Welcome to the November edition of FAQ’s and RAQ’s!
Here we answer client questions, some asked Frequently, and others asked Rarely.
This month, the questions are both frequent and pressing…
FAQ: How should investors treat the latest decline in the stock market?
The economy grew 4.9% last quarter. 4.9%! One would expect the stock market to cheer such good news. Yet, paradoxically, the S&P 500 is down 10% over the past few months.
Why the apparent contradiction?
It all comes back to the Federal Reserve. For nearly two years, the Fed has been turning the screws to the economy by raising interest rates. This has weighed on stocks. Now, imagine the opposite scenario: an economy growing at 4.9% while the Fed is lowering interest rates. In that situation, stocks might thrive. Thus, for a given set of economic circumstances, the stock market might fare either well or poorly depending on the actions of the Federal Reserve. It’s difficult to overstate the Fed’s influence (which means investors should not assume that economic weakness would lead to stock market declines if it is accompanied by Fed rate cuts).
The key for investors is to not confuse a temporary situation at the Fed with a permanent one. Are the Fed rate hikes painful? Absolutely. Are they permanent? Not likely. This is easy to forget with rate hikes continuing for so long.
Typically, an investor’s worst enemy is panic. But today the risk is something else: running out of patience. With that in mind, investors should recall the words of Charlie Munger, the 99-year-old business partner of legendary investor Warren Buffet, who remarked, “The big money is not in the buying and the selling but…in the waiting.”
FAQ: How much higher will interest rates rise?
The Fed’s influence is evident in the bond market, as well. The ten-year Treasury yield rose to 5% last week. That’s up from 0.5% three years ago. This has been the worst bear market in bonds on record, courtesy of the Fed.
With interest rates so high, however, further increases may be self-limiting.
Why?
Should interest rates continue to climb, it could trigger a recession, which would likely cause interest rates to fall again.
This applies to Treasury bonds, but we think additional increases in yields for riskier bonds, like high yield corporate bonds, might also be self-limiting.
Currently, high yield corporate bonds offer yields that are competitive with the historical returns for stocks. If yields were to rise further, these bonds could be positioned to outperform stocks. At that point, we think investors would step in to buy high yield bonds.
Of course, the bond market has delivered its share of surprises, and may continue to do so. Nevertheless, we think bonds are an attractive buying opportunity today.
FAQ: How should investors react to the crisis in the Middle East?
Nobody can predict how a geopolitical crisis will unfold. However, investor behavior during such events tends to follow a predictable pattern.
Consider an investor who, out of nervousness, sells their equity positions and plans to repurchase them once the crisis has subsided. Often, by the time a crisis resolves, stocks have already rebounded, resulting in the investor buying back at a higher price than they sold.
Alternatively, if the crisis escalates and stock prices continue to fall, few investors have the appetite to buy back their equity positions when the situation is even worse. Thus, they’re back to waiting for the crisis to resolve, by which time the market has likely rebounded.
The upshot is that we’ve rarely – if ever – seen an investor get ahead by maneuvering their portfolio around a geopolitical crisis. A better approach is to find an allocation that is appropriate for your situation and stick with it. Crises events come and go, yet the stock market has generated tremendous wealth over the long run.
Have a question? Drop us a line at carlsongroup@rwbaird.com. We'd love to hear from you!
All investments carry a level of risk, including loss of principal. Fixed income is generally considered to be a more conservative investment than stocks, but bonds and other fixed income investments still carry a variety of risks such as interest rate risk, credit risk, inflation risk and liquidity risk. In a rising interest rate environment, the value of fixed income securities generally declines and conversely, in a falling interest rate environment, the value of fixed income securities generally increases. High-yield securities may be subject to heightened market, interest rate or credit risk and should not be purchased solely because of the stated yield. Municipal securities investments are not appropriate for all investors, especially those taxed at lower rates.