Search
  • Ben TeSelle

Dorato News - July 2022

Portfolio Issues - The Long Term


Negative stories surrounding the market seem to be everywhere you look. Inflation, the Russian invasion of Ukraine, and supply chain issues continue to get a lot of attention. Investors are trying to figure out how long these issues will persist while trying to predict what the economic consequences will be. With gloomy headlines dominating financial news and more talk of trouble ahead, it isn’t surprising to see the markets moving downwards.

Fed Chairman Jerome Powell has made it clear that combating inflation is their primary goal and they are willing to endure some pain to get it under control. Investors have adjusted to the changing environment and sell-offs have been especially pronounced in the riskier sections of the market. The NASDAQ, which includes many of the pandemic winners, is down close to 30% for the year.

As the Fed moves to tamp down inflation, the fear is that the economy will enter a recession. While recessions are not ideal, they are a normal part of the business cycle. And recessions are temporary, not permanent.

We mention all this because it is very easy to get caught up in current events and the news cycle. Without realizing it, investors can find themselves reacting to news in the short-term, and losing sight of the long-term. We find the best way to navigate through the noise is to stay consistent with your allocation. Sentiment shifts fairly quickly, you don’t want to find yourself left behind when it does.



“She called me a short-term investor!”

 

Market View - Recessions and Inflation


Unless you’ve been hiding under a rock, you’re probably aware that by mid-June the US stock market was down 20% for the year, the classic definition of a bear market. Yuck. But not so yucky as at the beginning of the Covid pandemic, when stocks dropped 35% within several weeks. The difference this time around is that the large technology stocks are leading the market downward. And, in contrast to 2020, solid, dividend-paying companies are holding up reasonably well. This makes sense to us. Indeed, it makes more sense to us than the pandemic-era stock prices. The pandemic era had the whiff of gambling about it; this market seems more reasoned. Well, at least a bit.

Bonds are down, too. Now this is the hard part, if you’re a conservative investor. Bonds are supposed to be the safer investment, but the typical bond fund is down 10% for the year. That’s due to rising interest rates. While rising rates means that you will get higher interest payments in the future, the transition to those higher payments can be painful. The ten-year US Treasury rate is now around 3%. The flat yield curve (long-term bonds pay about the same interest rate as short-term bonds) implies that bond investors think that long-term interest rates won’t rise much above the 3.5% range, which would mean that perhaps we’ve seen the worst for bond losses.

Why are interest rates rising? Because of inflation and the Federal Reserve’s fight against it. Some might argue that a recession is worse than inflation, but we strongly disagree. Recessions are temporary, but inflation can become permanent, and it is destructive if it gets out of control. Ask anybody in Argentina about that. So perhaps the Federal Reserve is a little late to the inflation fight, but it is doing the right thing.

While inflation is scary, recessions are to be expected from time to time. Our view is that we are likely to have a recession within the next year or two, but that it is unlikely to be severe. A recession is simply two quarters in a row when the economy shrinks. Because banks are strong, and because households have built up significant savings, we think a recession will be relatively mild. A re-run of the severe recession of 2008 is highly unlikely. Looking beyond any recession, we also think a recovery will be mild. A mild recovery means that company earnings will show modest progress, as will future stock prices.

As we’ve mentioned before, stock prices are ultimately tied to company earnings. With a mild recession and mild recovery, earnings will not be shooting higher, and neither will stock prices. Modest increases are more likely. Over the last couple of years, analysts have had to raise their earnings estimates for companies, because they had been too cautious in their initial estimates. That is likely to reverse over the next year or two, in a mild-recession, mild-recovery environment. One sector in particular where earnings estimates are probably still too high is the big technology companies. Amazon can't grow at a rate of 30% if the rest of the economy is growing at one or two or three percent. If it could, we’d become the United States of Amazon. So we think those big tech companies can fall further.

While the drop in stock prices is, well, yucky, there is a silver lining. Lower prices means that valuations are more in line with long-term averages, so expected returns are also more in line with long-term averages. In short, the future looks a bit brighter for stock returns.

Mike Tyson, a fearsome boxer, once said that every boxer has a plan, until he gets punched in the mouth. Similarly, everyone is a long-term investor, until the market drops. Then we suddenly get more myopic. It’s a natural reaction. The key is to step back (and to get as far away from Mike as possible). We don’t need to change anything just because the markets are fluctuating. Markets will always fluctuate. If we stick with our plan and stay invested, we will continue to build wealth.

Sources: Economist, Wall Street Journal, Value Line, Vanguard, Applied Finance Group, Schwab

11 views0 comments

Recent Posts

See All