"Price of Admission" | ETF Trends

The third quarter of 2022 began with signs of promise as stocks bounced off their June lows and proceeded to gain over 17% into mid-August.  However, that hope quickly turned to despair, with stocks then dropping 17% and finishing the quarter firmly in the red.  Bonds experienced a somewhat similar ride directionally, showing signs of life early in the quarter only to falter down the stretch.  In the end, this past quarter proved more of the same – a continuation of one of the most challenging market environments in history.

It’s not often that the term “in history” can be uttered when referencing financial markets.  Just how challenging have the markets been in 2022?  The bellwether 60/40 stock and bond portfolio is now down over 20% on the year, its worst performance ever – by far.  That’s saying something, considering the previous two worst episodes were during the Global Financial Crisis in 2008 and the dot-com bubble burst in 2002.

Where Art Thou Bond Protection?

Most successful investors know that periodic and even substantial stock declines are part of the deal.  After all, on average, stocks experience intra-year drops of approximately 10% every two years and 25% every five years.  Longer-term, multi-year bear markets also happen with fairly regular frequency.  On average, a 30% multi-year decline occurs every nine years and a 50% drop every 20 years.  Compound Capital’s Charlie Bilello refers to the risk of these declines as the “price of admission” – more on that later.  This year’s 24% decrease in the S&P 500 – while certainly painful – is most definitely not abnormal.  What is unusual is the lack of protection, or hedging, offered by bonds.  Historically, high-quality bonds have served as a ballast during steep stock market sell-offs.  Not in 2022.

Source:  JP Morgan

The end result is that bonds have offered no offset to the stock bear market.  According to Strategas Research, “this is the first time stocks and bonds have fallen in tandem for three consecutive quarters since 1976”.  Notably, the stock and bond returns referenced above are for U.S. markets (S&P 500 Index and Bloomberg U.S. Aggregate Bond Index, respectively).  Global stocks and bonds have fared even worse this year, providing little benefit in the portfolio diversification process.

What’s Behind this Unique Situation?

By now, most investors are well aware of the single biggest driver of financial markets this year:  the Federal Reserve.  The Fed continues embarking on an aggressive monetary tightening path to rein in the highest inflation in 40 years.  These efforts include raising interest rates and reducing assets held on their balance sheet.  The Fed is doing this despite indications that inflation is likely more of a supply-side problem than a demand-driven one.  In other words, an argument could be made that the Fed is hiking rates into a less-than-stellar economic backdrop – one where consumer demand isn’t the primary driver of inflation.  Instead, a lack of supply is the primary culprit.

Regardless, the key question right now is, “when will the Fed pivot, backing off from their aggressive posture?”.  The answer is not until they believe inflation is under control – and they appear willing to damage the economy in the process.  So far this year, the Fed has raised interest rates by 3% and expects they will hike an additional 1.25% by year-end.

Bringing all of this back to bonds, recall that bond prices move in the opposite direction of interest rates.  As rates go up, the prices of bonds fall – which is exactly what we’ve witnessed in 2022.

So, Where Does This Leave Investors?

As noted earlier, an occasional downturn in stocks – even a fairly significant one – shouldn’t come as a surprise.  Successful investors know that a year like 2022 is the “price of admission” to the stock market “ride.”  If an investor is unwilling or unable to stay on that ride, what’s the point of paying the price of admission, to begin with?  In other words, with stock market risk comes the potential for longer-term rewards.  While declines are always unpleasant, a proper perspective is important to actually capture those rewards.  Additionally, bear markets are typically much shorter in duration and smaller in magnitude than bull markets – which is why stocks have historically delivered a roughly 10% average yearly return.

Source:  Charles Schwab

As for bonds, the price of admission has never been as steep as what investors have paid this year.  However, there is a silver lining in that the ride will likely be much more enjoyable moving forward.  Savers were severely punished following the 2008 Global Financial Crisis as the Fed pushed rates to historic lows.  That culminated with a zero-interest rate policy during the Covid-19 pandemic.  One year ago, a 2-year Treasury bond yield was a paltry 0.30%.  Today?  It’s well over 4%.

Source:  Morningstar

There are now real, meaningful opportunities to generate reliable portfolio income, which has been nearly impossible unless investors have been willing to chase riskier yields.

The bottom line with bonds is similar to that of stocks.  An investor’s ability to focus on longer-term rewards is paramount.  While rising interest rates have caused some short-term pain for bondholders, the good news is that higher yields now equate to greater portfolio income moving forward.

Whether stocks or bonds, the goal for investors should be to always keep the “price of admission” as low as possible for their particular situation and ensure they are getting on the correct “rides.”  Investors can do that by focusing on areas they have certainty on and control over the longer-term benefits of global diversification, lower fund costs, tax efficiency, disciplined behavior, and, most importantly – staying focused on their unique financial goals.

Source – The ETF Store

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