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.

I hope you are enjoying a wonderful summer so far!

In my April newsletter, I shared my thoughts and predictions that 2022 would be a difficult year. Let’s jump in and see what’s changed since the second quarter.

Let’s Recap 2022 Thus Far

2022 has been a challenging year (and we are barely past the halfway mark).

But it could have been worse.

If you were only in stocks, you might have been down over -21%. This ranks as the worst start to a year in nearly 60 years.  (If you were only in growth stocks, you might have seen even bigger declines.)

If you were in a 60/40 portfolio, your accounts might still be down -16%, the second worse performance for such a “diversified” portfolio since 2008.

Now imagine if you were in crypto?  Bitcoin, the largest cryptocurrency by market cap, is down nearly -60% this year.  (Disclosure: no client portfolios managed by AWM have any crypto exposure.)

The first half of this year seemed like a game of “keep away” or “hot potato”.  We have spent the last six months really focusing on making sure your portfolios are not exposed to investments at risk from higher interest rates, inflation, and/or risk of recession.

Consequently, we pared down exposure in your growth bucket to equities, particularly in sector ETF’s and Japan.

Even though we entered the year quite cautious on fixed income, we don’t want to buy things because they are on sale. We want to buy quality.  (Coincidentally, you might see a higher balance of cash than usual.  You might expect to see some of it invested in the coming months, though we continue to be cautious with a lot of patience.)

What Are We Hoping to See in the Second Half of 2022?

One question that we wrestle with is this: what do we want to see for an “all clear” to buy risk assets?

Some observers allege that the Fed will “cry uncle” and stop raising rates soon.  They hope that by doing that, inflation will have stopped, interest rates plunge, and risk assets will resume their bull market surge.

History of past 1H corrections in recent years might indicate this is a possibility.  However, we are less optimistic near term.

What conditions would we like to see to become more optimistic? (It does not mean everything will line up.)

• Inflation is truly tamed (supplies in commodities grow and consumers are able to spend without borrowing)
• Stable interest rates (preferably with the 10-year Treasury yield starting at a 4% or 5% handle, thus returning to historically average rates and also providing a real positive return relative to potential future inflation of 3 or 4%)
• Economic growth and corporate earnings estimates reset downward once a recession is acknowledged (but be careful of what you wish for – that might also imply a lower price for stocks to begin with)
• Government policies less hostile to private enterprise (you might see a minor reprieve depending on outcome of midterm elections, real focus though comes in 2024)
• Geopolitical tensions stabilize or ease (détente with Russia, China does not commit incursion into Taiwan).

Addressing Risk in Your Investments

Let’s talk about one way we look at whether to add or reduce risk in your investments.  (We cannot eliminate risk completely.  Even cash has risk as do stocks.)

Over the long term, stocks in most time periods tend to provide the highest returns.  However, there are moments when they don’t (and in fact can decline, such as now).  The reason is that they are valued at a price which drives most of the return of a stock (in many cases, the dividend a stock pays can also be an important source of return). If the price of a stock is higher in the future than now, then you earn a positive return (and vice versa).

Think of this: a stock’s price can be considered as two components:

1. The profits (or cash flow) that the underlying company can deliver, and
2. The multiple (how many times one year’s worth of profits or cash flow) the market is willing to pay for that stock.
   • Higher multiples tend to be associated with companies with strong growth prospects, market share, and/or stability.
   • Lower multiples often come with lower confidence in those metrics.

One can consider a broad-based stock index (such as the S&P 500) as simply a group of many individual stocks.  Thus, the same components that drive the price of a stock also drive the price of an index.

In a year such as 2021, confidence was high and earnings were expected to grow nicely.  Consequently, investors were willing to pay a higher multiple on growing earnings, resulting in a strong price performance in 2021.

However, investors risk becoming complacent in bull markets.  Multiples can (and did in 2021) surge to above normal levels, even though earnings prospects might not have changed nearly as much.

Switch to 2022, and we face a different environment.  Indeed, the bulk of the correction in prices in 2022 resulted from the market assigning a lower multiple to a relatively flat level of earnings (for the broad stock market).  However, changes in earnings prospects within sectors masked the earnings.

Reasons for investors paying a lower multiple for earnings might include:

• The Fed announcing it would raise rates and cease from buying more debt (ending “Quantitative Easing”) in order to try to lower inflation.
• Inflation starting with higher commodity prices (such as food and energy) has extended into other goods and services (airline prices, taxes). The war in Ukraine and China Covid lockdown policies have exacerbated a situation that began in 2020.
• Rising interest rates would dent future economic growth prospects. The Fed seeking to tighten interest rates might send the US into recession.  Europe and emerging markets also are teetering on recession.
• Geopolitical volatility (Ukraine the latest example) also dampened investors’ willingness to pay a higher multiple for stocks.

If the US has truly entered into recession (which we believe is likely either in 2022 or 2023), then earning estimates likely go lower.  In past recessions, earnings on the S&P 500 have been cut anywhere from -15% to -30% or more (such as in 2008).

A number of Wall Street banks estimate earnings on the S&P 500 to total around $240 per share in 2022.  Taking even a mild -17% cut in a recession would drop them to $200.

In the good old days of last year, multiples reached as high as 21.  Prior to 2021, multiples on market earnings have ranged between 13 to 18 times earnings.

In an environment of high confidence, fair value for the market might be around $3600 (18 times $200 in earnings).  If confidence were to ebb somewhat (but not collapse), we could see the market sell down further to $3000 (15 times $200 earnings).  As of June 30, the market closed roughly at $3800.

In a word, we believe the markets could still decline this year.  It is possible to see near-term rallies (indeed, we have had 3 of them this year).  However, at least thus far, the market has not gone to new highs.

Closing Thoughts

We encourage all of our clients to have a financial plan in place. This will help with navigating uncertain times, preparing for retirement, understanding what income can be taken without depleting principal, strategizing tax implications, and help you avoid pitfalls.

My most successful clients always know where they are going and what their options are. Let us help to prepare you for retirement by properly adjusting risk in your portfolio, implementing strategies to save on taxes, and protecting your principal while not giving up your standard of living.

Please remember, it’s not about how much you make, but in the end, how much you keep that really matters.

Sincerely,

Petr Burunov, CFP®
President / Wealth Strategist

The post Client Newsletter 3Q22 appeared first on AWM.

Precisely where people have the greatest need is also when they are most vulnerable to misunderstanding. Making mistakes with income risks lowering your future standard of living.

We continuously run into clients who seek income, but who have misunderstood what they will actually receive.

• Oftentimes, we find people who mistake yield for total return (and forget that they need to earn at least their principal back with some positive return).
• In other situations, investors fail to consider taxes into their overall equation.
• Sometimes, people lock up their money in hopes of a greater coupon. Yet, they leave a lot of money on the table because they fail to understand the intricacies of illiquid investments.
• One of the greatest pitfalls we see is people who buy into the promise of durable, high-income payment. Because they forget about risk, the investment might not live up to its promise. Thus, investors suffer losses, including reduced income.

Get my free guide

The post 3 Ways Reaching for Income Can Make You Broke appeared first on AWM.