PENDULUM
90% of the time it works every time.
This paraphrased line, from the comedy gem Anchorman, should be standard disclosure in describing one of the fundamental principles of investing – diversification.
An investment portfolio comprised of several asset classes will deliver smoother returns over time…but not every time.
The typically negative correlation between stocks and bonds (represented by the two ETFs in the chart below), is not only positive now, but is at multi-year highs. It is this breakdown in the countervailing behavior of these two asset classes that makes today’s bear market especially biting.
Central Bank action is the culprit.
Coming out of the COVID recession, the Fed left the monetary spigot open for too long, keeping rates at 0% and injecting liquidity into the financial system well after the measures were needed.
The pendulum is swinging back now.
In seven months, the Fed raised rates by 3.0%; another 1.5% increase is on the horizon before year end. Higher interest rates depress the valuation of all financial assets – stocks and bonds each represent a claim on future income, which becomes less valuable at a higher discount rate. Ordinarily, the income from bonds helps to offset some of the price declines, but heading into this year, bond yields were close to 40-year lows, offering little to no protection against the ensuing price declines.
As a result, while stocks are in a bear market, long dated bonds are faring even worse. Thankfully, we do not hold any long bonds in our portfolios and except for pension plans, I don’t know many investors who do!
A pause in the rate hike cycle, and ultimately the swing back to an easing monetary policy, will be the catalyst for the next bull market. For now, the tight labor market and continuing hot inflation is not giving the Fed much room or reason to pause, but I do believe we have fewer rate hikes ahead of us, than behind us.
Signs of cooling are showing up in the economy and the official inflation data will begin to pick that up too. Job openings declined by over 1 million in August – while the overall openings are still high, this drop was the largest amount in over two years.
Used car prices are starting to pull back, with the Manheim used vehicle price index now down 0.1% from last year. Container shipping costs are moderating. In the services industry, prices are still increasing, but now at much slower rate. The ISM Services Industry Price Index below typically leads the Consumer Price Index (CPI) by three months.
The cost of shelter (rent and rental equivalent cost of home ownership) is increasing and as the largest component in the CPI, it has substantial impact on overall inflation readings. However, since existing lease agreements take time to renew, the measure is highly sticky and is a lagging indicator of inflation.
What we see from Zillow is that rental growth on new leases signed today is slowing.
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While it may be premature to talk about Fed policy easing, some of these deflationary trends will start to make their way into the inflation data and a Fed pause in the next several months is highly likely. Stocks have re-rated too, reflecting the higher discount rate and slower economic growth ahead. The S&P is now trading at 15.5x next year’s earnings, down from the 21.5x valuation at the beginning of the year. Markets will continue to be choppy the next few months, but with the substantial declines this year, much of the impact of higher rates and expected slower growth is in the price. We will know the true market bottom only in hindsight, but we do know that every bear market sows the seeds of opportunity to grow capital. Another important investment principle like diversification.
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Alexander Bass, CFA, CFP® |
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