Investing Past the Inflation Bear

       I hope you all are doing well and enjoying time with friends and family as Summer officially begins. 

       It can be challenging to have a sunny outlook when nearly everything is going up in price except for stocks and bonds.  I empathize with all of you, especially new retirees, during this rough patch for your investments.  Be reassured, however, this too shall pass. 

      My message from April's newsletter remains the same: Don't panic; stocks are helping us achieve our goals.  I encourage you to stay positive and if anything, double down on things you can control: spending, saving, and investing according to your time horizon.  

     My goal with each newsletter is to summarize in plain English what's happening in the financial markets and the economy and direct your attention to things that will help you thrive in retirement.       

     First, I want to address those who are most fearful about inflation.  How do I have confidence in brighter days ahead for our economy?  The foundation of the U.S. financial system is built on democracy and capitalism.  The bigger the issue, the more people work to fix that issue.  Our system is not perfect by any means, but it has a proven track record that you shouldn't bet against. 

The Psychology

    This bear market (when stocks decline 20%+) stings because we haven't been accustomed to such a correction for a long time.  

     Over the past 13 years (since 2009), the stock market has experienced only a few setbacks of this magnitude and length.  In each of the past two market hick-ups, China Tariff's in 2018 and COVID in 2020,  stocks were back at all-time highs within 6 months.  This time is different with the S&P 500 recently down -23% and uncertainly abounds. 

     It's critical that you maintain a long-term perspective when investing.  Stocks increase in value over the long-term at an average rate of 10%+ per year (see more below), but it doesn't go up in a straight line.  Up and down markets occur in quick unexpected spikes, which are what we have experienced year to date.

    Remember, your future self will need money that grows faster than the rate of inflation and an allocation to stocks will help you achieve your goal of financial independence: being able to do what you want, when you want, with whom you want.

The Cause

     The U.S. central bank, known as the Federal Reserve (The Fed), used two powerful levers at its disposal at the onset of COVID to keep the economy growing during the shutdown.  They lowered the Federal Funds Interest Rate (rate at which banks borrow from the Federal Reserve) and increased the money supply (measured by M2 - see more below) by purchasing U.S. Treasury Bonds and Mortgage Backed Securities, a technique knows as quantitative easing.  The Fed's $4.5T of bond purchases in addition to $3.6T spent by the Federal Government directly to businesses and consumers (fiscal policy) resulted in too much money chasing too few goods. We are now paying for these loose monetary and fiscal policies with runaway inlfation.


The Problem

      All this money in the economy has caused a big problem.  The Fed tracks the supply of money and reports the data through what they call M2 - the total of all deposits held at banks. 



      Notice the comparatively large increase in 2020 compared to the slight increase in 2008 when we have very low inflation in subsequent years.   

The Fix

     To truly cool inflation, the Fed needs to reduce the money supply.  The Central Bank is working towards this by gradually raising the Fed Funds Rate (0.75% on June 15th) and slowly allowing the bonds they purchased to mature without buying more, which is causing a shrinkage in its balance sheet.  What the Fed is not doing yet, however, yet is actively selling the bonds out of their inventory.  Doing that would drain bank reserves and decrease M2, but would also cause interest rates to increase more dramatically, which would increase the chances of a recession. 

     The Fed is hoping to "run out the clock" in the hopes that inflation will come down without tipping the economy into a recession, a so called "soft landing".  Such a Goldilocks-scenario is difficult but possible. Unfortunately, the Fed's track record in this regard is not encouraging. 

     The good news is that stocks have already fallen quite dramatically, already pricing in the possibility of slower economic growth.  In fact, this year has been the worst start for stocks since 1932.  Recessions and bear markets are unfortunately part of the process.  Fortunately, these periods don't last long.  


      The chart above shows all of the recessions since WWII and the price changes of the S&P 500 index before, during, and after the recessionary periods.  Recessions typically last around one year.  Stock prices tend to fall dramatically in anticipation of a recession and rebound well before the recession is technically over.  

      This table is proof of why market timing is a bad idea.  If you knew all of the data and negative headlines a year in advance and tried to time the market, you'd most likely sell before the top and miss out on a lot of upside.

     Thankfully we can take the guess work and emotion out of the equation.  Take a look at the table below showing the performance of the iShares Core S&P 500 ETF (ticker IVV) which tracks the S&P 500 index.  This data for the past 10 years prior to May 2022 show annualized returns of 14.36% despite the 2022 YTD decline.  

     Using the rule of 72, your investments double every 5 years at this rate.  My point is that stocks are helping us to achieve our growth goals.



What You Need To Do Now

       The good news is you likely don't need to do anything differently than what you were doing 6 months ago when the stock market was at all-time highs.  Spend less than you bring in, maintain an emergency fund of around 3-6 months of basic living expenses, and invest a portion of each pay check if you're still working.  Turn off the news and don't login to your investment accounts if it stresses you out.  Focus on enjoying life within your means.  

      We have a thoughtful, disciplined plan for each of our clients.  We diversify your investment holdings according to your risk tolerance and time horizon and rebalance those holdings quarterly to maintain the appropriate balance.  

     Temporary declines in the stock market are an expected and necessary part of the plan.  Investments that offer the greatest potential returns in the long-term will suffer the greatest temporary declines.  Risk and reward will always be tightly correlated over time.  

      The current owner of the Carolina Panthers, David Tepper, made his billions by investing in the stock market.  In the midst of ugly markets like we're experiencing today he's quoted as saying, "It is not yet time to make money, it's the time not to lose money." 

      Selling now would be the worst mistake you could make.  To be successful at growing our savings to outpace inflation over the long-term, it is imperative for you to understand that temporary stock market declines are inevitable.  If you think you need to adjust your risk tolerance, let's schedule a call to discuss your circumstances and a plan on how to do that as the market recovers.  But be careful, adjusting your risk tolerance due to volatility in the securities markets is not a good stratgy.  Your personal circumstances should drive such adjustments.

     To bring this point home, I recommend you click the following link to read a recently written article by Ron Copley, PhD, CFA titled Gains and Losses - The Illusion Puzzle .

     I encourage you to give me your comments.  Thank you for taking the time to read this important message.  All the best, JB