At about this time each year I go through a due dilligence process to review investments that I use in client portfolios. I look at quality, cost, performance, compare to alternatives, and try to poke some holes in my logic about using Fund A versus Fund B, and so forth. Of course I’m biased because I liked the investments enough to use them in the first place, but I try hard to be objective. All this work usually leads to few changes. Instead, it’s often a recommittment to using what we already own.
That said, a real struggle right now is what to do about bonds. The asset class, as we’re all aware, has been underperforming for awhile and headwinds are building. The Fed is expected to raise short-term interest rates three or more times this year to fend off the inflation monster. The mixed messages in the economy right now, such as headfakes coming from the labor market (very low unemployment of 3.9% but very high amounts of job openings amid the so-called Great Resignation) have got to be confusing for Fed policymakers. And this isn’t helping the confidence of bond investors.
Core bonds lost nearly two percent last year and have taken another leg down of about 1.5% (as of yesterday) to start 2022. While dishesartening, it’s important to remember that the bond market isn’t immune from volatility. Looking back at performance for a common bond index fund since 2008 we see a steady rise in value with several bouts of nastiness along the way. The two big ones were during the Great Financial Crisis and then again recently during the early days of the pandemic. Of course, this is nothing like stock market volatility but it’s still unsettling for investors when even this “safe” asset class gets wobbly.
But looking at more recent performance of the same fund, we see a bond market continuing to digest lots of uncertainty. The chart below looks like a rollercoaster ride but if we compared the fund to the stock market you’d see how relatively mellow bonds were, even though they finshed last year and through yesterday lower.
Here’s the chart adding stocks over the same timeframe.
To illustrate the reversal, or perhaps the stalling of bonds lately, this final chart shows year-by-year performance going back to 2008. Low and declining interest rates were the main driver over this timeframe. We don’t know how many times the Fed will actually raise rates this year and if this will begin a fundamental shift to a rising rate envronment. Market prognosticators have been expecting this for years now and, for lots of reasons, it hasn’t happened. Still, it’s helpful to look at bonds, and everything else in our portfolios as well, with a skeptical eye.
My point with all this is that bonds should continue to play an important role in a diversified portfolio, but they require more attention. This is especially true for folks nearing or currently living in retirement because the right bonds act as a store of value while providing current income. And they’re liquid, which is a benefit easily scoffed at until it becomes a problem.
But recent performance and the aforementioned headwinds beg some reasonable questions, like should we jettison bonds in favor of some other asset class? Maybe just have cash in the bank where it’s secure? Or how about preferred stocks, junk bonds, real estate, even crypto?
So over the next few weeks I’ll write up some of my due dilligence work around these questions and share my thinking with you. We’ll look at the case for bonds, which types are best for which situations, and where reasonable alternatives might fit in your portfolio.
Please let me know of any questions and feel free to share your opinions along the way.
No rest for the weary. Isn’t that what people say as they push through a growing onslaught of obstacles? However one uses the adage, I think it’s appropriate as we head into the end of another eventful year.
In any other year we’d have deadlines for saving, gifting, harvesting losses and gains, and a host of other investment-related issues. Those are typical and can be planned for. But this year-end, on top of everything else we’ve been enduring, we also have to contend with what’s shaping up to be another eleventh hour set of major changes to our tax code.
While Congress has missed its own deadlines for the Build Back Better legislation, some senators are making noise about a vote occurring by Christmas. If that happens, and if the House plays along with the Senate’s version, we could be looking at the so-called social stimulus bill being signed into law right as the year closes. Most of the provisions don’t start until next year, but some, such as a dramatic increase to the cap on deductible state and local taxes (known as the SALT cap) could be retroactive for this year.
This matters because many property tax payers in expensive areas like ours would get to deduct more, or even all, of their property taxes whereas the current cap is $10,000. The Build Back Better version passed by the House raised this cap to $80,000, well within range of local median home values. This also matters because a larger tax deduction can create room for planning opportunities like Roth conversions, or even generating extra spending cash in retirement by selling appreciated investments. These would have to be done by year-end and would only work for some folks if the SALT cap was raised substantially. The final dollar amount of the cap will continue to be hotly debated in the days and weeks ahead, but there at least seems to be some consensus that it should be raised.
The problem, of course, is the waiting. Since we’re not likely to know when or even if Congress will send a bill to the president’s desk for signature this year, how does that impact our decisions today? I’m an advocate for making the best decisions now with the information you have available and not becoming a victim of analysis paralysis, but I’m still holding off for a bit to see how this plays out in D.C. After all, if it’s as simple as selling investments prior to market close on the 31st, I can do that in minutes.
But for anything requiring the processing of paperwork, the longer the wait the lower the chance that anything gets done. Typical processing cutoffs are around the 15th, or maybe Friday the 17th this year, well before Build Back Better becomes law. Big firms like Schwab and TD Ameritrade have pushed their cutoffs to earlier in December anyway, so we’re trying to cram in as much as we can at this point. Further waiting is unfortunate because any 2021 planning opportunties created by the legislation are likely to be a victim of the calendar.
On top of this back office stuff and pending legislation, we’re also living through the first meaningful spike of inflation in decades, looming issues with the debt ceiling again, and of course tons of uncertainty having to do with the pandemic. Each of these are big issues on their own, but also weigh down the Build Back Better legislation itself.
Here’s a recent podcast on these topics from Michael Townsend, Schwab’s Washington-based commentator. In a little over 20 minutes he breaks down the news from D.C. that’s important for investors to know.
Finally, I want to wish you and your family Happy Holidays. It’s been another challenging year and connecting with those most important to you seems that much more important because of it. That said, I’ll be taking the next couple of weeks off from writing this blog. This creates more time to spend with family and opens up additional time for working with clients as we react to whatever Congress does, or doesn’t do, in the waning hours of the year.
Never a dull moment. That’s maybe a good way to sum up how markets reacted last Friday to the latest iteration of the coronavirus pandemic. Understandably, investors around the world sold stocks on the thin, but potentially worrisome, news that the omicron variant emerged overseas. Post-Thanksgiving Fridays are usually pretty quiet, but not this year. I imagine many short-term investors, and the algorithms they often employ, waking up from their day off to the cascade of negative headlines and thinking one thing: sell.
At one point the Dow Jones Industrial Average was down over 1,000 points. Scary, sure, when you hear it quoted on the radio or on TV, but still less than a 3% decline on an index that’s up roughly 17% year-to-date. We’ve seen market reactions like Friday play out many times and each raises an important question for long-term investors. What, if anything, should you do when others are freaking out? The short answer is usually nothing. The slightly longer answer is to be ready to buy.
Buying while others are selling takes real intestinal fortitude, no doubt about it. What helps is the basic understanding that the stock market is made up of thousands of individual companies. Some will go bust but most will continue to be around for a very long time, through thick and thin. Values will rise and fall day-to-day, sometimes in dramatic fashion, but will trend higher as the companies continue to produce and sell their products and services. This sounds pretty basic, and it is, but it helps us remain calm when markets get wobbly. And make no mistake, we’re in an unstable market that is merely a representation of the times we’re living through.
The other thing that helps is reviewing market history. To help us here I’ll again pull from my research partners at Bespoke Investment Group. The following are snippets and charts from two different pieces, one from Friday and one from yesterday morning. These cover recent market responses to bad news and a longer-term look at a key gauge of investor anxiety, the VIX. There’s some detail here but, again, looking at information like this helps put market gyrations into context.
As they often do, Bespoke’s research provides good perspective during unsettling times. I can’t praise their work loudly enough. The bottom line is that long-term investors should try to think about the investing process differently than the short-term folks do. It’s just unfortunate that the latter drives the market and the news day-to-day; they’re the smaller group with a louder megaphone, especially on days like Friday.
2021 was another year where market returns didn’t seem to line up with reality. Multiple waves of the coronavirus pandemic added uncertainty while domestic and global politics dampened the mood at times. Inflation took off midyear and negative news seemed to mount as the year closed. The stock market reacted to all this, sometimes in volatile fashion, but prices for most asset classes just kept rising. The S&P 500 hit a new high nearly 70 times last year, just missing the record of 77 in 1995. Simply amazing when you consider the current social and economic backdrop to our lives.
Here’s a roundup of how major markets performed during the fourth quarter and year-to-date, respectively:
US Large Cap Stocks: up 11%, up 29%
US Small Cap Stocks: up 2%, up 14.5%
US Core Bonds: basically flat, down 1.8%
Developed Foreign Markets: up 2.7%, up 11.7%
Emerging Markets: basically flat, up 1.3%
We can easily see from this list which asset classes were investor favorites during the year and a similar dynamic played out during Q4. The largest stocks fared best while smaller stocks struggled. Domestic stocks performed substantially better than foreign stocks. Top performing sectors were Energy and Real Estate, up 53% and 46% respectively, for all of 2021. Investors had shunned both sectors during the worst of the pandemic but seemed eager to make up for lost time this year. Financials and Technology were each up almost 35% for the year while more defensive sectors like Utilities and Consumer Staples grew a little over 17%. Communication Services, home to massive companies like Google, Facebook, Apple, and Disney, outperformed in 2020 but underperformed this year, rising nearly 16%. Not bad for the worst performing sector!
Underperformance was easy to spot during 2021 because the spread was so large. Small company stocks in the US underperformed for most of the year. These companies are generally more susceptible to pandemic woes (supply chain disruptions, interest rates and inflation, changes in consumer behavior, etc.) and have historically been more volatile anyway. Investors couldn’t decide how to feel about these stocks as uncertainty rose around the Delta and Omicron variants. Still, all things considered, a 14.5% annual return for small caps is nothing to sniff at.
Underperformance was more pronounced in the bond market. Granted, bonds are fundamentally different from stocks but since most investors own bonds, and sometimes in large proportions, a superficial comparison is warranted. Core bonds (high quality, medium term) had a dismal 2021, returning around -1.8%, depending on the index. Short-term bonds lost less than a percent while longer-term bonds fared worse, down 5-6% for the year. This poor showing had mostly to do with the extravagant stock performance referenced above, which was itself driven in large part by the Federal Reserve.
In response to the pandemic in 2020 the Fed took short-term interest rates to zero and, with help from Congress, injected trillions of dollars into the economy. A natural result of all this cheap money and government spending was that investors got hungry for risk. This hunger has only increased since. Investors bought stocks, digital assets, houses, basically anything that was likely to grow in value. Bonds don’t grow in the same way as stocks. Instead, they act as a store of value that pays interest but the interest rate, or yield, offered (about 1.5% or less on the 10yr Treasury bond for much of the year) is far from exciting. Riskier parts of the bond market understandably performed better as some investors reached for higher yields. Lower credit quality, or “junk” bonds, returned about 4% for the year while preferred stocks, really a hybrid of bonds and stocks, brought in 7%. If past is prologue, this complacency about risk will come back to bite some investors.
Inflation-protected bonds also performed better than the bond market, up around 5-6% in 2021. This category is also riskier than core bonds because it relies on above-average inflation setting in. Well, that’s exactly what we saw last year. The nation’s CPI hit 4% in April, 6% in October, and ended November up 6.8%, an increase in consumer prices not seen in decades. And those are just averages. The price of gasoline rose nearly 50% from 2020, housing was up over 20% in much of the country, and many grocery items were up double digits. The Fed intended to stoke inflation in response to the pandemic and planned to allow prices to run hot for a while, but time will tell if the Fed can manage the inflation it created. Investors are expecting the Fed to raise short-term rates as much as three times in 2022. This would limit inflation but also risks broader negative economic consequences if not managed perfectly.
As we roll into 2022 many of the trends from last year are expected to continue. Pandemic uncertainty will reign supreme. Existing domestic and global political issues seem likely flashpoints this year. Bond returns are expected to remain subdued and could turn volatile in a rising rate environment. Asset prices are expected to keep rising but could get rocky for all of the aforementioned reasons and then some.
All things considered, 2021 was a great year to be a long-term investor. And that’s something to be grateful for during challenging times.
Bonds have been going through a rough patch lately. No, they haven’t tanked in exciting fashion like stocks can do sometimes. They’ve just been boring and uninspiring. They’ve been like dead legs as you head out for a run on an otherwise beautiful day; an unworthy detractor. And they’ve underperformed.
This underperformance is heightened by how well the stock market has done since the pandemic lows in March 2020. Since then the major bond market indexes have gained about 8% while stocks, depending on the index, have doubled. And pre-pandemic, from early-March 2020, bonds have only returned shy of 3% to the stock market’s 50% or more, again depending on the index.
The following chart shows this clearly. Here we see four big ETFs that each track a separate market index. SPY tracks the S&P 500, the primary US stock index. IWM tracks the Russell 2000, the main index for small-cap stocks. VEA tracks the MSCI EAFE, an index of developed foreign markets including Europe. And BND, the orange line, is Vanguard’s Total Bond Market fund, a good proxy for bonds issued by the US government, government agencies, and high-quality corporations.
It’s apples and oranges, but extended underperformance like this coupled with low interest rates leads many to ask reasonable questions like: Why should I own bonds at all? Shouldn’t I sell them and buy stocks instead?
This is a tricky question, but the following chart of market activity during the last month provides a great example of why bonds are valuable to many investors. It’s all about downside protection.
Heading into this autumn, BND had been down about 2% year-to-date. Again, this stood in stark contrast to the stock market being up 20% or more during the same timeframe. And underperformance from bonds was dragging down moderate portfolios that might hold 30%, 40%, or even 50% in bonds. It’s hard to see one side of a portfolio performing so well while the other is acting like dead weight. So some head scratching was to be expected.
But of course that was when the stock market had been rising steadily. Add in the news of omicron causing overnight market anxiety, and bonds were suddenly showing investors what the asset class is best at: not being stocks.
What I mean is that when investors, individual and institutional alike, sell stocks they typically buy bonds, often short- or medium-term, to park money while waiting for the stock market to settle down. This raises bond prices during periods of stock market volatility and leads to the kind of behavior seen in the chart above. While this dynamic isn’t a guarantee day-to-day, and there can be periods when the relationship falls apart, it’s typical over time.
You own bonds in a moderate or conservative portfolio because the asset class smooths out stock market volatility and provides regular income. The give up is that bonds can’t rise as much as stocks overtime. So you have to choose how much protection you want versus how much volatility you’re willing to stomach in the name of growth potential. Part of the art and science of portfolio management is determining what proportions of stocks and bonds is ideal for the individual investor. There are rules of thumb, but no single right answer.
Do you have to own bonds? No. If you’re focused on growing your portfolio and see risk and volatility and your friends, you could maybe do with having less in bonds, or even cut them out entirely. And I’ve written before about how some investors could do other things to dampen their exposure to market volatility by enhancing their capacity to take risk. They could pay down debt instead of owning bonds. They could, under the right circumstances, buy a rental property for regular income instead of owning bonds. There are other options too.
But for most investors it’s just easier to buy high-quality bonds as part of a diversified portfolio. The right bonds in the right proportions will help reduce your portfolio’s reaction to stock market gyrations and will, ideally, keep you from doing anything rash when markets get crazy. Bonds do their job over time, just don’t expect them to be very exciting along the way.
Inflation is on the minds of many this Thanksgiving week. We’re seeing higher prices on just about everything planned for the table, at the pump on the way to the store, and all points in between. There’s also the growing issue of shrinkflation, or having to pay the same price for less. This was happening pre-Covid, of course, but has only gotten worse since.
Unfortunately, nobody knows where prices go from here or when it will get better. As we’ve discussed previously, our chief inflation fighter, the Federal Reserve, expects that the recent spike in prices will be short-lived. It’s due to complex supply chain issues and unexpected pandemic-driven changes to consumer behavior (hoarding, shifting priorities, etc), even inflation expectations themselves, all forces that should ease during 2022. But other inflation drivers like rising wages amid labor shortages and the so-called Great Resignation, seem likely to linger. Only time will tell if the Fed is right.
That said, I don’t think inflation is of grave concern yet. The economy continues to grow and that’s expected to continue well into next year, perhaps beyond with all the stimulus money in the system and what’s yet to come. But it would be silly not to worry.
It’s also prudent to ask about the potential impact of not-so-transitory inflation on the stock market. We know that stocks are one of the best tools we have to fend off inflation from hurting our personal finances over the long-term, but they can be rocky when investors get nervous. Investors have so far only shown mild interest toward inflation, and sentiment can turn on a dime. So what does history tell us about how the market reacts to extended bouts of inflation?
Here’s some information on this subject from my research partners at Bespoke Investment Group…