It’s been a very difficult year for capital markets, to say the least. At Columbus Wealth Management, we appreciate how this can weigh on our clients. With the S&P 500 down nearly 25% and the US Aggregate Bond Index down about 14.6% through September 30th, it’s been very difficult to escape the pain of the current environment. In fact, the only asset classes showing positive returns Year-to-Date are Commodities (+13.6%) and Cash (+0.6%), the former mostly being propped up by Energy and Grains. We’ve spent countless hours constructing diversified portfolios for our clients, and we feel those have held up very well in this environment. We also feel we will be positioned to take advantage of the recovery when it happens. We sincerely appreciate your continued support and offer the following summary to give you more insight into how we are currently thinking about the market and your portfolio.
Equities (Stocks)
U.S. earnings have remained relatively stable (albeit flat). The tight employment market, along with prior fiscal and monetary stimulus from the government, have helped to keep consumer spending (and therefore corporate revenues) at a healthy level. This dynamic is also contributing heavily to inflation as demand continues to exceed supply after the COVID-19 pandemic seriously weakened the global supply chain. Nonetheless, increasing revenues have mostly been offset by rising costs (especially wages), resulting in very little recent earnings growth, but still a far cry from the earnings declines we see in a typical recession.
So, with no meaningful decline in corporate earnings, why have we seen a 25% drop in the S&P 500? The Federal Reserve has implemented a plan to drastically increase interest rates to tame inflation. Higher rates mean companies need to apply a higher discount rate to future earnings, which then implies a lower intrinsic (fair) value for their stock price today. This has resulted in stock market declines that are almost entirely attributed to multiple contraction, which means prices have declined with no meaningful decline in earnings. This makes stocks appear “cheaper”, and supports our view that equities are a good buy for long-term investors.
There’s also a chance that the Federal Reserve will raise interest rates too quickly, and not be able to manage the “soft landing” everyone is hoping for. Since higher interest rates reduce the availability and affordability of capital to consumers and business alike, there is a real possibility that such a strategy will kick off a cycle of reduced consumer spending, declining corporate revenues, and layoffs - resulting in a recession. While this is a very plausible scenario, we share the view of many experts that any recession is likely to be mild relative to prior occurrences, as the Fed will likely pivot and begin cutting rates again should economic conditions deteriorate past a certain point.
Fixed Income (Bonds)
We can observe an even more straightforward relationship between bonds and interest rates. As interest rates rise, previously issued bonds with lower coupons (interest payments) are less attractive than the newer bonds issued at the prevailing rates. This means existing bonds must trade at a lower price to compensate investors so that they would be indifferent between purchasing older bonds with lower coupons and current issues with higher coupons. The Federal Reserve’s historic rate increases have therefore caused dramatic drops in the bond market, which is especially distressing for investors who considered their bond holdings to be “stable”. This further supports our belief that bonds deserve special attention, especially for investors depending on regular withdrawals. We utilize several different strategies within our fixed income portfolio with the goal of improving stability so we can continue to fund client withdrawals while we wait for equity markets to recover.
Cash
Cash has become interesting once again. High-yield savings accounts and money markets are starting to pay compelling interest rates. We believe in the importance of maintaining an adequate cash reserve for all clients and have been helping to evaluate interest rates on various cash reserve options.
Portfolio Strategy
Finally, we believe in keeping an eye out for opportunities in a down market:
· Tax loss harvesting – We can sell assets in taxable accounts at a loss, and then immediately reinvest the proceeds into very similar securities. Doing so keeps the assets invested in the market and the portfolios in line with Investment Policy Statements but allows us to reduce your tax bill.
· Asset location – Paying attention to the location of securities across different account types can also make a big difference on your tax return. For example, if we own an Emerging Markets mutual fund that is known for pushing out large capital gain distributions to investors at year-end, we try to locate positions like this in retirement accounts instead of taxable accounts so you can avoid reporting that capital gain on your tax return this year.
· Rebalancing – If left alone, your portfolio will drift away from your desired allocation over time. For example, if you start with a portfolio of 60% stocks and 40% bonds and the stock market takes a hit, perhaps your bond allocation grows to 45% and your stock allocation falls to 55%. We can then sell bond positions to buy equities while they are trading at more attractive valuations and maintain the risk/return exposure that we agreed on when we initially designed your portfolio.
As always, our advice is to remain patient and disciplined by following the guidelines on your Investment Policy Statement. We don’t believe efforts to time markets will prevail in the long run. With the average recession lasting around 14 months and the average expansion lasting 47 months, the good times tend to outweigh the bad. We encourage you to reach out to us with any questions or concerns.
Sincerely,
Your Columbus Wealth Management Team