Bonds and Stocks Tumble Together

Nick Levinson Comments

You’ve probably seen the headlines about how badly the stock market has performed so far in 2022.

“Bear market.”

“Worst first half of a year in the last fifty years.”

The broadest index of world stocks declined over 21% through June 30, 2022, caused in part by the highest inflation in 40 years and the largest land war in Europe in 80 years.

And the outlook for the rest of the year appears similarly bleak, with many predicting worldwide recession as the US Federal Reserve and other central banks raise interest rates quickly in an effort to stem inflation.

Less publicized, but in many ways much more surprising, has been the decline in bond prices, with the broadest index of US bonds down over 10% through June 30th.

This is the largest drop for bonds since 1994. And it has reversed a trend from recent periods of stock market declines, including 2000-2002 and 2007-2009, when bond prices rose and were widely viewed as a buffer against stock volatility.

Here’s a summary of how bonds work and what it means for you.

Bond Basics

Bonds are one of the main ways companies and governments raise funds to do their work. Stocks are the other.

Bond issuers borrow money from investors over a period of time (the “term”), promising to pay the investors periodic interest and return the money at the end of the term (or “maturity”).

This is why bonds are considered debt for companies and governments, while stocks are considered “equity,” or ownership stakes, in companies. Governments generally don’t offer stock.

The interest rate that bond issuers pay to investors is typically determined in the bond market (the Fed sets short-term rates for banks).

Very stable issuers, like the US federal government and well-established corporations, generally pay less in interest than local governments or less successful companies, because the risk of default on the interest payments and/or principal repayment is lower. This factor is often referred to as “credit quality.”

Shorter-term bonds typically pay less interest than longer-term bonds because the investor has an opportunity to reinvest funds more quickly after the bonds mature.

Another key concept for bond investors is that there are two components of total return for bonds: one is income, represented by the interest rate the issuer pays out, and the other is price change, which can be positive or negative.

This is also true for stocks (and almost all other investments), where income is earned as dividends. Stock price changes typically have wider ranges, both up and down, than for bonds.

Interest income typically represents the main part of total bond returns and is fairly straightforward: for most bonds, issuers pay investors the stated interest rate a few times each year.

Price changes for bonds are less intuitive: as market interest rates rise, typically due to factors such as positive economic growth and rising inflation, the prices of existing bonds, with lower fixed rates, decline.

As market interest rates fall, typically due to factors such as negative economic growth (i.e., recession) and lower inflation, the prices of existing bonds, with higher fixed rates, rise.

This “inverse” relationship between rates and prices causes much confusion but is very important in understanding your bond investments.

The latter scenario (i.e., lower rates/higher prices) characterized the bond market for most of the past three decades. Interest rates stayed relatively low, and bond prices rose.

Since the start of 2022, on the other hand, interest rates (represented by the 10-year US Treasury bond, which often serves as a benchmark for the broader bond market) have risen from 1.5% to almost 3.5% in mid-June.

This very rapid increase has led to the severe bond price declines through June.

Implications and Advice

Interest rates have fallen back to around 3% from the 3.5% high, and bond prices have recovered somewhat, especially in comparison with stock prices.

While bonds and stocks declined by almost equal amounts through March 31, 2022 (with bonds down 6% and stocks 5.5%), stocks had fallen twice as much as bonds through June 30th (down 20% and 10%, respectively).

For the longer-term, rising rates generally have positive implications since they are usually associated with periods of economic growth. Higher rates also typically offset bond price declines over time, providing a “self-correcting” mechanism for bonds that stocks lack.

But all of this is cold comfort for most bond investors, who have come to expect the “fixed income” part of their portfolios to churn out regular interest income with little or no volatility, especially on the downside.

Despite these short-term setbacks, for bonds as well as stocks, we continue to advocate for broadly diversified portfolios for long-term investors.

As Jeff Sommer, a New York Times business columnist whom we regularly cite, put it recently:

“A period of wrenching volatility is inescapable. This happens periodically in financial markets, yet those very markets tend to produce wealth for people who are able to ride out this turbulence.

“It is important, as always, to make sure you have enough put aside for an emergency. Then assess your ability to withstand the impact of nasty headlines and unpleasant financial statements documenting market losses.”

(PPA note: We use the word “declines” to describe reductions in the value of your portfolio on monthly or quarterly statements. “Losses” only come when you’ve actually sold an investment for a lower price than you originally bought it.)

“Cheap, broadly diversified index funds that track the overall market are being hit hard right now, but I’m still putting money into them. Over the long run, that approach has led to prosperity.

“Count on more market craziness until the Fed’s struggle to beat inflation has been resolved. But if history is a guide, the odds are that you will do well if you can get through it.”

As always, please don’t hesitate to contact us with questions or comments about these and other financial topics.

Inflation

Tom Levinson Comments

Gas prices above $5 and $6 per gallon. Spiking costs for airfare, cars, rent, and groceries.  Significant declines in the stock and bond markets.

Earlier this month, the Department of Labor reported that in May, the Consumer Price Index (CPI) had surged 8.6% from May 2021. This marks the highest inflation rate in the U.S. since December 1981. (CPI is an index measuring what consumers pay for goods and services.)

What is causing the surge in inflation?

Perhaps needless to say, over the past year inflation has become a major economic and political issue. Both domestically and around the globe, rising prices have made a big impact on households and businesses alike.

There are a number of causes: Russia’s invasion of Ukraine and the continuing war there have interrupted the global supply chain, which had already been severely strained during the global pandemic and China’s recent Covid-related lockdown.

At the same time, there has been strong demand among consumers, who have more spending capacity due to low unemployment and wage growth, as well as emergency pandemic support.

Inflation more generally

High inflation is the unfortunate flipside of economic growth.

Recall that inflation, at baseline, means a loss of purchasing power over time. You can think of inflation as the annual change in prices for goods and services like food, clothes, travel, etc.

The Federal Reserve has a goal to maintain the inflation rate at around 2% annually. So the most recent rate of 8.6% is historically quite high and merits intervention by the Fed.

Responses

Unfortunately, there’s no pain-free path to easing this period of high inflation.

The main governmental tool for lowering inflation is the Federal Reserve’s ability to raise its benchmark short-term interest rate. After raising rates by 0.5 percentage points in March and May, the Fed raised rates by 0.75 percentage points in June.

It’s quite likely, over the coming months, that the Fed will raise interest rates again, with the objectives of reducing inflation and “cooling the economy,” if possible, without triggering a recession.

How long will this high-inflation period last?

It’s hard to say.

Even government economists and members of the Federal Reserve are reluctant to offer predictions. But there will be a sustained effort to reduce inflation.

More inflation means greater uncertainty for the economy. Businesses you’ve invested in might cut back on hiring or expansion plans. Households might reduce their spending.

These responses, naturally, can lead to reduced activity in the economy. And, as we’ve seen over the first several months of 2022, as interest rates rise quickly, the prices of stocks and existing bonds tend to go down.

What can help reduce the impact of inflation for your portfolio?

Diversify:

Stocks have historically been an important part of investment portfolios, as a means of increasing your purchasing power over the long-term.

As for bonds, rising interest rates do reduce the value of existing bonds. But, the higher rates mean bondholders will receive the benefit of more interest income over time. This can be a long-term benefit for savers.

Stay calm:

Headlines are blaring about inflation. This will likely be a major topic for the news media to cover over the months to come.

Generally speaking, the financial industry benefits when you feel panicked and pressured to do something, which often results in a transaction fee. But doing something, especially when asset prices have declined, tends to lock in losses.

And since timing when to re-enter the market after sales is exceedingly difficult, if not impossible, investors who sell often miss out on the recoveries that, at least historically, have followed.

Retain perspective:

As noted by The Wall Street Journal’s Jason Zweig in his “Intelligent Investor” column, “U.S. stocks, even after this year’s setbacks, have still gained nearly 13% annually over the past decade.”

“Invest like clockwork”:

Dollar cost averaging is another strategy that helps diminish the possibility of remorse about bad timing and/or subpar returns.

As Zweig writes, “Those who invest like clockwork tend to worry less about buying at the wrong time, making it easier for them to stay the course” and avoid selling at the wrong time.

Stay flexible:

When portfolios decline, some adjustments may be necessary.

For those nearing or in retirement, reducing spending, maintaining some continuing work and income-producing activity, and delaying Social Security until age 70 are all strategies that can help avoid the negative impact of selling during market declines.

Remain focused on goals:

The key priority is to stay focused on your goals.

If long-term, then the longer time horizon is likely to smooth out these inescapable rough patches. If shorter-term, then it’s important to ensure that your asset allocation reflects the shorter time horizon, with more bonds and fewer stocks.

 

As always, please reach out to your Park Piedmont advisor with any follow-up thoughts or questions.

Stock Price Declines as of Friday, May 20, 2022

Victor Levinson Comments

Given the continuation of S&P 500 stock price declines in 2022, which briefly touched a new “bear market” on May 20, 2022, we are sharing another set of our Special Comments.

As the financial media has been emphasizing recently, bear market means a decline of 20% or more from a previous high.

While infrequent, these substantial down markets do happen; since the 1970s, there have been five such down markets before 2022, with declines averaging close to 40% and lasting approximately 1.5 years.

Remember, history is only a reflection of what has happened; it may not be repeated in the future.

Of course, the most recent three full years of stock market results, from 2019 through 2021, were very rewarding, as the S&P 500 rose from 2,507 to 4,766, a gain of just short of 100%. (This is inclusive of a tumultuous period, with the pandemic and the 2020 election and its aftermath.)

Measuring from the same 2,507 starting point, the May 20, 2022, figure of 3,901 still leaves a 56% gain over three years and nearly five months.

Further, stock prices did reach very high levels in 2021 relative to Price/Earnings ratios (almost 25, compared to the historic norm of 15-18), as the stock market presented almost the only opportunity for portfolio gains in a financial market environment in which interest rates reached historic lows following the pandemic.

Since increasing interest rates are cited as a major factor for stock declines, and typically lead to declining bond prices in the short term, it is worth noting that bond yields (i.e., interest rates) have stabilized for the most recent ten days. The 10-year Treasury yield is lower than at the end of April, after peaking at 3.13% in early May.

While we have no doubt there are real economic issues for the financial markets to deal with, perhaps some of this volatility is caused by traders and gamblers seeking to benefit from each day’s back and forth activity. They are not long-term investors looking to benefit from the long-term economic growth represented by stocks.

In sum, there is no telling how long current declines are likely to continue. Prices reflect all current and anticipated bad news, making accurate predictions a seemingly impossible task.

Our advice remains to rely on your previously established allocation of stock and bonds, unless your goals, time horizon, or risk tolerance have changed. In that case, a conversation with your Park Piedmont advisor is appropriate.

How the Boston Celtics Saved Their Season

Tom Levinson Comments

Late in the evening of January 6, 2022, Tom sent a text message to a friend. This friend lives in Boston, follows the NBA closely, and is a lifelong Celtics fan.

Earlier that evening, after trailing by as many as 25 points, the New York Knicks (a grim, unfortunate passion of Tom’s) had staged a stunning comeback, beating the Celtics on a desperation, last-minute shot.

Tom texted his friend to console and, it must be acknowledged, to taunt, as well.

Tom’s friend replied that the Celtics were “done.” They had blown a winnable game the night before, against the mediocre San Antonio Spurs, and these two losses had brought Tom’s friend to the point of surrendering the season.

As casual NBA observers know, the Celtics are now one of four teams remaining in the playoffs.

Following that dispiriting loss to the Knicks, the Celtics went 33-10 the rest of the season – including a 9-game winning streak and another stretch where they won 11 of 12 games. They are favorites to win the NBA championship this year.

What happened? How, exactly, were they able to turn it around?

Well, part of the explanation is that they had a new coach, and it can take time for a coach and players to mesh. The coach began experimenting with new players and varied lineups, and the Celtics built the best defense in the league.

At the same time, their two-star players bought into the team concept, sharing the ball unselfishly and getting other players involved in the offense.

The Celtics’ season is a helpful reminder that positive and negative developments can and often do take place at the same time.

Surveying the current financial and economic landscape, we can see this clearly. Some illustrations:

  • While market returns were strongly negative in April, April was, at the same time, another month of solid job growth. US employers added 425,000 jobs in April, matching the previous month, with broad-based growth across every major industry, and the unemployment rate remained at 3.6%, just a touch higher than its level right before the pandemic (NY Times, 5/7/22, page A1).
  • Strong economic growth is usually favorable, but not if it gives rise to undesirably high inflation.
  • Undesirably high inflation can cause the Federal Reserve to raise the short-term interest rates it controls, in larger amounts and at a faster pace than would be preferable to the financial markets.
  • The Fed needs to control inflation so that the purchasing power of the US dollar remains stable; otherwise, prices in the economy can rise too quickly.
  • Rising prices can of course be a boon to businesses. They receive the extra revenue, which can in turn help increase profits, and workers can receive extra money in terms of higher salaries and wages. But since this extra money also represents higher costs to these same businesses and workers, the overall impact can be harmful, taking all the data in aggregate. The impact on people with fixed incomes is even worse.
  • Since the pandemic started in March 2020, economic activity and stock and bond market prices have experienced a number of unusual periods. During the pandemic, the Fed kept interest rates at historic lows, which presumably helped reinvigorate economic activity and financial market prices. Of course, no one wants a pandemic to recreate those conditions. Now that interest rates are rising, and quickly, is economic activity going to slow down meaningfully and adversely impact financial market prices? This is the key issue as near-term events unfold.
  • The terrible war in Ukraine presents another example of the highly unexpected. Its ongoing impact on the economy and financial markets is also unclear.
  • It is to be expected that bond prices decline when interest rates rise substantially and quickly. Even so, the extent of the price declines, particularly on the longer end of maturities, is always an uncertainty, as it is never known when the actual and expected bad news has been priced into current prices (see Jeff Sommer, NY Times, 4/17/22, section BU, page 3).
  • One important relationship is that as interest rates rise, bonds become more attractive as an asset class, because (a) their prices have declined, (b) they historically decline much less than stocks in the same time period, and (c) the higher interest rates end up being paid to the bond investors as time passes. In this way, the benefit of higher interest rates will happen for bond investors over time, even as they experience price declines over the short term.
  • Finally: while rising interest rates have a clear and direct impact on bond prices, their effect on stock prices is much less clear and direct, given the many other factors that influence stock prices.

An important part of weathering periods of uncertainty lies in recognizing that even as certain trend lines look negative, there are countervailing trends happening simultaneously.

Another important part: remembering that your goals and your time horizon – not what’s happening over the short-term – are most essential for you.

Our narratives frequently can’t capture the world’s complexity. A period of recent negative performance doesn’t necessarily signal what’s to come.

Good luck to the Celtics – and whoever else your team is. As Cleveland Browns fans are accustomed to saying: “There’s always next year!”

Stock Price Declines as of Friday, April 22, 2022

Victor Levinson Comments

Whenever the financial markets experience unusual declines, Park Piedmont Advisors has made it a practice to write Special Comments to supplement our regular Monthly Comments. During 2022, we have already written two such Special Comments, the first as of January 21 and the second as of February 24.

The S&P 500 stock index closed at 4,272 on April 22, after a two-day decline of 187 points from 4,459 (or approximately 4.5%). The year-to-date decline from a high of 4,796 is now 524 points (or approximately 11%).

Note that Wall Street refers to a stock market “correction” as a decline of between 10% and 20%. There have been eleven corrections since the turn of the century – how many do you remember? “Bear” markets, declines of 20% or more, also occur from time to time, especially after periods of large gains.

Perhaps most remarkable, however, is the fact that the S&P 500 value of 4,272 for April 22 is only 16 points below the February 24 value of 4,288 (or less than half of one percent).

You may recall February 24 as the date of our most recent Special Comments and the start of Russia’s war against Ukraine. It is PPA’s guess that most investors think the April 22 level would be considerably lower than that of February 24.

We should also recall that as recently as March 2020, a few months into the pandemic, the S&P 500 had declined to 2,237. The April 22, 2022, level of 4,272 therefore represents a gain of approximately 90% since the pandemic low.

As PPA readers know, it is our view that no one can consistently and accurately predict whether declines have further to go before prices become attractive again to buyers. In an almost perfect example of this thinking, we quote from Jeff Sommer’s April 17 New York Times article:

“The bad news has already been incorporated in stock, bond and commodity prices. The headlines about inflation have once again been awful… Stocks and bonds have been shaky since the start of the year, and the tragedies of the larger world are profound and proliferating, including a lingering pandemic and Russia’s assaults on Ukraine…

“This is all terrible. Yet precisely because so much awful news has already been incorporated in stock, bond and commodity prices, there is reason for suspecting that market conditions may not get much worse, and may even get better before long. When the consensus is this glum, it may be time for cautious optimism.”

Sommer’s timing is obviously terrible given the declines from last week, but his larger point may still be true, at least over some period of time.

The whole concept of asset allocation, which PPA emphasizes at all times, is to allow you to retain your stock positions during the inevitable rough periods, by allocating only a portion of your overall investment portfolio to stocks.

Thus, if your allocation is 50% stocks and 50% bonds, a 10% decline in stock prices results in closer to a 5% portfolio decline. And although the extent of the recent bond prices declines has been significant, these declines have historically been far less than those for stocks.

The financial media has most recently focused on the likely quickened pace of the US Federal Reserve raising the short-term interest rates it controls as the likely villain for declining longer-term bond prices set by the buyers and sellers in the bond market.

(Remember: bond prices decline when interest rates rise, and prices rise when rates decline).

This is happening currently, as ten-year US Treasury bond yields have increased rapidly from the year-end 2021 rate of 1.50% to the current rate of just under 3%.

Indeed, there is some current discussion of the Fed raising rates too high and too fast, giving rise to the next economic recession. Of course, this is all part of the unknown future.

As always, PPA encourages our clients to remember that declines do occur from time to time, in stocks and bonds, but that historically markets also recover. We will continue to provide historical context and help all our clients focus on specific long-term goals.

Casey Stengel, Crystal Balls, and the Movement of Stock Prices

Victor Levinson Comments

Hall of Fame baseball manager Casey Stengel is reported to have said, “Never make predictions, especially if they’re about the future.”

Stengel’s quip helps us pose our question this month: let’s say you had a crystal ball – and assume for the purpose of this hypothetical it is a functional crystal ball – would knowing the outcome of key events before they actually occur help you predict the future direction of stock prices?

The answer would seem obvious… of course that knowledge should be useful. If you know what’s going to happen, the market’s response should logically follow from there.

But as it turns out, the real world is frequently far more complex than the projections and predictions of even the best-informed experts.

Think back to early November 2016, in the days and hours before Donald Trump was elected President; or to late 2019 and early 2020, when you first heard news stories about a mysterious virus emerging from China.

It’s surprising but true: advance knowledge of key events is often not a helpful forecaster of market movements – specifically, the future prices of stocks and bonds.

In a NY Times “Outlook” column dated Feb 27, 2022, Jeff Sommer writes,

“Global markets usually weaken as wars approach, strengthen long before wars end, and view human calamity with breathtaking indifference…The recent stock market has been afflicted by multiple troubles [in addition to the war in Ukraine]: fears of rising interest rates, sizzling inflation, and continuing supply chain bottlenecks.”

(PPA note: no mention of problems associated with the ongoing pandemic, now at two years and counting.)

So even assuming investors knew in advance that all these problems would continue, the month of March showed monthly gains over 3% for US stocks, making a meaningful reduction in the YTD 2022 declines.

It is therefore worth asking what benefit investors would have realized knowing the problems in advance.

Sommer writes that “long-term investors with well-diversified portfolios of stocks and high-quality bonds–whether held directly or through low-cost mutual funds and exchange-traded funds (ETFs)–will probably be likely to ride out this crisis as they have so many others.”

Sommer also makes a case for owning bonds, even if their prices decline during certain time periods as interest rates rise, as a “buffer against major stock downturns.”

Another more recent article, with a similar point of view, appeared in The Economist magazine:

“A lot of bad stuff is happening just now, most notably a war in Europe, but also inflation and growing fears of recession.”

(PPA note: these recession fears are based on the Federal Reserve raising the short-term rates it controls and thereby slowing the economy to try to contain inflation.)

“Stocks are surprisingly buoyant, with the S&P 500 only 7% below its all-time high around the end of 2021… There are lots of plausible explanations for the resilience of stocks, one is that there is no good alternative to owning them… Ten-year yields are still below the rate of inflation… stocks may offer some protection against inflation if companies can raise their prices… Underlying all these rationalizations is a sense that equity investors do not quite believe the Fed will follow through on all the interest rate increases the bond market is pricing in.”

Here again we ask how investors are well served, even if they were correct in their knowledge of the outcome of current problems, since stock prices are “surprisingly buoyant.”

Just to show that there are also many times when knowing the outcome of future events would indeed be helpful in ascertaining future market direction, look no further than bond prices in March.

Since the rate of inflation did continue to rise in March, and the Federal Reserve did begin to raise its short-term interest rates, bond prices did in fact fall.

A few points to the bond pricing decline are worth noting:

1) While overall inflation went above 8 percent, “core” inflation, which excludes highly volatile food and energy prices, rose less than one percent.

Even though inflation definitely affects food and energy, which are important daily expenses for consumers, various financial institutions, including the Federal Reserve, do pay attention to the “core” rate as well.

A key question to answer now is whether a few more inflation readings like the one in March may result in a decline in the ten-year Treasury yield and an increase in bond prices, because the Fed may see less need to aggressively raise the short-term interest rates it controls.

(Note that longer-term rates, like that of the ten-year Treasury, are set and reset each day by the buying and selling of bonds in the marketplace, not by the Fed.)

2) The extent of bond price declines is typically measured by the amount and pace of the interest rate increases.

In this current environment of unusually large bond price declines, the anticipated quarter point Fed rate increases would likely not produce these kinds of price declines unless the market believed that the pace of these rate increases would be unusually rapid.

If the actual future pace of rate increases is slower than currently anticipated, it may well be that current prices are as high as they will get in this period.

3) History indicates that at some point in a market cycle, interest rates stop rising and bond prices stop declining.

Bond investors then receive the benefit of the higher interest rate payments associated with the bonds they own, thereby offsetting the price declines over time.

Long-term investing has two basic principles:

1) As Casey Stengel recognized, the future is inherently unknowable. Analysts and pundits and gurus may pore over their assorted crystal balls to accomplish this task, but it simply cannot be done.

2) Trying to time the direction of market prices is very difficult to do with any degree of consistency – even when you know the outcome of events before they happen. Market timing is defined as the effort to be in the markets when prices are rising, and to be out of the markets in advance of serious declines.

If the future is unknowable, and guessing at the market’s price movements is unlikely to succeed, what is left for investors to do?

Stay focused on your asset allocation and time horizon, be in touch with your advisor if you have any questions, and leave the crystal ball where it is.

The Many Segments of the Stock Market

Victor Levinson Comments

When we discuss stock prices at Park Piedmont Advisors, we usually are referring to the price level of the S&P 500 stock index, a broadly diversified set of approximately 500 companies, mostly large and based in the US.

We also recognize that there are many other ways to participate in the stock market. To the extent these other alternatives are used, usually with the goal of outperforming the S&P 500, there is also the risk of underperforming and ending up with very different results in the same time period.

The following is a general discussion of a number of these alternatives; we can provide additional details as requested. Suffice it to say, investors can choose to emphasize any of these various parts of the stock market in developing the stock portion of their portfolios.

1) Company Size

This is determined by market capitalization, which multiplies the market price of the stock by the number of shares of stock outstanding.

The investment community typically splits company size into three levels: large, medium, and small. Until last year, several companies flirted with being worth $1 trillion, but after the stock price gains of 2021, a few have now reached that level, with Apple leading the way at almost $3 trillion.

While different market observers have different ranges of value to be considered “large cap,” any company worth $30 billion or more would probably be considered large, with $15 to $30 billion considered “midcap,” and under $15 billion considered “small cap.”

These ranges have increased dramatically over the past three years, given the substantial gains in US stock prices prior to 2022.

Most of the S&P 500 companies are considered large cap, and many of the large cap companies are household names. Large cap companies tend to be more stable than smaller companies, since they generate sufficient profits to be included in the top 500 companies to begin with.

But large cap companies also share a great deal of the price volatility of their smaller counterparts, and large cap stocks typically decline only slightly less than smaller stocks when the entire stock market is declining (the first quarter of 2022 being the latest example of declining stocks).

2) Growth and Value (P/Es)

Another way the overall stock market can be analyzed is to divide stocks into so-called “Growth” and “Value” companies.

The distinguishing characteristic of Growth stocks is that they sell for high prices relative to their earnings, while Value stocks sell for low prices relative to their earnings.

The relationship between market prices and company earnings is captured in the Price/Earnings (P/E) ratio.

If a company has earnings of $10 per share, and its market price is $100 per share, it is said to have a P/E of 10. Another company that also has earnings of $10 per share and has a market price of $200 per share has a P/E of 20.

It is obvious that the company with the 20 P/E has a higher P/E than the company with a 10 P/E, but the real question is why one company’s earnings are valued more highly. The underlying reason is that investors think the company with the higher P/E will grow its earnings faster than the other company.

While it is often a good sign for stocks to have high P/Es, if and when the company’s earnings growth rate disappoints the market, the price declines are often considerably greater than those of lower P/E companies.

Technology companies are an example of a group of companies with high P/Es, whereas Consumer Goods companies typically have lower P/Es. Note there is nothing inherently better or worse among these different groups of companies, only that investors should understand what to expect in the way of price changes based on how future earnings develop.

Note also that it is the price of the stock that is constantly changing, so companies can transition from a growth to a value company, and vice versa, based on the same earnings.

3) US and International Companies

Another way to diversify from US stocks is to add international exposure with companies based in “developed” and “emerging market” countries.

Most European countries and Japan are typically considered developed countries. China, India, and most of South America and Africa are typically categorized as emerging markets.

This distinction is harder to maintain in current times, as so many large companies do business in so many different countries. If Apple has a large percentage of its business outside the US, should it continue to be classified as US?

In this situation, investors should look to see what companies are actually owned in their various investments, or use broad-based index funds that capture the results of the parts of the markets they want to invest in, which is the PPA response to this issue.

4) More Specific Sectors

In addition to the categories discussed above, there are many investments focusing on specific sectors. Technology and Consumer Goods, mentioned earlier, are two of the many more targeted investments.

 

All of these subcategories of the asset class “Stocks” can be accessed using Exchange Traded Funds (ETFs), mutual funds (actively managed or passively indexed), and individual stocks.

Unless there is some compelling reason for the investor’s choices, PPA considers it likely that most investors will be better off using the most broadly diversified investments to meet their allocations to stocks.

Emphasizing one or the other of these many categories, to the exclusion or reduction of others, amounts to trying to figure out in advance of the occurrence which category will do better than some other category.

As an example of this advice, an investment company called MFS presents the performance of four of the categories we have been discussing (Large Cap Growth, Large Cap Value, Small and Midcap, and International, out of a total of ten categories, including Cash and Bonds) over a rolling twenty-year history through year-end 2021.

The results are that even the top performing sector over the entire twenty years was best in only five of those twenty years, and was in the bottom half of the categories in six of the twenty years.

The chart is presented in color coding and is available on request. It makes the point that “just because an investment type or style outperforms one year, there is no guarantee that it will outperform the next. Stay diversified.”

One other set of observations worth presenting during a period of substantial stock and more modest bond market declines appeared in a NY Times interview by Jeff Sommer of 2013 Nobel Prize co-winner in Economic Science Eugene Fama.

“Markets do not behave irrationally. What may look like craziness is just the markets attempting to evaluate information they can’t entirely digest… The markets are struggling to come up with prices for stocks, bonds, commodities, all kinds of things.

“We’re in a period where we have had an injection of uncertainty into the world, so speculative prices are going to go up and down in response… People are continuously trying to evaluate information. But it’s impossible for them, given the amount of uncertainty, to come up with good answers…”

Sommer asked whether Fama “reads the analyses of Wall Street investment houses that recommend strategies for coping with tumultuous markets,” to which Fama replied, “No, it’s investment porn…what do they really know?”

His recommended investment approach is to “eschew market timing and invest for the long term in diversified, buy and hold investments, precisely because it is so difficult to accurately forecast market returns… What isn’t adequately stressed in most professional investment analyses is that there is always risk in the stock market, always, and it’s impossible to know which way the market is heading.”

As our regular readers know, we think similarly to Professor Fama and dispense our advice accordingly.

Year to Date Stock Price Declines as of Thursday, Feb. 24, 2022

Victor Levinson Comments

As the year 2022 stock price declines have continued through most of February, we are writing to follow up on our January Special Comments. February’s YTD figures − which include the remarkable gains from yesterday (February 24th), when Russia invaded Ukraine and the intraday price range (low to high) was 4% (using the S&P 500 to represent the US stock market) − are as follows:

  • From the November 2016 level of 2,140, the S&P 500 gained approximately 50%, to 3,225, by January 2020, just before the start of the pandemic.
  • At the low of the pandemic, in late March 2020, the index had declined all the way back to 2,237, or just 4% above November 2016.
  • From March 2020 through year-end 2021, the S&P 500 soared to 4,766, for a gain of 120% (more than doubling).
  • Through Thursday, February 24, 2022, the S&P 500 index has declined to 4,288, which, while approximately 10% below year-end 2021, is 100% higher than November 2016. (Note: a decline of 10% is referred to as a “correction.”)
  1. The war in Ukraine has been added to the list of current negative events, which includes higher inflation leading to likely higher interest rates, and the continuing, albeit declining, impact of the COVID-19 pandemic.
  2. No one can consistently and accurately predict whether the declines have further to go before prices become attractive again to buyers. Indeed, stocks closed higher during the day of the Russian invasion. To PPA’s thinking, this reinforces the idea that even if you know about an event in advance of its occurrence, you could just as well be wrong about how the market will react to it.
  3. The whole concept of asset allocation, which PPA emphasizes at all times, is to allow you to retain your stock positions during the inevitable rough periods, by allocating only a portion of your overall investment portfolio to stocks. Thus, if your allocation is 50% stocks and 50% bonds, a 10% decline in stock prices results in closer to a 5% portfolio decline. Moreover, even in periods of declining bond prices, the extent of bonds declines is historically far less than that of stocks.
  4. Most of the stock gains from 2016 and the pandemic lows are still intact. Periods of declines of 10% to 20% are not uncommon with stocks – this is the 11th correction since the turn of the century – and so-called “bear markets” of 20% or more should be expected once every few years, especially after the huge gains of the past three years. For more details and a historical chart, see https://www.nytimes.com/article/stock-market-correction.html.
  5. Since the likelihood of the Fed raising the short-term interest rates it controls has become an important news item, we present a similar recent history of the ten-year US Treasury bond yield, which is the benchmark used by market participants in buying and selling bonds.
  • November 2016: 1.86%
  • Year-end 2020: 1.50%
  • Pandemic lows (March 2020): 0.76%
  • Year-end 2021: 1.51%
  • Current (February 24, 2022): 1.96%

There is much to discuss regarding these figures in future Monthly Comments, but it is worth noting that the ten-year yield often anticipates the Fed’s actions, and it is not possible to determine how much of the Fed’s likely future rate increases are already priced into the ten-year yield. If the timing of the rate increases is sufficiently spread out, bond investors should have higher returns as they receive the higher interest rates.

As always, please contact your PPA advisor with any questions. We are here to help.

Financial Market Price Volatility: Focus on Bonds

Victor Levinson Comments

January 2022 was a month of significant price volatility for stocks. Since rising interest rates/inflation continue to be mentioned as important factors in this stock price volatility, and these same factors influence changes in bond prices, we are focusing this month on bond price volatility.

In the financial markets, volatility refers to the extent to which prices fluctuate, both up and down, in a given time frame. The greater the fluctuation, the higher the volatility. In January 2022, stock prices (S&P 500) went from a closing high of 4,796 (on January 3rd) to a closing low of 4,326 (on January 27th), a variance of 451 points, or approximately 10%, in less than one month. Intra-day variances were as much as 5% (on January 24th). This constitutes significant, and harmful, downside price volatility. We say this because whenever stock price changes make long-term investors (as distinguished from short-term traders) want to even partially abandon their long-term allocations to stocks for fear of continuing declines, volatility can be harmful.

We of course recognize that financial market prices vary all the time, but we encourage our clients to focus on the long term as much as possible. As Jason Zweig wrote in his recent Intelligent Investor online column, “Why You Should Sit Out the Mayhem” (WSJ, 1/25/22): “What matters most isn’t what the market does – but what you do in response.” Zweig then quotes from his own 2014 writing: “Individual investors should tune out the futile efforts by commentators and strategists to extrapolate the market’s latest swings into a prediction of what will happen next.”

We discuss stock prices first because historically it is their volatility, both up and down, that provides one of the strongest rationales for owning bonds as part of a broadly diversified investment portfolio. While stocks have had three multi-year declines exceeding 40% since 1970, the largest of three annual down periods for bonds was negative 5% in 1994 (data from Ibbotson, Duff & Phelps, 2020 Yearbook, page 2-9; more detailed data from Ibbotson on the extent of stock and bond price volatility will be presented in future Comments). But since bond prices do change from day to day, it is useful to understand how bond price volatility differs from stock price changes. For this discussion, we will make some preliminary observations and then quote extensively from a recent NY Times article (1/31/22, page B1 and continued).

1) Bonds are investments in which lenders provide money to borrowers, typically companies and governments, and the borrowers promise to repay the money at a specific date in the future. The borrowers also pay interest to the lenders while the bonds are outstanding.

2) Bond prices fluctuate while they are outstanding, with the changing level of market interest rates being the major determinant of bond price changes. When interest rates are rising, bond prices fall because the investor can buy either the existing bonds with lower interest payments or newly issued bonds with higher interest payments. The lower prices for existing bonds compensate investors who buy the lower interest payments. Conversely, when interest rates are declining, prices for existing bonds rise.

3) Overnight, “ultra short-term” interest rates in the US are set by the Federal Reserve. Longer term interest rates, starting with even a few weeks, are established by financial market participants who buy and sell bonds.

4) Bond maturities impact prices. Maturity refers to the time when the principal amount of the bond is due to be paid. The longer in time until maturity, the more price fluctuation, because the owners of the bonds have to wait longer before they can get their money back to reinvest at the new interest rates. When rates are rising, longer maturity bonds are likely to decline more than shorter maturities; conversely, when rates are falling, longer maturity bonds should gain more in price than shorter-term bonds.

5) Credit quality affects prices. Credit quality refers to the likelihood that the bond issuers will pay interest and then repay principal at maturity. Bond issuers include the US and international governments, state and local governments in the US (which issue “municipal” bonds), and businesses. All these borrowers are looking for sources of money to finance their various activities. Governments, especially national governments, tend to have the highest credit ratings, since they have the power to tax and print money, albeit with political and economic limits to each. Business borrowers have wide differences in credit quality, depending on their financial stability. All other characteristics being equal, the higher the credit quality, the higher the price of the issuer’s bond and the less interest they have to pay to attract investors. Some credit quality is so low that the bonds are referred to as “junk bonds,” but these bonds typically pay much higher interest than the higher credit bonds to compensate investors for the higher risk of nonpayment.

6) Although rising interest rates lower bond prices, the buyers of the new bonds receive the benefit of the higher interest rate payments. These higher rates typically offset price declines over some period of time.

7) One key reason the Fed raises interest rates is if the economy is growing too fast, generating undesirable rates of inflation. Higher interest rates tend to slow the economy down, which in turn lowers the rate of inflation. Our December 2021 Comments provided a table of contents for all 2021 Comments, where we frequently discussed the current connection between interest rates and inflation.

We now turn to the NY Times article referenced above (1/31/22, page B1, titled “US Bonds Hold Appeal Despite Yields”, and page B3, titled “Inflation and Deficits Don’t Dim the Appeal of US Bonds”). “Headlines are proclaiming that government bond yields are near two-year highs. But the striking thing about bonds isn’t that yields – which influence interest rates throughout the economy – have risen. It’s that they remain so low. In the past year, with consumer prices rising at a pace unseen since the early 1980s, a conventional presumption was that the demand for bonds would slump unless their yields were high enough to substantially offset inflation’s bite on investor’s portfolios. Bond purchases remained near record levels anyway, which pushed yields lower. The yield on the 10-year Treasury note – the key security in the $22 trillion market for US government bonds – is about 1.8%, roughly where it was on the eve of the pandemic or when Donald Trump was elected President, or even a decade ago, when inflation was running at a mere 1.7% annual rate – compared with the 7% year over year increase in the Consumer Price Index (CPI) recorded in December.”

“Because the 10-year Treasury yield is a benchmark for many other interest rates, the rates on mortgages and corporate debt have been near historical lows as well. And despite a binge of deficit spending by the US government – which standard theories say should make a nation’s borrowing more expensive – continuing demand for government debt securities has meant that investors are, in inflation-adjusted terms, paying to hold Treasury bonds rather than getting a positive return.”

The article then offers possible explanations: “The major reasons for this odd phenomenon include long-term expectations about inflation; a large (and unequally distributed) surge in wealth worldwide and the growing ranks of retiring baby boomers who want to protect their nest eggs against the volatility of stocks (PPA emphasis) … Several major market participants attribute these stubbornly low yields, in spite of a high growth, high inflation economy, to a widening sense among investors that a time of slower growth and milder price increases may eventually reassert itself.” (PPA note: while our regular readers know we avoid attempts to explain certain financial market events or to predict the future, we are including the views in this article because we think they are relevant to this discussion of bonds.)

In Park Piedmont’s view, bonds do provide a cushion against the much higher volatility of stocks. Bonds are a necessary component of a well-balanced asset allocation suitable for clients and their particular needs and goals. Even if we are entering a period of higher, more normal interest rates, remember that the Fed has yet to raise its rate even once, let alone three or four times, and that the actual rates of short and intermediate bonds, actively traded daily, are still quite low by historical standards. How high the 10-year yield needs to go to cover the Fed’s anticipated actions remains to be seen. Further, the strength of the economy in the recovery from the pandemic is still unclear and will impact interest rates. And remember the silver lining of higher interest rates: as a bond investor, you get the advantage of receiving higher interest payments, which have historically offset price declines over time. We continue to advise maintaining the asset allocations established in calmer times, and reevaluate allocations for possible rebalancing as market prices change.

January Stock Price Declines as of Friday, Jan. 21, 2022

Victor Levinson Comments

During periods when stock price declines attract the attention of many people outside the financial and investment communities, it has been Park Piedmont’s (PPA) practice to share our perspective. We want to emphasize the importance of taking a longer-term view of investments and avoiding the short-term, day-to-day fluctuations of the markets, which are driven by those seeking to benefit from the fluctuations. “It makes sense to think in periods shorter than a year if you’re a trader, and much more than that if you’re an investor” (Jeff Sommer, NY Times, 1/9/22, page 9; emphasis added).

In order to put the current declines in context, when Donald Trump was elected president (early November 2016), the S&P 500 US stock price index was 2,140. (Note: we are using the S&P 500 as a proxy for US stock prices rather than either the narrower Dow Jones Industrial index, which contains only 30 companies, or the technology-dominated NASDAQ index. International and Emerging market results are also not included in this intentionally short report. PPA recognizes there can be wide disparities among the results of these various indexes, which we will discuss at greater length in future Monthly Comments.)

  • From the November 2016 level of 2,140, the S&P 500 gained approximately 50%, to 3,225, by January 2020, just before the start of the pandemic.
  • At the low of the pandemic, in late March 2020, the index had declined all the way back to 2,237, or just 1% above November 2016.
  • From March 2020, the S&P 500 soared to 4,766 as of year-end 2021, for a gain of 120% (more than doubled).
  • Through Friday, January 21, 2022, the S&P 500 index has declined to 4,398, which is 105% higher than November 2016 and approximately 8% below year-end 2021.

While the financial media presents reasons for the decline – namely, the surprisingly rapid economic recovery from the negative impacts of the pandemic, which in turn has triggered more inflation than the US Federal Reserve (Fed) is comfortable with, which in turn has the Fed discussing meaningful interest rate increases to slow inflation (see again Jeff Sommer, NY Times, 1/22/22, page B1) ­– PPA notes the following important points:

  1. These conditions have been in place for some time, certainly to the end of 2021, when stock prices were still increasing. The fact of the January price declines occurring when they have was simply not knowable in advance.
  2. No one can consistently and accurately predict whether the declines have further to go before prices become attractive again to buyers.
  3. Most of the gains from 2016 and the pandemic lows are still intact.

Since the likelihood of the Fed raising the short-term interest rates it controls has become an important news item, we present a similar recent history of the ten-year US Treasury bond yield, which is the benchmark used by market participants in buying and selling bonds.

  • November 2016: 1.86%
  • Year-end 2020: 1.50%
  • Pandemic lows (March 2020): 0.76%
  • Year-end 2021: 1.51%
  • Current (January 21, 2022): 1.77%

There is much to discuss regarding these figures in future Monthly Comments, but one main point is the lack of extreme change in these yields (other than the pandemic low). Also, the ten-year yield often anticipates the Fed’s actions, and it is not possible to determine how much of the Fed’s future rate increases are already priced into the ten-year yield.

PPA’s constant emphasis on an asset allocation appropriate for each client’s goals and circumstances means that the negative impact of significant stock price declines should be diminished by the less risky bond holdings in each portfolio. For example, a 50-50 stock and bond allocation implies that an 8% stock price decline represents just a 4% decline for the overall portfolio. And this decline may be modestly more or less than 4% depending on the period’s bond results. Developing and maintaining appropriate allocations is a far better approach to successful long-term investing than trying to time the ups and downs of financial asset prices. As Wall Street Journal columnist Jason Zweig wrote earlier this month, “Discipline is the greatest investing virtue. When you drastically change your long-term course based on what feels like a short-term sure thing, you’re likely to end up caught by surprise – and racked with regret” (“The Best Investment for This Coming Crazy Year,” WSJ, 1/7/22).