I hope you are staying cool in our July heat. The second half of 2024 promises to be eventful with the upcoming presidential election. Let’s dive into our updates and thoughts.

Market Outlook: Don’t Get Carried Away with Last 9 Months, Clouds Are Gathering

The market’s rally over the last 9 months has far exceeded expectations.  Yet, most stocks have not participated in this rally.  (For instance, until this week, small cap was flat for the year and well below its peak.)

Some other assets like precious metals have done well due to hopes of interest rate cuts and concern over economic and geopolitical stability.  Traditional fixed income, small cap stocks, and base commodities have not performed as well.

The relevant question is not simply looking at the past, but rather considering what to do now and in the near future?

Particularly for those of you in or about to enter retirement, you cannot afford to simply chase the herd.  Potential red signs are flashing.  As much as we seek returns, we also must guard against risks that could hurt your nest egg.

Concerns we see include:

• Potential turning point on the US economy (US consumer health deteriorating, jobs sputtering, commercial real estate declining)
• The Fed still has not cut interest rates (unclear if inflation is actually improving that much)
• Bubbly market behavior (bloated concentration of market performance in less than a dozen names, speculation in limited areas at the neglect of others, “everyone is in the pool” technicals, valuations extreme for the winners relative to history, though the losers appear much less overvalued)
• Geopolitical tension (US November elections, EU elections portend change)

AI is the one thing powering the market – but there exist some similarities to the Internet rage leading up to the year 2000.  (Does anyone remember AOL or Yahoo?  They were some of the darlings in 1999, but we hardly hear of them today.  That is because new winners emerged.)

As a reminder, after NASDAQ peaked in 2000, it sold off and did not recover for nearly 14 years.  Most of you in retirement (and many approaching retirement) simply do not have that much time for your savings to recover from such a potential drawdown if it were to happen again.

Questions exist as to the ultimate economic returns that most companies would actually get on current AI development.  Cost synergies appear feasible, but revenue growth less so.  Undoubtedly, there are many menial, mental processes that could be automated.  Yet, replacing a human worker with a humanoid robot powered by the state of the art chips is nearly double current employee cost.  Robo taxis are the rage, but the reality is that other players in the auto industry rely on the same data and, thus, over time, competitive advantage gets whittled away.

We maintain a defensive stance while looking for opportunities to grow your portfolio even with risks out there.  Your accounts continue to be invested in a variety of sleeves, including growth, income, and diversification.

What Do I Own in the Income Bucket?

“Why do I need anything but NASDAQ stocks?”  Today they rise, but that is no guarantee in the future they will keep rising.  In fact, especially if stocks become overvalued and/or earnings disappoint expectations, the stocks possibly might even fall.  Just remember the year 2000 followed 1999.  After the decline, it took over a decade for investors to recoup losses.

Except for those with the longest time horizons and most aggressive risk appetite, most of you own investments in the “income” bucket.  (Recall in the last newsletter that we discussed the “diversification” bucket.)

The Income bucket is designed to allow you to clip coupons by being paid interest, yet with potentially limited (up or down) appreciation on your principal.  The Income bucket functions to fund short-term needs for cash and potentially stabilizes the total portfolio when volatility rises and risk markets decline.

US Government T-Bills are the primary exposure in those of you with the Income bucket.  Low duration (less than 2-year maturity) and minimal credit risk (US government) along with a mid-single-digit coupon offer potentially attractive risk-adjusted returns.  The greatest risk to returns on T-Bills is the possibility and extent to which the Fed decides to reduce interest rates in response to a weaker economy.  Lower interest rates mean lower (but not negative) returns on T-Bills.  In fact, a cut in interest rates near-term benefits the value of your principal.  However, the bad news is that future yield on new T-bills is lower.

Our hunch is that the Fed might make a moderate cut in rates over the next 18-24 months if and as the economy continues to weaken.  However, we doubt it brings us back to the near zero rates of pre COVID; fiscal spending and debt are at much higher levels.  Lower interest rates might also add gasoline to the fuel of a possible resumption in inflation.

For the most part, we have avoided buying bonds with high duration or credit risk.  (A few accounts with high cash needs might own some highly rated corporate bonds in limited amounts.)  Risk of inflation and economic weakness coupled with low rates relative to the risk one takes in owning the bonds keeps us cautious.

While not officially part of the Income bucket, one mutual fund strategy might provide slightly higher returns with a risk profile similar to fixed income.  This fund utilizes an event driven strategy (officially classified in the Diversified bucket).  We described it briefly in our last newsletter, but here is a brief description.  Roughly 2/3 of the strategy is merger arb, where the fund buys the securities (equities or bonds) of a company that has announced it will be acquired.  The fund hedges its exposure by selling short the equity of the buying company.  These trades tend to be low return but low risk and mostly short term (3-6 months).  The other 1/3 of the strategy is classic event driven, where the fund conducts a variety of short-term strategies around corporate events (one example might be announcements on investor days, where the fund might purchase both calls and puts to anticipate a strong stock reaction positive or negative).  The fund does not generate income in the literal sense.  Yet the fund’s strategies potentially result in low volatility similar to traditional fixed income with the potential for higher returns (and lower correlation to the direction of interest rates).

Keep Your IRA Beneficiaries Up to Date

Why Beneficiary Forms Matter

You’ve spent years building up your IRA, watching it grow, and perhaps even rolling over funds from a company plan. But have you thought about what happens to your IRA after you die? Many people mistakenly believe their will controls who inherits their IRA. In reality, the beneficiary designation form you filled out with your IRA custodian determines who receives your IRA funds.

Completing and Updating Your Beneficiary Form

When you set up your IRA, you named primary and contingent beneficiaries on a beneficiary designation form. This form decides who gets your IRA if something happens to you. It’s crucial to update this form after major life changes, like marriage, divorce, or the birth of a child, to ensure it reflects your current wishes.

Regular Reviews Are Essential

Regularly check your beneficiary form to make sure it’s accurate. Clear identification of all beneficiaries and their shares is vital. If the form is missing or outdated, update it immediately. Problems can arise if the form is lost due to bank mergers or other issues. Completing a new form now can prevent complications later.

Take Action Now

To protect your hard-earned IRA funds and ensure they go to your intended heirs, keep your beneficiary designation form updated and accurate. Regular reviews and updates can prevent legal battles and ensure a smooth transfer of assets to your loved ones.

Sincerely,

Petr Burunov, CFP®
President / Wealth Strategist

The post Client Newsletter 3Q24 appeared first on AWM.

2022 has been a momentous year!  It has reminded us that investments do not just travel in one upward direction.

We will discuss how we see things near and longer term.  In short, we still lean toward playing defense, though we could see temporary reprieve in the markets.

We have emphasized defense, especially this year, because this is not just your money.  Your nest egg is a source of funding your retirement income, future dreams, and health care costs in retirement.  While we seek ways to grow your assets and find income, we also keep an umbrella on hand for rainy days – like 2022, maybe a little longer.

If you have other investments that might benefit from this approach, please come talk to us.  If you know someone who feels a little beat up after 2022 and needs some help, have them give us a call.

We are here to help.

Enjoy the Bear Market Rally While It Lasts…

Near term, we could see a mild bounce in the markets.  Markets experienced a sharp -15% decline from mid-August to mid-October. Markets since then have shown mild resilience.

Seasonality, hopes for an end to Fed rate hikes, and options speculation might allow for a temporary bounce.  3^rd quarter earnings and macroeconomic data are a wild card.

While we have modestly taken up risk, we see it only as a tactical bounce over which major headwinds remain.  We would expect to take it off at higher levels perhaps toward the end of the year.

…But Serious Risks Still Remain.

Our medium-term concerns about risk assets remain:

1. Inflation continues to remain an issue.
   • Commodity scarcity: in spite of higher prices, supply in most commodities is not rising. OPEC+ is cutting 2 million barrels of production, the US Strategic Petroleum Reserve will soon run out of barrels, and diesel inventories in the US are less than 30 days of supply, near all-time low.  Food harvests and rare earth (used in renewable energy) are also supply-constrained.
   • Labor wage hikes are passing through the system. This in past cycles has been the real driver in times of stubbornly high inflation.  Railroad engineers, airline pilots, and other industries have received double-digit wage increases.
   • The question is not necessarily whether inflation near-term has peaked, but rather where will inflation plateau. Consensus expectations call for inflation to drop only to 5% next spring from over 8% currently. (Bulls need inflation to fall to 2%.  Given supply shortages and government spending, we are concerned that hope might be too optimistic.)
2. Interest rates remain an overhang:
   • Short and long-term interest rates hover at +/-4%, the highest in over a decade. In the meantime, the Fed is still catching up.
3. The bulls expect the Fed to “cry uncle” similar in 2018-9. In a matter of months, the Fed shifted from raising to cutting rates due to fears of economic recession.  The stock markets rallied.
4. What is different today 2018 is that inflation and fiscal spending are both much more serious issues.
5. If the Fed stops raising or even cuts rates, it runs the risk of a new inflation surge. Markets might like it initially, but at some point, we fear the rally would end as investors realize the inflation genie is out of the bottle.
6. If the Fed keeps on going, we risk seeing deflation in the form of price declines in financial markets.

Other Issues Include:

• Retail investor sentiment (what they really do, not what they say) is still elevated. BofA investors still maintain high allocations to stocks versus history (and well above pre-pandemic).
• Corporate earnings are subject to disappointment and reduction (margin pressure, demand weakness). Transport companies, a barometer for the overall economy, have warned about declines in volumes entering the holiday season (and the stocks have suffered).  Wall Street still expects earnings growth in 2023 despite signs of a weaker economy.  We believe this is overly optimistic.
• The surging US Dollar has not only driven debt costs higher for emerging markets, but also has pressured large developed market currencies (UK, Japan). Markets fear a violent spiral in devaluation might also take their toll on assets held in the US.
• Geopolitical risk (Ukraine, Taiwan) is another wild card.

How We Intend to Navigate This Landscape

Exiting the bull market of last year, we believe a prudent investment posture consists of 2 stages in the current environment.

Stage 1: “Play Defense.”

For 2022, we have focused on reducing downside risk.  We had entered the year moderately cautious on equities, and extremely cautious on fixed income (down over -15%, the worse year in decades).   Cash, large cap equities, and diversified strategies have been our main focus.

Stage 2: “Go Back on Offense, But Be Careful.” 

Timing is uncertain (it might take months or even years).  Markets and economic fundamentals will show true signs of bottoming.  The Fed might finally be able to cut interest rates.  Perhaps a systemic failure (a major bank or country) is needed to wash out markets.  At that point, we would begin to see some true value, especially in traditional assets.  Perhaps we might invest again in foreign markets (which have been major underperformers this decade).

The Newest Investment Is Not the Sexiest

For the first time in over a decade, US T-Bills might offer sufficient yield with minimal risk.  They now offer a potential tool to diversify investors’ nest eggs.

Opportunities:

• Meaningful interest rates are nearly 4% on a 1-year bill.
• High liquidity – you can get in and get out with minimal friction.
• Short-duration (< 1 year) cushions interest rate risk – if rates rise further, your T-Bill matures soon and can potentially be reinvested at higher rates.
• Credit risk is minimal – thank you, US Government.

Risks:

• Opportunity cost – other bonds have higher yields, but the risks are often much higher.
• Reinvestment risk – if rates were to fall, maturing debt would likely be reinvested at a lower coupon.

Do You Have Excess Cash Earning Next to Nothing?

If you have extra cash sitting in your bank account, chances are it’s earning yields next to nothing.

You might be able to allow more of your money to take advantage of higher interest rates with modest risk. Come talk to us to explore if this might help you.

Tips From a Pro

Do you want to avoid the slaughterhouse during this bad market environment? Here are a few tips:

• Pay intention to what you are invested in, especially in your retirement plans. Get Active!
• Actively manage your accounts and understand that buying index funds (today) might actually harm you.
• Avoid being invested in target-date funds.
• Prioritize quality and value over fads and trends.

Conclusion

As you set your New Year’s resolutions, I encourage you to be proactive with your financial planning.  You can control your future, but it’s up to you to make it happen.

2023 will likely be a difficult year. If you prepare, be proactive, and plan ahead you will be able to look to the future with confidence, even in times of uncertainty.

I’m here to cheer you on along the way.

Sincerely,

Petr Burunov, CFP®
President / Wealth Strategist

The post Client Newsletter 4Q22 appeared first on AWM.

The above chart suggests high yield corporate bonds are enjoying calm weather.

Data compiled by Cohanzick Management, a New York-based asset manager, and Bank America show the amount of US high yield corporate bonds[1] priced as if they were going to default in the near future.  The data include corporate bonds that trade 10% or more (1,000 basis points) above the yield of the equivalent US Treasury bond.  Such bonds appear to sport high yields, but they do so with a reason: fear that the company could choose not to pay bondholders back and default.  Think Toys R Us as one recent example of a company that eventually went bankrupt.

The blue bars represent the absolute level (market value) of bonds priced for bankruptcy for a given year.

The yellow line shows the percentage of the total high yield market that is priced as if it were going to default.

Whether an issuer priced as distressed actually defaults or not depends on the situation.  Often the market is correct about such dire prospects.  Sometimes, the market overly panics, and the company manages to find a way to bail itself out.  What matters for this discussion, though, is this: what message is the high yield market sending about the US economy overall?

Currently, the level of bonds priced for default is about 3% of the total US high yield market.  This is close to the lows set earlier this century.  While this number appears good for the moment, there are also reasons to be concerned.

Defaults at this level are likely to get worse, not better, based on past history. Two historical precedents for a bear case going forward might include:

1. 1999: TMT[2] on the eve of the dot-com bubble bursting, when the Fed also had just been hiking interest rates aggressively after pumping in excess liquidity to stave off contagion from the Russia debt default/emerging market crisis to the US. High yield defaults were concentrated mainly in those sectors, but the economy later turned into recession, and stocks corrected.
2. 2006: The housing bubble was about to burst. The Fed was raising interest rates while oil was over $100 a barrel.  It took another 2 years before we finally entered the Great Recession.  Numerous sectors experienced high defaults.  Stocks corrected.

A more benign case might consist of something like 2003.  Interest rates remained quite accommodative for a long time.  Steady economic growth and reasonable interest rates prolonged a benign credit cycle for years.  Eventually, however, it gave way to asset bubbles particularly in the housing and debt markets.

What lessons might we learn for today?

Economic recovery, while the second longest on record, has also been tepid, as evidenced by the weakest level of growth in recorded US history.  The hangover from the financial crisis has allowed central banks to keep interest rates low even after recent rises.  Additionally, low inflation has also resulted in robust profit margins for many companies.

However, any change in inflation might make central banks tighten short-term interest rates more aggressively.  Cost pressures from either wage or input price inflation might weaken corporate margins.  A combination of these two issues might put pressure on certain issuers in the high yield market.  That might send a warning signal to corporate credit and adversely impact other assets, including equities.

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[1] “A high-yield bond is a high paying bond with a lower credit rating than investment-grade corporate bonds, Treasury bonds, and municipal bonds.  Because of the higher risk of default, these bonds pay a higher yield than investment grade bonds.  Issuers of high-yield debt tend to be startup companies or capital-intensive firms with high debt ratios.”  Source: Investopedia, https://www.investopedia.com/terms/h/high_yield_bond.asp  accessed on May 17, 2018.
[2] “What is the ‘Technology, Media, and Telecom (TMT) Sector” on https://www.investopedia.com/terms/t/technology-media-and-communications-tmc-sector.asp  accessed on May 17, 2018.

The post Investments 101: High Yield Corporate Credit: Don’t Worry, Be Happy? appeared first on AWM.