Update on Recent Stock and Bond Market Activity

The Fed Gets Serious

On Friday, August 26, Federal Reserve Chairman Powell clarified the Fed’s commitment to continue raising interest rates until inflation is “under control,” even if it causes a recession. In response, the stock market dropped 5.8% between August 25 and August 31, as measured by the S&P 500 ETF (ticker: IVV).

Previously, there was more doubt about the Fed’s commitment to raise rates and the market expected interest rates would soon fall.

For context, the stock market (IVV) is down 16.7% through August 31 this year. Bonds haven’t fared much better. Bonds declined by 11.7% over the same period, as measured by the iShares Core US Aggregate Bond ETF (ticker: AGG), which is often used as a proxy for the bond market.

When Good News is Bad News

Because economic growth remains healthy in terms of gross national income and strong employment, many investors fear the Fed may raise interest rates too much before inflation subsides, causing a recession.

Contributing to that fear is that several powerful inflationary factors, such as snarled supply chains, Covid lockdowns in China, and the war in Ukraine, are not impacted by raising interest rates.

Why Interest Rates Impact Values

Higher interest rates typically reduce stock and bond valuations because most investors discount expected future profits (and interest income) by an interest rate to calculate what each security is worth.

The way the math works, higher interest (discount) rates mean that a given stream of company profits are worth less in today’s dollars.

In addition, higher interest rates can reduce company profits through higher costs for borrowed money and from lower sales, if there is a recession.

Highly profitable (“value”) companies hold their value better than unprofitable (“growth”) companies when interest rates rise because near-term profits are worth more than distant future profits when valued in today’s dollars.

Our stock portfolios are concentrated in highly profitable companies, many of which generate substantial dividend income. This approach is especially well-suited for current market conditions.

Where Do We Go From Here?

Periods of slower growth and recessions are normal and necessary to correct for imbalances that arise during periods of economic growth.

We’ve seen this pattern of economic cycles many times in the past, including how stock markets have declined and subsequently recovered to generously reward investors. The following chart is a good reminder of the big picture.

While it can feel unsettling experiencing a decline, successful long-term investing requires patience and persistence.

What matters most is that you have the money you need when it’s time to spend it, not how values vary along the way. This is why we set aside what you need for spending over the next couple of years in short-term bonds and bank accounts.

With 8.5% inflation, remaining invested in stocks of companies that can raise prices and increase profits represents the most promising way to preserve purchasing power and grow wealth over the long term.

For example, $100 invested in an S&P 500 index fund at the beginning of 1980, was worth about $9,789 at the end of 2020 (40 years), including reinvested dividends. This is a return of nearly 97 times the investment, or 11.8% per year. This beat inflation, for an inflation-adjusted return of about 30 times the investment, or 8.7% per year. Of course, past performance is no guarantee of future returns.

Conclusion

We are prepared for and expect stock market set-backs. We understand that experiencing variability in values is necessary for participating in the stock market’s long-term benefits.

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We create custom portfolios that generate sustainable retirement income throughout market cycles while pursuing long-term gains. We serve retired clients across the US who have more than $1 million to invest. For an initial strategy session, schedule an appointment or call Jeff at 201-266-6829.