A quick summary of 2022.
Inflation ran at 40-year highs, short term interest rates soared from .25% to 4.5%, the stock markets suffered their worst losses since 2008 and the US Treasury markets recorded their worst losses EVER. The US economy contracted in 2 out of 4 quarters and many other world economies slowed significantly with some sliding into recessions. Europe went to war when Russia invaded Ukraine which sent shockwaves through the world oil and gas markets as countries dependent upon Russia for oil and gas scrambled to find alternative sources. China’s policy of shutting down its economy to combat their covid pandemic forced the US and many other countries to accelerate relocating manufacturing from China to their own shores or to more reliable trading partners. The rift with China continued to grow and now is considered the greatest threat to the US both politically and economically. And yes, there was some good news. The unemployment rate in the US dropped from 4.0% to 3.5% which is the lowest level since 1969 and according to the US Labor Department there were 1.7 job openings for every unemployed worker.
With such a rosy outlook for 2023, why not just go to cash?
If your investment horizon is short-term, say less than 2 years, then yes it probably makes sense to be out of the Stock Market and maybe even the Bond Market. A prudent investment might be a Money Market, Certificate of Deposit or a bond with a less than 2-year maturity. But, if you're investing for the long-term, moving to cash could be very expensive. The chart below (Staying Invested: Missing the Best Days) highlights the cost of missing out on greater returns by making the mistake of being out of the Market on its' best days. As the chart shows, had you invested $1,000 25 years ago in the S&P500 it would have been worth $3,365 as of the end of 2022. If you had tried to time the market and missed the 10 best days, your investment would have been worth $1,543 or 54% less. So, if you started with $100,000 25 years ago, being out of the market for 10 of the past 9,125 days would have resulted in your investment being worth $154,300 versus $336,500. The cost of being out of the market was $182,200.
The second chart (The Value of Staying Invested) shows a comparison of 3 strategies investing $100,000 since the crash of the markets due to the Financial Crisis of 2008. A move to cash and staying invested in cash resulted in an ending balance of $134,217, whereas remaining in the Market yielded a balance of $648,442. It pays to be patient.
Over the past century, the stock market has endured countless crises – Nothing new under the Sun.
Investing is often as much about psychology as it is about facts and figures. Even though many investors understand that staying invested is the best way to achieve long-term financial success, doing so across all phases of the market cycle can be difficult. Negative headlines and economic news grab our attention while positive trends can be slow-moving and sometimes invisible. The holiday season, especially given the market rebound over the past few weeks, is the perfect time for investors to remember that there is still much to be thankful for amid the uncertainties. There are a few reasons for this.
First, the fact that there are risks for investors to navigate is not only normal but is always the case. The truth is that there are always reasons to be concerned when it comes to the economy and world events. Investors often refer to this as the "wall of worry" - a concept that is not dissimilar to the 5 stages of grief.
When a market-moving event occurs, whether it's economic, financial, or geopolitical, markets often go through the phases of denial, anger, bargaining, and depression. Eventually, markets enter the acceptance phase either because the situation can be resolved or because prices can adjust accordingly. Regardless of the circumstances, markets tend to move forward once it enters this phase.
So, although the stock market tends to rise over long timeframes, there has never been a period during which investors were perfectly content. In fact, the reason that investors earn positive returns is exactly because they are willing to stay invested during periods of market grief, knowing that eventually there will be acceptance. Thus, it is not just a nice coincidence that investors who stay diversified through thick and thin tend to do well - it is a direct consequence of market psychology.
Stock Market Cycles follow Business Cycles
As you can see from the chart (U.S. Business Cycles) below, the current business cycle is over 14 years (56 quarters) in duration, which is the longest expansion period since WWII. There is a saying that goes: "things that can't go on forever, don't". Periods of expansion can't go on forever; they never have. Periods of expansions are followed by periods of contractions which are followed by periods of expansions and on and on and on. There is no reason to believe that the things that make this so have changed, which means that the current period of expansion will come to an end, and then once again the economy will expand. As mentioned in the opening paragraph, most economists are predicting that the US economy will go into a recession during the current year 2023. The severity of the recession (economic contraction) is hotly debated and without consensus. Although it matters, because recessions mean that the economy is slowing down resulting in potentially millions of people losing their jobs, it matters less for investors that stick to their investment plan and reap the rewards of the period of recovery that has always followed.
Bear Markets and Bull Markets - 2 Sides of the Same Coin
Bear Markets are "unpleasant" to say the least and test the resolve of the most seasoned investors, but as the chart above makes clear Bear Markets (the Pain) are common and have always been followed by Bull Markets (the Gain). The saying goes: "Buy low and sell high." Of course, that makes sense, but the most common instinct is to sell when prices are low (fear) and buy when they are high (greed). Warren Buffet is famously attributed with the quote: "buy from the fearful and sell to the greedy"; or said another way is to buy when everyone else is selling and sell when everyone else is buying, because "everyone" is usually wrong.
The chart below (Stock Market Bull and Bear Cycles) shows graphically the consistency and thereby predictability of the bull and bear market cycles. Bull markets end in Bear Markets which end in Bull Markets. Another way of saying that is every Bear market ended where the next Bull market began and as we discussed previously, missing the subsequent Bull Market can be expensive.
The chart below (Bear Markets and Recoveries) shows that since WWII, Bear Markets have resulted in an average decline of 35%, lasted an average of 366 days, and taken an average of 2 years to recover to previous highs. The current Bear Market began on January 3, 2022 and as of December 31, 2022 was down nearly 20%. The thing about averages is that they represent a phenomenon that is seldom if ever the average. Rather they are made up of “greater than” and “lesser than” readings that when averaged out result in a value that moderates the highs and lows. We know that the current Bear market is already longer in duration than the average. We don’t know how much longer it will continue, but we can be confident that it will come to an end with the start of the next Bull market.
Rising bond yields make it easier to generate portfolio income – The Silver Lining
With the sharp increase in interest rates, investors can be thankful that it's easier to generate income from their portfolios than at any point since the global financial crisis. Until recently, the case was made that fixed income investments (bonds, c.d.’s, money markets, etc..) yielded so little that there was no alternative but to invest in the stock market. This sentiment was popularly labeled TINA (there is no alternative). Unfortunately, since interest rates were nearly zero for so long, investors were forced to "reach for yield" – by taking on more risk than they would otherwise like to in order to generate income via riskier bonds, dividend-paying stocks, or even more extreme measures such as crypto lending. So, while bond prices struggled last year as interest rates have jumped, the silver lining is that yields are now higher across many types of bonds.
Cash is King? – Maybe Not.
Unfortunately, while the yields on savings accounts are also creeping higher, the value of cash is directly eroded by inflation. If a Money Market is paying 4% (nominal rate) and inflation is running at 6% than your “real rate” from your Money Market is -2%.
Thus, while it may be tempting to hide in cash while markets stabilize, inflation makes this approach unattractive. The problem with timing the market is that you must be right twice; when you get out and you get back in. As we discussed previously, this has historically resulted in missing out on significant future gains.
Understanding 2 biases that threaten our financial future.
Framing bias and Availability bias are 2 cognitive errors that we fall victim to that sabotage our future financial success. The framing bias "trap" is to see (frame) the future in light of the present. Sort of the "what is will always be" syndrome. A good example is the way the generation that experienced the collapse of the economy in 1929 and the great depression framed their future versus the generation that came of age as investors since 2009. The first could see no good in the stock market and the second could see no bad. Both were wrong. This trap is closely connected to the "availability" bias which assigns a greater weight of validity to an experience that occurred more recently than to one that occurred in the more distant past. A line of thought might be: "I feel great pain in losing 20% in my stock portfolio in 2022 which causes me to believe that this will be the likely result in the future.
Last Word.
So how do we guard against such huge mistakes? We frame what's happening in the present through a long-term historical view to position ourselves for the most probabilistic outcomes in the future. That is to say, if we are investing for the long-term, it is wise not to get lost in the short-term machinations of the markets. Have an investment plan that is suited to your particular goals and time horizon and align it with your capacity and preference for risk. The Best is yet to come.
Important Disclosures:
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. This content was created as of the specific date indicated and reflects the author’s views as of that date. Supporting documentation for any claims or statistical information is available upon request.
Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.
Investing involves risk including loss of principal.
Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. For more information on indexes please see www.schwab.com/indexdefinitions.
International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.
Diversification, asset allocation and rebalancing of a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.
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