funds waived their fee in order to maintain stability of their NAV. Now that yields have increased for shortest-term investments, cash stands to earn the highest return since 2008. As a result, money funds reinstated their fees. Now, the problem is a large portion of the yield earned on money funds is sucked up by fees.
We have constructed an alternate solution for clients that reduces costs and improves the returns on what is effectively a cash position. We construct a portfolio of short-term exchange-traded funds that offers stability, liquidity, and comparable income to a money fund but at a lower cost. We find managing the mix between high-quality, short-term corporate bonds, Treasury bills, and short-term Government notes doesn’t drastically alter the stability of this portfolio compared to a money fund and allows you to keep more of the yield your cash earns.
What It All Means
Volatility, or the ups and downs of the market over time, is one measure of risk; the main reason equities have outperformed every other asset class over time is their inherent riskiness. Our job is to make sure you get the return you are due for a given level of risk. A separate benefit is that collectively, over time, stocks are able to weather inflationary periods better than other assets. Take a simple example of a company that only makes toothpaste – when its input costs rise, what does it do? It passes the cost along to the consumer, insulating their profits from higher costs. It can do this because consumers have few alternatives when it comes to dental hygiene.
Sentiment for stocks ebbs and flows. Enthusiasm is not necessarily a reason to be worried nor should fear be shunned. The S&P 500 has gained over 350% since February 2009 and all the while many pundits denounced the stock rally as artificial. Now, more positive sentiment is finally kicking into high gear. Fundamentally, we believe that successful investing is not about calling tops and picking bottoms. It is about what happens in the middle. Have you set up a mix of growth and safety assets that you can live with? If your view on the markets turn out to be wrong, how much will it hurt your portfolio? Successful investing is as much about protecting your portfolio from costly behavioral mistakes as it is about predicting the next market decline.
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DISCLOSURES: The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy or investment product, and should not be construed as investment, legal or tax advice. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaim any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.). The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income or other categories. An index is a reflection of the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income, but do not account for any transaction, custody, tax, or management fees encountered in real life. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Industry and specific sector returns (technology, utilities, etc.) do not account for the reinvestment of dividends or other income. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. Past performance does not guarantee future results.