Silver Oak Insights

Investment Perspectives: What We Know and What We Can Control

by | Jul 19, 2022 | Investment, Newsletters

“The stock market is a device which transfers money from the impatient to the patient.” –  Warren Buffet

 

Dear Friends of Silver Oak,

The continued market gyrations, coupled with rising interest rates, record inflation, and global conflict, have caused many investors to pause. What is going to happen this week, this month, or for the rest of 2022? The truth is that no one has a crystal ball to predict the future. Is it possible that things will get worse? Yes. It is possible that things will improve? Yes. As always, the path ahead is uncertain, but we can draw on what we KNOW and what we can CONTROL to navigate a bumpy ride with as much peace of mind as possible.

 

WHAT WE KNOW: A Look at the Past

From 1928-2021, the S&P 500 had 25 negative years. In other words, 73% of the time, stocks had positive returns. The characteristics and drivers of the negative years, however, are varied. Market crises can be relatively short, such as during the onset of COVID-19: the S&P 500 saw a 30%+ drop in a month, followed by a 60%+ subsequent increase from the trough over the rest of 2020. Periods of volatility can also be long and drawn out, such as in the Great Depression of the 1920s-30s, when stocks brought negative returns over three consecutive years. However, no matter the market crisis or how unprecedented it was, the stock market has always bounced back.

The chart below examines the worst performing years for the U.S. Stock Market. Notice that after these historically negative years, the average 3-year return was +35%, while the average 5-year return was 80%.

 

The Worst Years Ever For a 60/40 Portfolio

 

While the past does not predict the future, a glance back at the last century tells a story: markets rise, and markets fall. But the probability of market rising is much higher than the market falling at any given time. If you are willing to tolerate the turbulent periods, you have the greatest chance of meeting your long-term financial goals.

In addition, we know that this current period of volatility differs from some historical ones in a specific way: the risk materialized in the bond market – not the stock market – first. Often in periods of economic uncertainty, investors will flee the stock market and find a haven in bonds, causing bonds to be in favor. 2022 has shown the opposite.

The interest rate hikes that precipitated bond prices to fall first may not yet be over, but as of March 31stthere were 9 more rate hikes baked into the current prices of bonds expecting the future rate to be 2.4% by the end of 2022. The chart to the right shows the implied Federal Funds rate.

Implied Federal Funds Rate & Number of Hikes/Cuts

Unless investors expect interest rates to be on a permanent upward trend or above this market expectation, we do not expect that bonds will continue to decline at the same magnitude as they already have this year.

WHAT WE CAN CONTROL: A Look at the Future

Inflation and Spending Choices | As 2022 has shown, savers, spenders, and investors alike might all be understandably concerned with inflation readings in the 8-9% range. If that level is sustained, how will households maintain their standard of living? Where is inflation going?

According to present consensus, breakeven inflation rates published by the St. Louis Fed point to a 2.9% inflation rate over the next five years, and 2.6% over the next ten years. The change in these long-term inflation expectations is minimal, if any: in February 2022, we saw the same breakeven rates as we do today. While the 8-9% inflation stings in the short term, these readings imply that the market expects the inflation to return to the historical average over the long run.

Despite the long-term perspective, running errands to purchase groceries and gas for the week can still be shocking. For now, perhaps the best tool at our disposal is to defer unnecessary discretionary expenses to make room in the spending plan for higher costs on essentials. Discretionary spending is something we can control and timing these expenses wisely will help the bottom line. For example, once supply shortages ease and oil prices fall,  we believe prices for home improvement items and autos to normalize, and airfare and hotel costs to become more feasible. Delaying these expenses is something you can do to help your lifestyle remain sustainable despite higher costs.

Investment Choices| Besides spending choices, investors can navigate the current market by choosing investments wisely. Though no one knows how any specific investment will perform in the future, perhaps the most valuable lesson for investors from the last few years is how important it is to stay diversified and to stay disciplined. Avoiding an overconcentration on any one company stock or one type of investment prevents a big loss when that bet goes bad. For example, some of 2021’s biggest winners have turned out to be 2022’s biggest losers. Bitcoin far outpaced the market in 2021 with a 48.5% gain but has dropped 56.3% this year. Tesla, up 50% in 2021, is down 39% so far in 2022. Meta (Facebook), up 23% last year, is down 50% this year. In short, having the discipline not to chase after the hottest and shiniest investment products can reward investors over time.

The Bottom Line: What investors KNOW and what they can CONTROL will help navigate this period of economic and market uncertainty. Whether short or prolonged, bear markets have historically recovered. In the meantime, it is helpful to remind yourself of the positive historical evidence and take proactive measures to adjust your discretionary spending as you see feasible.

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