Mid-Year Review

The first six months of 2022 saw the S&P 500 decline 21% from its all-time high at 4,796.56 on January 3 to a closing low of 3,785 on June 30th.

More noteworthy even than the extent of the decline was its gathering violence: in mid-June, the market ran off a streak of five out of seven trading days on which 90% of S&P 500 component stocks closed lower.  This is one-sided negativity on a historic scale.

Regardless of all other points I wish to make to you in this report, the most urgent should already be clear.  Simply stated, the best way to completely destroy any chance for lifetime investment success has historically been to sell one's quality equity portfolios in a bear market.

But to sell when investor sentiment is sufficiently negative to drive 90% of S&P stocks lower on five out of seven trading days—to sell, that is, when everyone else is selling—must strike us as the height of long-term folly.

I need to take you back to the bottom of the Great Panic on March 9, 2009. From that panic-driven trough, the S&P 500 (with dividends reinvested) compounded at 17.6% annually for the next twelve years, through the end of 2021. At its peak this past January 3, the Index was up seven times from its low. This was one of the greatest runs in the whole history of American equities.

Moreover, the Index's compound return over the last three of those years—2019 through 2021, encompassing the worst of the coronavirus plague—shot up to 24% annually.

But when inflation soared late last year, it became evident that equities' jaw-dropping advance over those three years had been fueled to some important extent by an excess of fiscal and monetary stimulus, mounted to offset the economic devastation of the pandemic. In one sentence: the Federal Reserve created far too much money, and then left it sloshing around out there far too long.

And since inflation, as Milton Friedman taught us, is always and everywhere a monetary phenomenon, we investors now find ourselves having to give back some of the extraordinary 2009–2021 market gains, as the Fed moves belatedly to sop up that excess liquidity by raising interest rates and shrinking its balance sheet.

Yes, the war in Eastern Europe and supply chain woes of various kinds have exacerbated inflation, but in my judgment they're irritants: monetary policy (seasoned as well with a bit too much fiscal stimulus) got us into this mess, and monetary policy must now get us out. The fear, of course, is that Fed will overtighten, putting the economy into recession.

My position is if an economic slowdown over a few calendar quarters is what it takes to stamp out inflation, it would be by far the lesser of the two evils. Inflation is a cancer, and it must be destroyed.

In the first quarter of 2022 the US economy shrank at a 1.5% annual rate.  The report for the second quarter is due later this month.  It may reveal that economic growth declined in the second quarter too.  If it does, that would fit the rule of thumb definition of a recession.  Officially, a recession is a sustained period of declining economic growth.  There is a government agency, the NBER, that decides when recessions start and end.  Of course, they can’t do this in real time.  However, looking back several months they declare the length of recessions.

So, it is certainly within the realm of possibility that we are already in a recession and that it started sometime in the first quarter of this year.  This chart provides some historical context for the depth and length of recessions.  The average recession lasted 14 months.  There are few outliers, but most recessions are around that long before the economy starts to turn around.

In economic downturns, there is an order of events.  Stocks are an early indicator of downturns and recoveries, economic growth is next, and jobs are last.  This is true both on the way down and back up.  So, stocks drop first, then growth, and finally employers pull back on hiring and often have to reduce their workforce.

However, stocks tend to hit bottom halfway through a recession because investors can see the light at the end of the tunnel.  Eventually, economic growth turns from negative to positive.  Jobs are the last part of an economic recovery.

Currently, there are 1.9 jobs open for every one job seeker and the unemployment rate stands at 3.6%.  This is a very loose job market.  No one would ever hope for an economic downturn that leads to job loss, but if they are an inevitable part of an economic cycle, this isn’t the worse time to have one.

We won’t know until this is all over when things will turn around or how deep stocks and the economy will slide until they reach bottom.  The only thing we know is that we are closer to the bottom now that we were at the beginning of the year when we reached the top.

The forward price-to-earnings ratio (P/E) which is a basic tool to evaluate whether stocks are over or under valued now is just below its long-term average.  This means that they are slightly undervalued compared to long-term norms when they were quite overvalued by that same metric at the last market high.

With regard to our investment policy, nothing has changed, because nothing ever changes. That is: we are long-term, goal-focused, plan-driven equity investors. We own diversified portfolios of superior companies; these companies have demonstrated the ability to increase earnings (and in most cases dividends) over time, thus supporting increases in their value.

We act continuously on our financial and investment plan; we do not react to current events, no matter how distressing they may be. After 30 months of chaos—the pandemic in its several variants, the election that would not end, roaring inflation (most painfully in gas price increases), the supply chain mess, war in Europe and so on—we're all understandably exhausted. That's when the impulse to capitulate—to get to the illusory “safety” of cash—becomes strongest. So that's when the impulse must be resisted most strongly. And that's my job.

This too shall pass. I'm here to talk all this through with you at any time. Thank you for being my clients. Thank you for your patience and understanding during this tumultuous time.  It is a privilege to serve you.

Dani Earned Letters Behind Her Name

Since her college graduation in July of 2020, our office manager, Dani Dursteler, has been recovering from the years-long commitment and living the good life.  However, this year, she decided to expand her skills by enrolling in a certificate course from the College for Financial Planning.  The course is called Foundations in Financial Planning.

The course covered a wide range of financial planning topics, including real estate, investments, various insurance, income taxes, Social Security, time value of money calculations, and estate planning.  After passing the final exam with flying colors, she was awarded the title of Financial Paraplanner Qualified Professional, or FPQP for short.

So, what is a paraplanner and what do they do? Each financial planning office works in unique ways, but in general, paraplanners take care of administrative, back-office, and clerical duties that get delegated their way.  This may include preparing or reviewing reports and financial plans, preparing client invoices, or updating financial or tax information in our planning software. 

You could think of a paraplanner as the financial advisor office equivalent of a dental hygienist or a paralegal.  If you’ve ever worked with an attorney, you know that the paralegal will be the one who actually gets stuff done.  The same is true in our office.  Dani is the engine that gets accounts set up, investment funds transferred in, and the money out the door to spend in retirement.  Her contributions cannot be understated, and her new designation shows her commitment to serving our clients.  Congratulations, Dani!

A Safe and High-Return Investment

The first half of 2022 has been a rough investing environment for both stocks and bonds.  The US stock market is down 20% through June 30^th, and bonds have also been down as rates have gone up.  On top of that, inflation is at its highest rate in 40 years.  Bank accounts offer safety in the short-term but a virtual guarantee of losing purchasing power as they have no chance of keeping up with inflation.  Stocks have worked well over the years in keeping up with inflation, but they come with short-term volatility.

There is an alternative that looks to be the best of both worlds, safe and keeping up with inflation. Although urban legends may dispute whether Al Gore invented the internet, he actually did invent the I-Bond.  The I bond is a version of a US Savings Bond, and the I stands for inflation.  The interest rate is variable and changes based on the current rate of inflation.  Since inflation is at a generational high, the rate is quite high too.  It is a loan to the Federal government which is risk-free since they have the ability to print money if they need to.  The current interest rate for I Bonds is 9.62% from now through October.

I Bonds can only be purchased directly from the US Treasury, usually through their website, treasurydirect.gov.  The maximum amount that can be invested is $10,000, and you can't access the bonds for the first year.  After that, you can withdraw your funds at any time, but you'll lose the last three months of interest if you take it out within 5 years of purchase.  Unless you need the funds, the penalty shouldn’t be too bad if the variable rate falls at some point in the future.

Savings bonds also have the feature of deferring the tax on the interest to the year that you redeem your bonds.  This means that you can pay the taxes on the savings bond all at once rather than every year.

Or, if you would rather not pay taxes on the interest at all, I Bonds and Series EE Bonds are both eligible to for a tax break if the funds are used for college expenses.  The interest earned on savings bonds can be excluded from income if it matches up in the same year that you have qualified higher education expenses.  You can even rollover your savings bonds into a 529 college saving plan and avoid paying taxes on the accrued interest.

 This little-known investment vehicle hasn’t been very attractive for decades while inflation remained tame, but today it stands out in today’s environment of turbulent markets and high inflation.  Unfortunately, savings bonds are not eligible to be purchased in brokerage accounts or we would already have them in our client accounts.  If you are interested in investing in Series I Savings Bonds, let us know and we can walk you through the process.