Q3 Portfolio Results

Posted On October 2, 2022 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Q3 Portfolio Results are in and no surprise, it’s ugly. Today we are going to dive into the numbers and give a realistic overview of the situation. More importantly, we are going to share some reasons for optimism, or at least patience. And we will discuss the remarkable situation being created from currencies and interest rates.

Market Returns YTD

We use two benchmarks to design and evaluate our portfolios. For stocks, we look at the MSCI World Index, using the ETF ticker ACWI. For bonds, we use the Barclays US Aggregate Bond Index, or AGG. Year to date through September 30, the total return of ACWI was -25.72% and the total return of AGG was -14.38. (Source: Morningstar.com)

Our portfolios are a blend of stocks and bonds. For example Moderate is 60/40, which has a benchmark of 60% stocks in ACWI and 40% bonds in AGG. Your hypothetical, benchmark returns YTD are as follows:

Conservative 35/65: -18.35%
Balanced 50/50: -20.05%
Moderate 60/40: -21.18%
Growth 70/30: -22.32%
Aggressive 85/15: -24.02%
Ultra Equity 100/00: -25.72%

Category Performance

This has been a difficult environment. We are doing a couple of points better than our benchmarks across our portfolios, net of fees. Our move to shorter duration bonds and floating rate at the beginning of the year was a positive. And our Value funds have lost less than the overall market. No doubt, it has been a tough year for investors and I am not happy with our results.

Q3 deepened the Bear Market in stocks and extended losses in bonds with rising interest rates. Commodities, which were up dramatically in Q1, reversed in Q3. Thankfully, we have been well positioned in our bonds which has been our primary area of defense.

International stocks are down more than US Stocks and this has detracted from our returns. A large component of the loss in International stocks is due to the currency exchange. The dollar is up 16% to the Euro, and the dollar is up 25% to the Japanese Yen. So, even if a European stock was flat on its price in Euros, it would be a 16% loss in dollars.

Don’t Time The Market

When the market is up, and I say that we don’t time the market, everyone nods in agreement. But when stocks are down 25%, even the steeliest investor may want to throw in the towel. It’s natural and it’s human nature. It’s also the worst thing an investor can do.

But Scott, this time is different!

The economic outlook is terrible. The Federal Reserve is determined to crush inflation regardless of the short-term pain it inflicts on the economy. The 30-year mortgage hit 7% this week. Corporate earnings are starting to decline and consumer confidence is plunging.

Yes, all this is true. But, the stock market is a leading indicator. Stocks move ahead of economic data and investors aim to predict what will happen. Even if markets are not perfectly efficient, it is possible that a lot of the future economic woes are already priced into stocks. Stocks typically rebound before we fully exit a recession.

I am not making light of the severity of the current market impact or the economic situation which faces the world. But when we see the historic graphs of when the stock market was down 25% and where it was a few years later, it is pretty obvious that we should to stay on course.

In fact, I have spent a lot of time kicking myself for not being more aggressive in March of 2020, when we had such an amazing buying opportunity. But these opportunities are only obvious in hindsight. In real time, these feel like horrible, painful times to be an investor. Selling didn’t work in 2002, 2008, or 2020. Those were years to stay invested, so you could recover in 2003, 2009, or the second half of 2020.

International Stocks Improving

Q3 has been especially tough for international stocks and they’ve fared even worse than US stocks. Shouldn’t we focus more on the high-quality US companies then? After all, the dollar continues to go up. Why fight that trend?

There are going to be future ramifications of the strong dollar. Besides that it’s a great time to go visit Europe or Japan, let’s think through the implications of a strong dollar. For US companies, a strong dollar hurts us. It makes our exports more expensive to the rest of the world. And it makes the foreign profits of US companies look smaller. (Almost half of the profits from the S&P 500 index comes from foreign sales.) Over time, a strong dollar will hurt the US stock market.

On the other hand, the strong dollar can benefit foreign companies. As US imports become more expensive, they can gain local market share. Their products are now cheaper to US consumers and we buy more imported goods. They sell more and have higher profits.

This creates a leveling mechanism where currencies may tend to pull back towards each other rather than continue to widen apart. A stronger dollar will help Europeans (including through our increased tourism), and those international companies will see their profits grow. When the dollar eventually weakens, that currency headwind will become a tailwind, pushing foreign stocks higher. I don’t know when the dollar will reverse, but based on their improving fundamentals, I don’t think now is the time to give up on international stocks.

No More ZIRP, Bye Bye TINA

In 2008, central banks reduced interest rates to zero to save the global economy. For the next 11 or so years, we had a Zero Interest Rate Policy, nicknamed ZIRP. The US had just begun to test the waters of moving up from 0%, when COVID-19 hit. And we went right back to 0% and piled on unprecedented stimulus to the economy.

The stimulus worked. It worked so well, in fact, that we created 8-10% inflation around the world this year. And so now, central banks are raising rates around the world. Last week, I wrote about being able to buy a 5% US government agency bond for the first time in over a decade. It’s a game changer.

For the past 14 years, 0% interest rates meant that There Is No Alternative to stocks. You simply could not invest in bonds. It became such a reality, that it became its own acronym. Like FOMO or LOL, every advisor knew TINA meant There Is No Alternative. Well, bye bye TINA, because bonds are back.

Bond yields are up and we can now buy high quality bonds with 4-6% yields. At those rates, we have a very real alternative to stocks. While we patiently wait for an eventual stock market recovery, we can buy attractive bonds right now. We are laddering our bonds from 1 through 5 years and will hold bonds to maturity. For clients with established withdrawals or Required Minimum Distributions, we are buying bonds to meet those needs over the next five years.

Discouraging but not Discouraged

Q3 has been rough, especially September. All the expectations about weak Septembers and mid-cycle election years certainly came true in 2022. I know the markets are incredibly disappointing right now, looking back over the last nine months. Both the stock and bond markets have double digit losses for 2022. I don’t think that has ever happened before and it means diversification hasn’t been much help.

We did make a few beneficial choices at the beginning of the year, with short-term bonds and Value stocks. Looking forward, there are reasons to be optimistic. Historically, after a 25% drop, stocks are usually higher 12 months later, and often see a double digit gain. Our international stocks have been hammered by the strong dollar. But that may ultimately be beneficial for foreign companies and the dollar may even reverse. Bonds yields are up and now there is a real alternative to stocks. (Can I coin TIARA, there is a real alternative? You heard it here first…)

No doubt these are frustrating times. I feel your pain and I am in the same boat, personally invested in our Aggressive Model. We’ve seen this before – Bear Markets in 2020, 2008, and 2000, and many before that. In fact, before 2000, Bear Markets were about once every four years. And one of three years in the market is down, historically. Every one of these drops feels unique and like the sky is falling. And in time, they work out eventually. I am looking at the markets daily and am ready to make adjustments. But sometimes, the sailor has to sail through the storm to reach their destination and it’s all part of the journey. We need patience, but also to keep asking questions and thinking long-term.

Bonds in 2022

Posted On December 12, 2021 By Admin In Portfolio Management /

Resuming last week’s Investment Themes, today we consider Bonds in 2022. It is a challenging environment for bond investors. We are coming off record low yields and the yield on the 10-year Treasury is still only 1.5%. At the same time, yields are starting to move up. And since prices move inversely to yields, the US Aggregate Bond index ETF (AGG) is actually down 1.74% year to date. Even including the yield, you’ve lost money in bonds this year. With stocks having a great year in 2021, it is frustrating to see bonds dragging down the returns of a diversified portfolio.

Inflation Hurts Bonds

Inflation is picking up in the US and globally. Supply chain issues, strong demand for goods, and rising labor costs are increasing prices. The Federal Reserve this week said they would be removing the word “transitory” from their description of inflation. And now that it appears that Jay Powell will remain the Chair, it is believed that the Fed will focus on lowering inflation in 2022. They will reduce their bond buying program which has suppressed interest rates. And they are expected to gradually start increasing the Fed Funds rate in 2022.

It is difficult to make accurate predictions about interest rates, but the consensus is that rates will continue to rise in 2022. So, on the one hand, bonds have very little yield to offer. And on the other hand, you will lose money if interest rates continue to climb. Then, to add insult to injury, most bonds are not maintaining your purchasing power with inflation at 6%.

Bond Themes for 2022

There aren’t a lot of great options for bond investors today. But here are the bond investment themes we believe will benefit your portfolio for the year ahead. This is how we are positioning portfolios

We will be increasing our allocation to Floating Rate bonds (“Bank Loans”). These are bonds with adjustable interest rates. As rates rise, the interest charged goes up. These are a good Satellite for rising rate environments.
Within core bonds, we want to reduce duration to shorter term bonds. This can reduce interest rate risk.
We continue to hold Preferred Stocks for their yield. While their prices will come under pressure if rates rise, they offer a continuous cash flow.
Ladder 5-year fixed annuities. I have been beating this drum for years. Still, multi-year guaranteed annuities (MYGA) have higher yields than CDs, Treasuries, or A-rated corporate and municipal bonds. If you don’t need the liquidity, MYGAs offer a guaranteed yield and principal.
I previously suggested I-Series Savings Bonds rather than TIPS. These are linked to inflation and presently are paying 7.12%. Purchases are limited to $10,000 a year per person, and unfortunately cannot be held in a brokerage account or an IRA. Read my recent article for more details. I personally bought $10,000 of I-Bonds this week.

Purpose of Bonds

Even with a negative environment for bonds, they still have a role in most portfolios. Unless you have the risk capacity to be 100% in stocks, bonds offer crucial diversification. When we have a portfolio with 60% stocks and 40% bonds, we have an opportunity to rebalance. When stocks are down, like in March of 2020, we can use bonds to buy more stocks while they are on sale. And of course, a portfolio with 40% in bonds has much less volatility than one which has 100% stocks.

Yields may eventually go back up to more normal levels. While it would be nice to have higher yields, the process of yields going up will be painful for bond investors. Our themes are trying to reduce this “interest rate risk”. We hope to reset to higher rates in the future, while reducing a potential loss in bond prices in 2022.

Do You Need Bonds?

Posted On September 6, 2020 By Scott Stratton, CFP(R), CFA In Portfolio Management /

With ultra low yields today, more investors are asking if you really need to have bonds in your portfolio. It’s going to depend on your objectives for your overall plan. First, let’s take a look at expected returns and how this impacts your allocation.

The primary role of bonds is to reduce the risk of a stock portfolio. Bonds fluctuate a lot less and most are relatively low risk. The trade-off is that they have a lot lower return than stocks. Of course, the stock market has a negative return in approximately one of every five or so years. From 1950 through 2019, 15 of 70 years had a negative return in the S&P 500 Index. Bonds are more consistent, and they can help smooth out your overall returns. In years when stocks are down, you can rebalance by selling some bonds and buying stocks.

The more bonds you have, the more you reduce stock risk, but also the more you probably lower your long-term returns. With the 10-year Treasury bond yielding only 0.721% this week, bonds offer almost no return on their own. Bonds used to offer safety and income, but today, you are really only owning them just for safety.

Portfolio Asset Allocation

We describe a portfolio by the percentage it has in stocks versus bonds. A 70/30 portfolio, for example, has 70% stocks and 30% bonds. Our asset allocation models target different levels of stock and bond exposure:

Ultra Equity (100% Equity)
Aggressive (85/15)
Growth (70/30)
Moderate (60/40)
Balanced (50/50)
Conservative (35/65)

Expected Returns

Next, let’s consider what Vanguard projects for the next 10 years for annualized asset returns, as of June 2020:

US Equities: 5.5% to 7.5%
International Equities: 8.5% to 10.5%
US Aggregate Bond Market: 0.9% to 1.9%

Let’s calculate hypothetical portfolio returns using these assumptions. If we take the midpoint of stock projected returns, we have 6.5% for US Stocks and 9.5% for International Stocks. If we invest equally in both, we’d have an 8% return. For our bond return, we will take the midpoint of 1.4%. Now, here’s a simple blend of those expected returns when we combine them in a portfolio.

Portfolio	Projected 10 Year Return
100% Equities	8.00%
90% Equities / 10% Bonds	7.34%
80% Equities / 20% Bonds	6.68%
70% Equities / 30% Bonds	6.02%
60% Equities / 40% Bonds	5.36%
50% Equities / 50% Bonds	4.70%
40% Equities / 60% Bonds	4.04%
30% Equities / 70% Bonds	3.38%
20% Equities / 80% Bonds	2.72%
10% Equities / 90% Bonds	2.06%
100% Bonds	1.40%

If you simply want the highest return without regard to volatility in a portfolio, you could invest 100% into stocks. Moreover, any addition of bonds should reduce your long-term returns. Of course, this assumes that returns are simply linear. In a real portfolio, there would be up years and down years in stocks. That’s when you would rebalance, which could be beneficial.

For young investors, in their 20’s, 30’s, or 40’s, you probably should be more aggressive in your asset allocation. For some, it may even make sense to be 100% in stocks. If you have 20 or more years to retirement, and aren’t scared of stock market fluctuations, being aggressive is likely going to offer the highest return.

The 10-year expected return of stocks is not bad, 8% combined today. That’s a little bit lower than the historical averages, but still an attractive return. Bond returns, however, are expected to be very weak. Consequently, 60/40, 50/50, and more conservative portfolios, are expected to have much lower projected returns.

Retirement Planning and Your Need for Bonds

For those closer to retirement, low yields are a challenge. You want to have less volatility but also want good returns. If you are within five years of retirement, you probably want to reduce the risk of a stock market crash hurting your retirement income. Now, if the hypothetical 8% stock returns were guaranteed, our decision would be easy. But getting out of bonds today, with the market at an all time high, seems too risky. This week has certainly been a reminder that stocks are volatile.

I think most pre-retirees will want to keep their current allocation through their retirement date. After that, they may want to consider gradually reducing their bond exposure by selling bonds. There is evidence that this strategy, The Rising Equity Glidepath, is a beneficial way to access retirement withdrawals. It allows retirees to benefit from the higher expected return of stocks, while reducing their risks in the crucial 5-10 years right before and at the beginning of retirement.

Some retirees have a high risk capacity if they have ample sources of income and significant assets. If their time horizon is focused on their children or grandchildren, they can also consider a more aggressive allocation.

We want to calculate your asset mix individually. I wanted to show you what the blend of stocks and bonds is projected to return over the next decade. We’ve had strong returns from fixed income in recent years because falling interest rates push up bond prices. Going forward, it looks like bond returns are going to be quite low. We do have to consider these projected returns when making allocation decisions.

If you’re looking for advice on managing your investment portfolio today, let’s talk. Our planning process will help you address these questions and have a better understanding of your options.

How to Increase Your Yield

Posted On August 2, 2020 By Scott Stratton, CFP(R), CFA In Portfolio Manag