Index Funds vs Mutual Funds

Index Funds vs Mutual Funds

Posted On September 21, 2023 By Scott Stratton, CFP(R), CFA In Portfolio Management /   No Comments

Twice a year, Standard and Poors updates their comparison of Index Funds vs Mutual Funds, called SPIVA (S&P Index versus Active report). I have written about SPIVA a number of times, and it is worth repeating, because the data is remarkably consistent.

The majority of actively managed funds do worse than a benchmark or index. The newest report was published today, covering all US Funds through June 30, 2023. When we look at long-term returns, here are the percentage of active mutual funds that performed worse than their benchmark:

Category5-yr10-yr15-yr20-yr
All Domestic Stock Funds89.08%90.19%93.15%93.12%
International Stock81.84%84.78%85.33%92.50%
Emerging Markets70.70%87.56%89.58%92.42%
Source: SPIVA US Mid Year 2023

The evidence comparing index funds versus mutual funds is clear: Index funds are the hands down winner. While past performance is no guarantee of future results, there continues to be overwhelming evidence that index funds do better than the vast majority of active funds over the long-term. And this finding is remarkably consistent, regardless of whether we are in a Bull or Bear market.

Equal Weight Index

2023 has been a strange year in the market, with narrow breadth of performance. Looking at the S&P 500, performance has been concentrated in a small handful of names, with five large stocks up more than 100% in the first half of the year. So for strategies which didn’t own these high flyers, it was tough to keep up. Value, Small Cap, and other strategies have lagged the Large Caps this year.

But that is likely to reverse, as it has been quite extreme. I’ve written previously about Equal Weight funds, specifically the S&P 500 Equal Weight. It owns the same 500 or so stocks as the S&P 500, but in equal proportion. The standard S&P 500 which weights each stock on its size (“market capitalization”).

Over the very long-term, the Equal Weight strategy (EW) has outperformed. From 1991 through 6/30/2023, the EW S&P 500 index has a return of 11.82% a year, versus 10.55% for the regular S&P 500. That is a noteworthy, long-term improvement in performance, and is typically attributed to the idea that EW has less of the “over-valued” stocks and more of the “under-valued” stocks.

While EW has outperformed over 30+ years, it has not done so consistently or every year. But what is interesting is that when EW has underperformed to an extreme level, it has historically snapped back. And that is where we are today: EW lagged by 9.9% for the first half of 2023. In the chart below from S&P, previous 6-month periods of EW underperformance were followed by periods of strong EW outperformance. The returns have been mean reverting, with EW providing long-term returns in excess of the cap-weighted index

Mean Reversion Ahead?

This would suggest that the outperformance by the Mega-Cap names of the S&P 500 is unlikely to continue. We own some Value and Mid Cap funds which have not kept up with the S&P 500 this year. That can be frustrating and make investors want to pile into those high flying stocks. But the reality is that the outperformance of the biggest stocks versus EW may be overdone. In fact, it is in the 2nd percentile for the first half of the year, more extreme than 98% of previous 6-month periods. Generally, I believe mean reversion is more likely than an extreme trend continuing indefinitely.

We diversify our portfolios broadly and tilt towards areas of better relative value. This has us owning Value funds, multi-factor strategies, small and mid-cap, and Emerging Markets. Why? Our belief in the two topics we discussed today:

  • Passive, index strategies are better than active management over the long-term
  • We count on mean reversion rather than performance chasing

Both of these approaches are well-grounded in research, but require patience and discipline to stay the course. That’s where we are today. And the data reminds us that this still makes sense. The question of Index funds vs mutual funds is just the beginning. There will be ups and downs, which no one can predict or time, so our focus is on having a good investment process and understanding the fundamentals.

Read More
Growth The Big Picture

Growth, The Big Picture

Posted On September 18, 2023 By Scott Stratton, CFP(R), CFA In Financial Planning, Portfolio Management /   No Comments

With all the noise in today’s markets, it is easy to miss the big picture about growth. 2022 and 2023 have been two of the strangest years in a generation for investors. As a result, it is easy to feel uncertain about investing right now. And that uncertainty often leads investors to make bad choices. So, we are going to step back and look at the 30,000 foot view of what really matters for investors.

In 2022, we saw inflation rise to 9% and the Federal Reserve start the process of slowing the economy. As the Fed raised interest rates, stocks dropped 20%, briefly entering Bear Market territory. In the bond market, rising interest rates snipped the price of bonds, sending the US Aggregate bond index down double digits. For diversified investors, 2022 was a perfect storm where diversification failed and both stocks and bonds were down an uncomfortable level.

Now in 2023, we have seen the Federal Reserve continue to raise rates up to the present moment. At the start of the year, I saw one report that said the probability of a recession in the next 12 months was 100%. 100%, a certainty! And while the full 12 months are not up yet, we have not had a recession. In fact, the S&P 500 Index is up 15.83% this year. While the yield curve remains inverted, a favorite predictor of recessions, it now appears that the likelihood of a 2023 recession is diminished and might not happen at all.

Don’t Time The Market

Comparing 2022 and 2023 doesn’t make sense. The market “should” not be up 15% this year. And yet here we are, with a very welcome gift of an amazing performance in the first seven and a half months of the year. The consensus economic forecasts at the start of 2023 were lousy. If we had listened to them, we would have sold our stocks and hid out in cash. We would have missed out on the gains that we have had for 2023!

There are often compelling historical precedents to entice investors to think we can predict what is going to happen over the next 12 months. Making changes to your investments feels obvious, a smart choice, and low-risk. Unfortunately, history shows us that it is hubris to try to time the market and more often detrimental than beneficial.

It is a challenge to actually stay the course and maintain your discipline. It is difficult to ignore the forecasters and not think that there is an opportunity for you to either protect your principal or rotate into a better performing investment.

Timing the market continues to be a bad idea. I didn’t hear any forecasters in January predict that stocks would be up 15% by August. If we had listened to their predictions, although well-intentioned, we would have made a mistake. Thankfully, we didn’t try to time the market this year. Here is how we manage a portfolio:

  • Establish a target asset allocation for each client’s individual needs and risk tolerance.
  • Rebalance portfolios when they drift from the targets.
  • Adjust our portfolio models annually based on the valuation and expected returns of each category.
  • Use Index Funds and manage each client’s portfolio to keep costs down and minimize taxes.

Rebalancing

The funny thing about rebalancing is that it often means doing the opposite of what you might expect. When stocks were down 20% last year or in 2020, we were buying stocks. Now, when stocks are up 15-20% and there is a lot of optimism for a soft landing, we are trimming stocks and buying bonds. In hindsight, this looks pretty logical. However, in real time, rebalancing often feels like not such a good idea. And sometimes it isn’t – there’s no guarantee that rebalancing will improve returns. But, what it does offer is a disciplined process to managing an investment portfolio, versus the behavioral traps of trying to time the market. The bizarre markets of 2022-2023 certainly reinforce the potential benefits of rebalancing.

Average Versus Median

Do you remember from high school algebra the difference between Average and Median? Average is the total sum divided by the number of items. Median is the data point in the middle. And there can be a big difference between Average and Median. Stock markets are cap weighted, so the larger stocks move the index more than the smaller stocks. Still, let’s consider how the “average” return of an index can be quite different from the median returns of its component stocks.

The year to date return of the S&P 500 Index ETF (SPY) is 15.83% as of August 16. But that is not the median return of the stocks. Of 504 components of the S&P 500, only 135 have done better than 15.83% YTD and 369 have done worse than the overall index. If you had picked a random stock from the S&P, there was a 73% chance that you would have done worse than “average” this year.

And what is the Median performance of the S&P 500 this year? Only 3.36%, an under-performance of more than 12% than the overall index. Even worse, 212 stocks in the S&P 500 are down, negative for the year.

What is the big picture of growth in stocks? Trying to pick individual stocks is extremely difficult. Don’t think that using an index fund means “settling for average”, the reality is that over time, the index return has done much better than the median stock.

This year has been such a frustrating year for investors because stocks are all over the place. If you don’t own a few of the top performers, you are likely lagging the benchmark by a wide margin. What is a way to make sure you own the winners today and tomorrow? Own the whole market with an Index Fund.  Realize that if you pick a stock from the S&P 500, it is not a 50/50 coin toss that you will beat the market average. The chance is lower than 50% because the market average typically does better than the median stock. The stocks which do outperform will move the index disproportionately and they will be fewer in number.

There is a lot of noise and confusion in the markets today, and that’s okay. We are in uncharted waters and seem to be going from one “unprecedented” event to another. Thankfully, I don’t think we need to have a crystal ball to be successful as long-term investors. What I believe can help is stepping back to remember the big picture: don’t time the market, stick to an allocation and rebalance, and use index funds. That’s our roadmap. When in doubt, we can recheck our directions and keep going.

What You Can Control

In the short-term, stock markets can be very volatile. As a result, I believe a lot of inexperienced investors mistakenly think that their success depends on their ability to game the markets. They think that growth is achieved through trading or superior returns.

Unfortunately, trying to outsmart the market often makes your performance worse, rather than better. Active management doesn’t work, at least not consistently over 10 or more years. We stick to passive, low-cost index funds or ETFs for our stock market exposure. And we remain invested in a long-term asset allocation.

Once that investment decision is out of the way, the main determinant of success is your savings rate. How much are you investing each month? That is what you can control. If you want to be more successful in accumulating your wealth, you don’t need to worry about the Jobs Report this week, or what was in the Federal Reserve meeting notes. You need to focus on how can you can save an extra $100, $500, or $1000 a month and make that a habit.

Instead of worrying about your YTD performance, calculate how much wealth you will have in 10 or 20 years, with an average rate of return. Because in the long-run, an average rate of return is excellent. And then what you can control – your savings – is what actually matters more. Growing your wealth is largely a factor of savings and time. Chasing investment performance is a distraction.

Develop Your Saving Habits

  1. Make savings automatic. Put your investing on autopilot with monthly contributions to your 401K, IRA, and investment accounts.
  2. Save More. Don’t just do the 401(k) match, try to put in the maximum to each account. And then ask where else can you invest? Do the math of how much money you want to accumulate. (I can help with that.)
  3. Keep the big expenses down. Living beneath your means is easy if you are smart about your housing costs and your cars. Many Americans who are not frugal in those areas do not have anything leftover to invest.
  4. Develop your career. If you can expand your income without increasing your expenditures, your savings can increase dramatically. If you ever have a chance to work for a company with stock options, go there. I have seen over the years, tremendous wealth accumulated from stock options.
  5. Be an Entrepreneur. This can be high risk, but when they are successful, entrepreneurs earn and save much more than employees. Besides a salary, an entrepreneur is growing a business that has value.

As a financial planner over the past 19 years, I’ve gotten to look at a lot of families’ finances. The difference between those who were struggling and those who were wealthy was seldom just income. I’ve seen a lot of high income folks who were living hand to mouth. Other families who had similar incomes were millionaires or well on their way. The difference was their saving rate. You can’t grow what you don’t save.

There is no substitute for saving. We have to make savings automatic and increase our savings whenever possible. It may help to work backwards: start with your goal and determine how much you need to save and for how long. Then you can see saving as the solution and beneficial process rather than as a sacrifice. Some Americans are saving very well. But the Big Picture is that the average American isn’t saving enough. We need to be talking more about saving, because for too many families, it is the step that they cannot get past.

Our recipe for Growth is simple. Save monthly and dollar cost average into Index funds. You can do this in your 401(k), IRA, or taxable account. The account is less important than the process. The more you save, the more wealth you can accumulate. The younger you start, the better. The faster you increase your saving, the sooner you can reach your goals. Saving is growth and investing is secondary.

Investment Taxes Eat Your Growth

Taxes matter. We work hard to establish a good portfolio and get a respectable rate of return. And then the government wants their cut. How about 37% for Federal Income Taxes (increasing to 39.6% in two years). And another 5% for state taxes. Don’t forget 15.3% for self employment taxes for Social Security and Medicare (or half that number if you’re an employee). Then, if you do well, how about an extra 3.8% in Medicare surtax (“Net Investment Income Tax”).

Once you have your “after-tax” money, it’s all yours, right? Well, not quite. You get to give the government another $5,000, $10,000, or more in property taxes. And when you want to buy something with your after-tax money, you get to pay 8% in sales tax.

The point is that it doesn’t matter how much you make, it matters how much you keep. That is why tax planning is such a big part of our wealth management process. As your portfolio grows, the tax implications can become a significant annual expense and a drag on returns.

What continues to shock me is how many Advisors are making huge mistakes with client portfolios and creating tens of thousands of dollars in unnecessary taxes. Taxes which could have been avoided or reduced substantially through better planning. Sometimes this is because they use a model portfolio that doesn’t attempt to have any tax efficiency. But other times, it is laziness and having too many clients to manage individual portfolios in a tax-efficient way. It’s easier to stick people into a model and let the computer automatically rebalance the portfolio.

This is the big picture for wealthy Americans: Your after tax-return matters more than your pre-tax returns. You have very little control over taxes on a monthly basis, but a great deal of control over taxes in the long run. Here are the mistakes we often see and how we can do better:

Portfolio Tax Efficiency

Mistake 1: Mutual Funds in Taxable Accounts. Mutual Funds have to distribute capital gains annually. Each December, many investors get a surprise tax bill from their funds. BETTER: hold Exchange Traded Funds (ETFs) in taxable accounts. ETFs rarely, if ever, have capital gains distributions.

Mistake 2: Short-Term Capital Gains. Short-Term Capital Gains (less than 1 year) are taxed as Ordinary Income, up to 37%. BETTER: Hold for Long-Term Capital Gains (more than 1 year), which are taxed at lower rates (0, 15 , or 20 percent). Trading which creates ST Gains should be avoided in a taxable account. We are very careful about the tax implications of our rebalancing trades, as well.

Mistake 3: Bonds and REITs in Taxable Accounts. Bond income is taxed as ordinary income (up to 37%). BETTER: Hold bonds in IRAs, which are tax-deferred. Also, IRA distributions will be taxed as ordinary income, so bond income isn’t treated worse in an IRA, unlike capital gains. When you have a LTCG on a stock ETF in an IRA, all that growth will be taxed as Ordinary Income. Traditional IRAs will have the highest tax rate, so it is better to allocate the low growth bonds to IRAs and high growth stocks to Roths and taxable accounts. This process is called Asset Location.

Mistake 4: Not harvesting losses. BETTER: Harvest losses annually in taxable accounts. Losses can be used to offset gains that year, and $3,000 of losses can be applied against ordinary income. Unused losses will be carried forward without expiration.

Mistake 5: Not asking about charitable giving. 90% of Americans are not itemizing and not getting any tax benefit from charitable donations. BETTER: We can get a tax benefit two ways, without itemizing: A) make donations of appreciated securities from a taxable account. Or B), if over age 70 1/2, make Qualified Charitable Distributions (QCDs) from your IRA.

Mistake 6: No Plan for Managing IRA Distributions. BETTER: Do Roth Conversions in low income years before RMDs start at age 73.

Mistake 7: Not understanding Taxes that will be owed by Beneficiaries. BETTER: Working with your Advisor to consider inter-generational taxes in your Estate Plan. For example, taxation of trusts, step-up in cost basis, charitable giving, and Beneficiary IRAs.

Mistake 8: Not doing a Backdoor Roth IRA. I’ve had advisors tell me it’s not worth their time to move $13,000 to $15,000 into a TAX-FREE account each year for a married couple. Not worth it for the advisor, I guess (no additional revenue). BETTER: Although the numbers are small annually, we have been doing back-door contributions for clients for many years, and it does add up.

The Changing Retirement Picture

Did your parents retire with a Pension? Maybe they worked for 30-40 years for the big company in town, or for a municipality, school district, military branch, or government agency. When they retired, they had a pension and Social Security which fully covered their expenses. They might have also had retirement health benefits which paid for deductibles and co-pays which were not covered by Medicare.

You probably don’t have the same benefits. How much is a Pension worth? Well, we can easily compare a Pension to the cost of a Single Premium Immediate Annuity, or SPIA. A SPIA works the same way as a Pension – it is a guaranteed monthly payment for life. For example, let’s consider a 65 year old female who has a pension which guarantees her $2500 a month for the rest of her life. We could buy a SPIA with the same guaranteed $2,500 a month for life, for a cost $437,063. So, a $2,500/month pension is worth $437,063.

To have the same retirement funding as your parents, you may need $400,000 or more in assets than they had. And that is just to replace one modest pension. If your parents had two pensions or had a bigger pension, you might need much more than $400,000 to get the same retirement income.

And you probably won’t buy a SPIA and would prefer to keep your money in an IRA. At a 4% withdrawal rate, you would need $750,000 in your IRA to get $2,500 a month. So maybe you need $750,000 more than your parents, not $437,000, to replace their pension! These pensions were worth a lot. It will take a worker 30 years of saving to build up their 401(k) to $750,000. It’s not impossible, but the big picture is that most Americans aren’t doing a good job of saving. The average 401(k) balance for workers age 55-64 is $207,874. The median balance at 55-64 is only $71,168, meaning that half of all 401(k) accounts are less than $71,168.

I’m afraid the promise of becoming wealthy through your 401(k)s has proved elusive for the average American. It’s a wedge that is driving wealth inequality in our country. But I don’t think Pensions are coming back – retirement preparation rests squarely on the individual’s shoulders. You certainly can get to $500,000 to $1 million in a retirement account, but you have to aim to put in the maximum, not just get the company match. Then you have to not withdraw it and let it compound for 30 to 40 years. That recipe will work, but it’s not easy, it requires some sacrifice and a lot of discipline.

Counting on Social Security

The Social Security Trust Fund will be depleted by 2033. After that, revenues will only cover about 70% of promised benefits. After kicking the can down the road for 20 years, Washington needs to get its act together soon. We can either reduce benefits or increase taxes. It may be a combination of both, but one thing is for sure: keeping the status quo is not going to be an option. The Social Security budget for 2023 is $1.30 Trillion. The Department of Health and Human Services (Medicare, Medicaid, and other health agencies) have a budget of $2.10 Trillion for this year. These two programs, largely for Retirees, have become the biggest portion of government spending.

There will have to be a reckoning in the years ahead about these programs. Something has to change, they are unsustainable in their present form. I think there will be changes in inflation adjustments, a gradual increase in the full retirement age, and probably some means testing which will reduce benefits for high net worth families. Or there could be a whole new system. As difficult as it is to imagine, the system is so broken that starting over from scratch might be better than continuing to try to put new band-aids on this fiscal cancer.

The big picture for the future of government retirement programs is very uncertain. These are not the only issues facing the government. Our debt is growing. This year, the interest payments alone on US Treasury Debt will be $964 Billion. We may top $1 Trillion in interest payments next year. And there is no plan to ever repay this debt, only to grow it every single year. When you look at debt projections, it only reinforces the need to reign in the expenses which are growing the fastest.

In our planning process, we include Social Security projections. But we had better be prepared for benefits to potentially be a bit less than promised. So, once again, it may be that more of your retirement income needs to be self-funded. If you don’t have a pension, the burden of funding your retirement has been shifted to you. Have you calculated what that will cost? That’s what we do with our retirement planning software, MoneyGuidePro. We create an ongoing plan for your retirement needs, which adjusts over time, and where we can continue to refine assumptions and expectations.

I hate to be such a downer, it’s really not my nature. But a lot of Americans are going to have worse retirements than their parents, because they don’t have a pension. The burden of saving for retirement has shifted from the employer to the employee. Now instead of everyone getting a good outcome, many Americans are under-prepared for retirement. And then we have to look ahead at the uncertainty that is facing Social Security and Medicare. It looks like we will have more individual responsibility for our outcomes and less universal assistance.

The Forest For The Trees

The Big Picture for Growth can be hard to see because the fog of current events makes it hard to see the long-term horizon. Here are our four pillars of The Big Picture:

  1. Don’t time the market. Stick to your asset allocation and rebalance. Use index funds.
  2. Once you’ve made the shift away from performance chasing, focus on what really matters: how much you save.
  3. Taxes hurt returns. Tax planning helps.
  4. You are responsible for your own retirement savings and financial security.

I’m sure things are going to change. We don’t really know how, when, or why they will change. While some may find uncertainty to be paralyzing, it doesn’t have to be. Even if the future is a moving target, planning is not a waste of time. Not at all! Being well prepared also includes the flexibility to adapt and evolve.

A lot of my day to day work is focused on the small details of implementing our plans. But the growth is created when we step back and take a long, hard look at The Big Picture. We should all be having more of those conversations, with our spouses and children, our bosses and colleagues, and especially with your financial professional.

Read More
Bonds and Interest Rates

Bonds and Interest Rates

Posted On March 31, 2023 By Scott Stratton, CFP(R), CFA In Portfolio Management /  

How are Bonds and Interest Rates correlated? Bonds move inversely from Interest Rates. When rates rise, the price of bonds fall. This simple fact led to the downfall of Silicon Valley Bank and Signature Bank this month. Banks invest your deposits in bonds and earn a spread on the difference between what they pay you and the bonds they buy. Banks are not vaults with piles of cash – they are bond investors. That is their business model.

In 2020, these banks bought long-term bonds with yields of 1-2 percent. Fast forward to 2023, and yields are now 4-5 percent on the same bonds, and some of those bonds are now trading at 90 cents on the dollar. A bank with $10 Billion in these bonds now has a paper loss of $1 Billion.

If they can hold to maturity, these bonds will return back to their full value. But if a large number of depositors all want their money out today, the banks have to sell their bonds for a huge loss. And if that loss is large enough, the bank becomes insolvent and doesn’t have enough assets to cover their deposits.

Bank Failures

When a bank fails, the FDIC steps in and seizes the bank. What is remarkable about these two bank failures in March is the size of the losses. These two banks represent $319 Billion in assets, which makes 2023 the second worst year ever for the FDIC, and it’s only March. In 2008, bank failures totaled $373 Billion in assets. So it is easy to see how bad things could get in 2023, if two bank failures in March almost reached the losses of the Global Financial Crisis of 2008.

These banks are collateral damage from rising interest rates, thanks to the Federal Reserve. The Fed held rates for too low for too long after the start of the pandemic, and helped create the accelerating inflation. Now they are raising rates to slow the economy.

While the Federal Reserve did set this in motion, the poor risk management at the Banks should bear the brunt of the blame. We have been talking for several years about reducing the duration of our bond holdings and lowering our interest rate risk. And I thought everyone else was doing the same, it seemed pretty obvious to me. But no, there were banks buying these long bonds which were just waiting to get crushed. When customers realized the size of bank losses, they pulled their deposits and there was a run on the bank. Could other banks follow? Maybe. If customers pull out their deposits en mass, it is possible.

I am not terribly concerned about this spreading to other banks, because the Fed has launched a new program. The Bank Term Funding Program will provide loans to banks so that they can hold on to their longer dated Treasury bonds and not have to sell for a loss. It will provide liquidity so that the banks can hold these bonds for longer. And like other government programs, I can see this program being expanded and made permanent.

It is remarkable to me how much of our news today has its roots in bonds and interest rates. The bank crisis, inflation, recession, unemployment, retirement programs, real estate and mortgages, etc. These are all linked. What should the individual investor do? Here are our thoughts:

FDIC Coverage

I would never have more than $250,000 at any bank and exceed the FDIC coverage limits. I heard about a corporate subsidiary that had tens of millions at SVB, which failed last month. Luckily, it looks like the FDIC has arranged for all of those large account holders of SVB to be made whole. But I would not just assume that FDIC coverage is now unlimited. Instead of exceeding FDIC limits:

  • You could use more than one bank and stay under FDIC limits.
  • We can buy brokerage CDs from multiple banks in your Ameritrade account. Each issuer will carry $250,000 of FDIC coverage. Today we have 6-month CDs at 5%. Investors are often surprised that I can show them much better yields from Chase or Wells Fargo than they can get at their local branch.
  • Ladder Treasury Bills. There are maturities every week. Treasury bonds are high quality and the most liquid market in the world.

Bond Strategies

Our core holdings for bonds consist of owning individual bonds laddered from 1-5 years. We buy investment grade bonds including Agency Bonds, Treasuries, Corporate, Municipal, and CDs. Today, the yield on Agency bonds is very competitive with Corporates. And CDs are yielding higher than Treasuries.

With today’s yields, I would avoid taking on significant credit risk. We are not buying any junk bonds, and have sold our Floating Rate bonds. In addition to rising interest rates, we are seeing liquidity problems in some areas of the bond market. It may become difficult or impossible for some low credit quality companies to refinance their debt in 2023 and 2024. It is probable that defaults will rise, another casualty of the Federal Reserve heading the economy towards a likely recession.

Inverted Yield Curve

While the Fed raised the Fed Funds rate 0.25% at their March meeting, the bond market moved the opposite direction. Over the past month, the 2-year Treasury has actually fallen from 4.89% on March 1, to as low as 3.76% on March 23rd. The bond market remains inverted, with the 2-year yields higher than the 10-year yields. This is a strong historical predictor of recession. The bond market is priced as if the Federal Reserve will begin cutting interest rates in 2023, which is not what Jerome Powell is saying at all. The Fed’s commentary shows that they anticipate raising rates to 5.10% (from the current 4.75-5.00%) by year end. The movement in the bond market is bearish for the economy and stocks.

So now there is the potential for the opposite movement of the bond see-saw. If rates do go down this year or next, bond prices will rise. If we enter a recession, investors will want to shift towards safety and the Fed will lower rates. This would be a good time to have longer duration bonds with higher credit quality. And so we have begun buying longer bonds, 7-15 years. And if nothing happens and we just hold these bonds, we have yields to maturity of 6%. That is also a good outcome, an alternative to stocks, which have a similar expected return today.

In spite of seeing losses in bonds in 2022, looking forward, bond returns look strong. Still, it is crucial to be mindful of the risks and to take steps to mitigate them. Here are some additional ways to improve safety in a bond portfolio:

Diversify Across Different Types of Bonds

It’s important to diversify across different types of bonds, such as corporate, municipal, and government bonds, as well as across different industries and sectors. This can help reduce the impact of any one bond issuer or industry experiencing difficulties.

Consider Active Bond Management

Active bond management can help adjust the portfolio to changing market conditions and credit risks. It may be worth considering investing in low-cost actively managed bond funds or working with an investment advisor who specializes in bond management.

Monitor Interest Rate Risks

Investors should keep a close eye on interest rate risks and how they may impact their bond portfolio. The longer the duration of the bond, the greater the impact of interest rate fluctuations. Investors may want to consider laddering their bonds to manage interest rate risks.

Use Credit Ratings as a Guide

Credit ratings can provide a guide to the creditworthiness of a bond issuer. Investors should be wary of bonds with lower credit ratings, as they may carry higher risks of default. However, it’s important to remember that credit ratings are not infallible and can sometimes be inaccurate.

In conclusion, while bonds can offer attractive yields and provide diversification to a high net worth investor’s portfolio, it’s important to be mindful of the risks and take steps to mitigate them. By diversifying across different types of bonds, actively managing the portfolio, monitoring interest rate risks, and using credit ratings as a guide, investors can help reduce their exposure to potential losses. Keeping cash in a bank may not be as safe as you might assume, especially if you exceed FDIC coverage. And why have cash earning next to nothing when you could be making 4-5% in short term CDs or Treasury Bills?

Within our strategic asset allocation models, we actually spend more time on managing our bond holdings than our stock holdings. Why? Because it’s that important, and it is an area where we believe we can add more value with our time. Interest Rates are in the news and there are a lot of risks today. Risk is often defined as a danger, but risk can also mean opportunity. We are seeing both dangers and opportunities in 2023, and you can bet there will continue to be a lot of headlines about Bonds and Interest Rates.

Read More
Investment Themes for 2023

Investment Themes for 2023

Posted On January 13, 2023 By Scott Stratton, CFP(R), CFA In Portfolio Management /  

At the start of each year, I discuss our investment themes for the year ahead. Today we share our Investment Themes for 2023. 2022 was a lousy year for investors, with a Bear Market in stocks (a loss of more than 20%) and double digit losses in bonds. And to add insult to injury, 9% inflation increased our cost of living even as portfolios shrank. War in Europe, supply chain problems, and political drama added to the uncertainty.

The Federal Reserve is committed to raising interest rates to slow the economy back down to 2% inflation. Economists are predicting a recession in 2023. With all these problems, it is easy to feel pessimistic about 2023 as an investor.

However, there are reasons for optimism. The call for a recession is so clear that it may already be somewhat priced into the market’s expectations for 2023. Many stocks are down 20%, 30% or more from their peaks and more fairly valued today. The large losses in international stocks were driven by a 17-20% increase in the value of the dollar to the Euro and Yen, and that headwind may be turning into a tailwind as the dollar starts to decline.

Today, we have very attractive rates in the bond market, 4.5% on short-term bonds and 5.5% on intermediate investment grade bonds. Bonds look better in 2023 than they have since the Global Financial Crisis in 2008.

My annual investment themes are not a prediction of whether stocks will be up or down this year. We don’t believe anyone can time the market or predict short-term performance. Instead, our process is to tilt towards the areas of relative value, with a diversified, buy and hold portfolio. Here is how we are positioning for the year ahead.

(And if you want to look back, here were our Investment Themes for 2022 and 2021.)

Stocks

In 2022, the Growth / Value reversal became widely acknowledged. For over a decade, growth stocks had crushed value stocks, but that leadership came to an end last year. Now, value stocks are performing better and growth stocks could have further to fall. We are using Value funds across markets caps – large, medium, and small.

International stocks have lagged US stocks, but today offer a better value. These stocks are cheaper than US stocks, have a higher dividend yield, and offer a hedge against a falling dollar. International and Emerging Markets are attractive today, and we are maintaining our international diversification. There are now more low-cost Value funds and ETFs offered in International stocks, and so we have replaced some of our Index Funds with a Value fund.

Overall, we have not made significant changes to the holdings within our stock allocations. What has changed is the expected return of stocks versus bonds. Over the next 10 years, Vanguard has an expected return of 5.7% return on US stocks. Yields have risen in A-rated bonds to where we can get a similar return from bonds. So, we are moving 10% of our stock allocation into individual bonds, 5-7 years with a yield to maturity of at least 5.5%. We are buying AAA government agency bonds (such as Fannie Mae or Freddie Mac), and some A-rated corporate bonds. These are offering a similar return as the expected return from stocks, but with much, much less risk and volatility. We aren’t giving up on stocks, but if bonds are going to offer similar potential, then we are going to add to bonds.

Bonds

Our core approach to bonds is to buy individual A-rated bonds, laddered from 1-5 years. We buy Treasury Bonds, Agency Bonds, CDs, Corporate Bonds, and Municipal Bonds. Yields are up and we want to lock-in today’s yields. For clients who are retired or close to retirement, our laddered bond portfolio will be used to meet their income needs for the next five years.

We use a “Core and Satellite” approach. The 1-5 year ladder represents our Core holdings today. For 2023, we decreased our Satellite holdings in bonds. Last year, we had a large position in Floating Rate Bonds. And these ended up being the best performing, most defensive category within Fixed Income in 2022. They worked exactly as hoped, protecting us during a year of rising interest rates. For the year ahead, though, they are less attractive. These are smaller, more leveraged companies. A year ago, their debt cost them 3%. Today, those companies are facing a recession and their debt now may cost them 7%. Floating Rate bonds have become more risky and more likely to have losses. We have sold Floating Rate and added the proceeds to our core 1-5 year ladder.

At the start of 2022, our focus was to minimize interest rate risk by keeping bonds short-duration. Yields have risen so much that in 2023 we want to extend duration and lock-in higher yields. Unfortunately, with an inverted yield curve, it is more challenging. Still, today, we are looking to add 5-7 year bonds to our ladders when cash is available and we can find attractive bonds.

We continue to own a small position in Emerging Market bonds. These have always been more volatile than other bonds, but history suggests that selling after a down year is a bad idea. The yields going forward are attractive, and many of these emerging countries are actually more fiscally sound than developed nations.

Alternatives

We are always looking for other investments which offer a unique opportunity for the current environment. We want returns better than bonds, but with less risk than stocks. If we can add investments with a low correlation to stocks, it will improve the risk/reward profile of our portfolio.

We purchased commodities early in 2022 with inflation spiking. Although they had a good Q1, commodities fared poorly for the rest of the year. We sold most of our commodities in October, and replaced them with TIPS, Treasury Inflation Protected Securities. The price of TIPS fell dramatically through the year, and by October, we could buy 5-year TIPS which yield 1.7% over inflation. TIPS are now a more direct inflation-hedge than commodities, which are frustratingly inconsistent. (If Gold doesn’t do well when there is 9% inflation, when will it shine?) Today, TIPS also offer a better yield than I-series US Savings Bonds.

Preferred Stocks were down in 2022 and we are trimming those positions to add to our Core 1-5 Year Ladder. Still, there are some good opportunities as many Preferreds are now trading at a 30% discount to their $25 par value. Preferreds with a set maturity date should be held to maturity. Perpetual Preferreds (those without a maturity) now offer 6-7% current yields or higher. While volatile, that is a decent level of income, plus the potential for price appreciation if interest rates fall in the future.

Overall, Alternatives are less attractive in 2023 because we now have such compelling bond yields. When we can buy risk-free T-Bills with a 4.5% yield, there is a higher bar for what will make the cut as an Alternative.

Summary

No one has a crystal ball for the year ahead, and our Investment Themes for 2023 are not based on a 12-month horizon. Instead, we are looking for assets that we think will be good over the next 5-10 years. We remain very well diversified, both in size (large, medium, small) and location (US, International, Emerging), as well as in Bonds and Alternatives. We diversify holdings broadly, with 10-12 ETFs, and each fund holding several hundred to several thousand stocks.

Although 2022 was an ugly year for investors, I wouldn’t bet against the stock market after a 20% drop. Historically, the market is usually up 12 months later. The expectations for 2023 are low and I would certainly caution investors to assume a volatile year ahead. Still, in these difficult periods, the best thing for investors is to stick to a good plan: diversify, keep costs and taxes low, and don’t try to time the market.

We take a patient approach and tilt towards the attractive areas, including Value stocks and International. Bonds finally offer a decent yield today and we have increased our core bond holdings and are looking to extend duration. We are making more changes in the bonds and alternatives than to our stock holdings. In 2022, we added more value on the bond side of portfolios, relative to benchmarks, than we did in stocks. So, as boring as bonds may seem, we focus a lot on bonds because we think there is an opportunity to add value for our investors.

Investing isn’t easy, but thankfully, it can be simple. We don’t need a lot of complexity to accomplish our goals over time. Years like 2022 are an unfortunate reality of being an investor. For 2023, we are making small adjustments but focused on staying the course.

Read More
Callable Bonds versus Discount Bonds

Callable Bonds versus Discount Bonds

Posted On December 3, 2022 By Scott Stratton, CFP(R), CFA In Portfolio Management /  

Bond yields are up this year and we are seeing newly issued bonds with 5 to 6 percent coupons. Which is better – to buy a new issue or an older one with lower coupon? Here is what we are looking at as we buy individual bonds.

Yield To Maturity

The return of a bond from the date of purchase to its maturity is its Yield to Maturity or YTM. We calculate YTM with three things: the bond’s interest payments, the price of the bond, and the number of years to maturity. While bonds are generally issued and redeemed at a Par value of $1000, they inevitably trade at a premium or a discount to Par.

The bonds of any issuer tend to have the roughly the same YTM, but the price can differ. For example, a newly issued 5-year bond could have a 6% coupon (interest payment) and a price of $1000. This bond has a YTM of 6%. But an older bond with 5-years remaining might have a 3% coupon. Today, that bond would likely trade for $872, and have the same 6% YTM. In the first one, the 6% coupon, all of your YTM is solely from the coupon. In the second bond, the 3% coupon, part of your return is coupon and part is from the price increasing from $872 to $1000 over five years.

I think most investors would prefer the first bond, the 6% coupon, and get the same steady income each year. They’d rather have the current income rather than the capital gains of the second bond. However, the annual return on both, held to maturity, is the same 6%.

Callable Bonds

Unfortunately, there is one problem. Most corporate and municipal bonds are callable. That means the issuer has the right to refinance their debt and buy back your bonds early, before the five years are up. So, if interest rates drop from today’s 6% to 4% two years from now, they can buy back your 6% coupon bonds at 1000. And now you have to replace those 6% bonds at a time when interest rates are only 4%. This is called Reinvestment Risk.

However, the discount bond (the 3% coupon) won’t get called in this scenario. The issuer will not refinance a debt that costs them 3% for the new rate of 4%. You hold it for the full five years and receive your expected YTM of 6%. It’s better to buy the discount bond with a 6% YTM than a 6% coupon bond at par because of the Call Risk of the 6% coupon.

I’m sharing this because clients may hear me talking about bonds at 6% but then see a bond listed as a 3% bond on their statement. No one really knows what interest rates will do over the next five years, but they will probably move around quite a bit, like they have over the last five years. And that Call Risk is a real problem for bonds with a high coupon. If you really want to lock in your return from a bond, you have to understand its call features.

Callable Bonds Don’t Appreciate

One other consideration – callable bonds don’t have the ability to appreciate much. If the issuer can redeem anytime for $1000, that bond is not ever going to trade at a significant premium. However, if interest rates fall, our discount bond (the 3% coupon) can increase in price in a hurry. It can move up from $872 quickly. We can have a bigger return in the short run, and even sell that bond if we want.

In managing our bond ladders, I focus primarily on Yield To Maturity, not the current coupon. We prefer to buy discount bonds, which have lower call risk, when possible. Non-callable bonds are even better, but harder to find in all categories. Today, interest in bonds is high (pun intended), and so we have been writing a lot about how we manage this important piece of your portfolio.

Read More About Bonds

Read More
Stocks Versus Bonds Today

Stocks Versus Bonds Today

Posted On November 14, 2022 By Admin In Portfolio Management /  

Where is the best opportunity – in stocks or bonds? I’ve been enthusiastic about the rising interest rates in 2022 and this has impacted the relative attractiveness of stocks versus bonds today. What do we expect from stocks going forward?

Vanguard’s Investment Strategy Group publishes their projected return for stocks for the next 10 years. And while no one has a crystal ball to know exactly how stocks will perform, this is still valuable information. They look at expected economic growth, dividend yield, and whether stock values (P/E ratios for example) might expand or contract.

Their median 10-year expected return for US stocks is 5.7%, with a plus or minus 1% range, for a range of 4.7% to 6.7%. This is actually up from the beginning of the year. As stocks have fallen by 20%, we are now starting from a less expensive valuation. But a projected return of 5.7% for the next decade would be well below historical averages, and most investors are hoping for better.

Is Vanguard being too pessimistic? No, many other analysts have similar projections which are well below historical returns. For example, Northern Trust forecasts a 6% return on US stocks over the next five years. And of course, these are just projections. Returns could be better. Or worse!

Bonds Are An Alternative

Last week, I bought some investment grade corporate bonds with a yield to maturity of 6% over three to five years. Bonds have much less risk than stocks and have only a fraction of the volatility of stocks. As long as the company stays in business, you should be getting your 6% return and then your principal back at maturity.

If we can buy a good bond with a return of 5.5% to 6.0%, that completely matches the projected stock returns that Vanguard expects. Why bother with stocks, then? Why take the risk that we fall short of 6% in stocks, if we can get a 6% return in bonds? Today, bonds are really attractive, even potentially an alternative to stocks.

For many of our clients, bonds look better than stocks now. And so we may be trimming stocks by year end and buying bonds, under two conditions: 1. The stocks market remains up. We are not going to sell stocks if they fall from here. 2. We can buy investment grade bonds, 3-7 years, with yields of at least 5.5% and preferably 6%. And we have to find different bonds, because we aim to keep any one company to no more than 1-2% of the portfolio.

We won’t be giving up on stocks – not at all. But we may look to shift 10-20% of that US stock exposure to bonds.

Three Paths for the Market

I think there are three scenarios, all of which are okay.

  1. Stocks do way better than 6%. The risk here is that stocks could perform much better than the 5.7% estimate from Vanguard. Maybe they return 8% over the next five years. Well, this is our worst scenario: we make “only” 6% and are kicking ourselves because we could have made a little bit more if we had stayed in stocks.
  2. Stocks return 6% or less. In this case, it is possible we will get the same return from bonds as the expected return from stocks. And if stocks do worse than expected, our bonds might even outperform the stocks. That’s also a win for bonds.
  3. Stocks decline. What if the economy goes into recession, and stocks drop? If stocks are down 10% and we are up 6% a year on bonds, we will be really happy. In a recession, it’s likely that yields will drop and the price of bonds will increase. The 6% bond we bought might have gone up in value from 100 to 104. Then, our total return on the bond might be 10%, and we could be 20% ahead relative to stocks’ 10% drop. And in this scenario, we don’t have to hold the bonds to maturity. We could sell the bonds and buy stocks while they are down.

Smoother is Better

I’m happy with any of those three scenarios. Many investors are feeling some PTSD from the market performance since 2020. Many will be happy to “settle” for 5.5% to 6% from bonds, versus the 5.7% expected return from stocks. And of course, stocks won’t be steady. They may be up 20% one year and down 20% the next. It is often a roller coaster, and so increasing bonds may offer a smoother ride while not changing our expected return by much at all.

Should everyone do this? No, I think if you are a young investor who is contributing every month to a 401(k) or IRA, don’t give up on stocks. Even if the return ends up being the same 6%, you will actually benefit from the volatility of stocks through Dollar Cost Averaging. When stocks are down, you are buying more shares. So, if you are in accumulation, many years from retirement (say 10+), I wouldn’t make any change.

But for investors with a large portfolio, or those in or near retirement, I think they will prefer the steady, more predictable return of bonds. When the yield on bonds is the same as the 5-10 year expected return on stocks, bonds make a lot of sense. The risk/reward comparison of stocks versus bonds today is clear: bonds offer the same expected return for less risk. We will be adding to bonds and adjusting our portfolio models going into 2023.

Read More
Q3 Portfolio Results

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.

Read More
Inflation Investment Ideas

Inflation Investment Ideas

Posted On July 15, 2022 By Admin In Portfolio Management /  

Inflation continues to shock the Global economy and has become a major concern when we discuss investment ideas. This week’s data showed the Consumer Price Index up 9.1% over last year, and the Producer Price Index is up over 11%. These are numbers not seen since 1981.

Today, I’m going to share some thoughts on inflation and get into how we want to respond to this situation. But first, here is an inside look at the government response to inflation.

Federal Reserve Hitting the Brakes

Last week, I attended a breakfast meeting for the Arkansas CFA Society at the Federal Reserve office in Little Rock. Our guest speaker was James Bullard, president of the St. Louis Federal Reserve Bank and voting member of the Open Market Committee which sets interest rates.

Bullard said that we were at a profound regime switching moment today, and that this is not just a blip in inflation but a “stunning amount of inflation”. He stated that the Fed would move aggressively to reduce inflation and that they were committed to their inflation target of 2%. He thinks the Fed will continue to raise rates until policy rates are greater than the inflation rate and may need to hold those high rates for years to come to bring inflation down.

Bullard felt that the current inflation levels are not simply a temporary supply shock from the Ukraine War. Output is actually up. In March 2020, the Fed responded very quickly to support an economy crashing from COVID-19 shutdowns. 60 days later, markets recovered and housing boomed. He wishes that they had reduced their asset purchases sooner. Instead, the Fed is only now ceasing to buy bonds and is allowing their holdings to run-off as they mature. The global stimulus response was correct, but has overheated.

He was less concerned about the possibility of a recession. Bullard said that recessions are difficult to predict and that the Fed is going to focus on getting inflation under control first. Inflation remains a global problem, but the US Federal Reserve will lead the way on fighting inflation, as the European Central Bank has other issues making them slower to respond.

Inflation, Rising Rates, Recession

It’s important to understand that even if inflation remains elevated for a couple of years, the impact of inflation may only be part of the story. Our investment ideas cannot simply assume high inflation as the only factor. We have to also consider the likelihood of rising interest rates and a recession. We’d love it if the Federal Reserve can orchestrate a soft landing as they apply brakes to this runaway economy. But they have not been very good at soft landings in the past.

The Fed policies are starting to work. Since the June inflation numbers, we’ve already seen the price of oil down by 20%. Mortgage applications are down and we should start to see housing inventories normalize and home prices stop their double digit increases. Interest rates have doubled compared to last year – 5.5% versus 2.75% for a 30-year mortgage – and this will impact how much home buyers can afford to pay. The Bloomberg Commodity Index was at 130 on June 16th and is now at 113, a drop of 13% in one month.

It is hard to imagine additional inflation shocks or surprises at this point. Despite the headlines, markets already know we have inflation. Inflation remains high, but may have peaked and should be starting to come down. The question is what is next? How will the markets respond to the Fed actions? Here are five thoughts about where to go from here.

Five Inflation Investment Ideas

  1. Rising Rates. Bond investors beware. The Fed is going to continue to raise interest rates for an extended period. Keep your duration short on bonds. Consider floating rate bonds, if you don’t have any. Stay high quality – rising rates may cause defaults in weaker credits.
  2. I-Bonds. These are inflation linked US savings bonds. They’ve been in the news this year, but I’ve been writing about them since 2016. Limited to $10,000 in purchases a year. These could do great for a couple of years.
  3. Recession and Stocks. We might already be in a recession today, but won’t know it until later economic data shows a negative GDP for two quarters. Please resist the temptation to try to time the stock market. Recessions are a lagging indicator; stocks are a leading indicator and stocks will bounce back sooner. If you try to get out of stocks, it will be very difficult to get back in successfully. Instead, focus on diversification, with Value and Quality stocks. Avoid the high-flying growth names, we are already seeing those stocks get pummelled.
  4. Roth Conversions. We are in a Bear Market, with the S&P 500 Index down 20%. This could be a good time to look at Roth Conversions, if you believe as I do that stocks will come back at some point in the future. An index fund that used to be $50,000 is now trading for $40,000. Do the Roth Conversion, pay taxes on the $40,000 and then it will grow tax-free from here. This works best if you anticipate being in a similar tax bracket in retirement as today.
  5. Cash is Trash. Inflation is reducing your purchasing power. Thankfully, rising interest rates means we can now earn some money on Bonds and CDs. We can build laddered bond portfolios from 1-5 years with yields of 3-5%. And we have CDs at 3% as short as 13 months. Those are a lot better than earning 0% on cash. If you don’t need 100% liquidity, short-term bonds, CDs,