May 8, 2023
Just remember, what the Fed giveth, the Fed taketh away.
And the Fed took the proverbial “punch bowl” away when it raised short-term rates from 0% to just over 5% over the past year (even though they only thought they’d need to go to 1% when they first began). The era of easy money is over for now, and the implications are manifold. For one, making money in the stock market isn’t as easy as it used to be.
When interest rates were low – which meant returns on “safer” investments like bonds and cash were minimal – riskier investments performed well as investors seeking return gravitated toward stocks, private equity, and real estate (among other things). It was hard not to make money. All you needed to do is catch the wave and hold on for the ride. That’s why investing in broad domestic index funds like the S&P 500 was sometimes an easy answer. Buy the S&P 500 and watch it grow.
With interest rates at essentially 0%, the “safer” asset classes were deemed as trash (cash, treasury bills, treasury bonds). This was a problem for savers – if you couldn’t get a sufficient return on the “safe” assets, the natural inclination was to take a little bit more risk – and many investors were forced to take on more risk than they might otherwise have been comfortable with. You buy more stocks when you would prefer to have more in bonds. Or you buy assets that are hard to sell (like real estate, private equity or venture capital) when you should be keeping more money in liquid assets. Many of these riskier investments performed well, until the game changed as the Fed began aggressively raising rates last year and investors flocked to safer assets like money markets and short-term treasury bills. The overly risky investments always seem like a good deal, until they aren’t, and you’re forced to sell at depressed prices to get the money when you need it.
Alas, as Warren Buffet explained, “Only when the tide goes out, do you learn who’s been swimming naked.”
Well, the tide in our current case was the rapid rise in interest rates and those unclothed swimmers are investors that took too much unmitigated risk. Oftentimes, when the Fed raises rates to this degree, things break. And we witnessed things break with the recent failures of multiple US banks, causing market uncertainty. The question now is: could something else break? And will our government agencies have the tools to put Humpty-Dumpty together again? We don’t claim to have that answer, and don’t believe anyone truly does, but we are certainly more aware of the unknowns that exist in the market today.
Hindsight is always 20/20 and it’s easy to look at the things that went wrong in the banking industry recently and explain it away as excessive risk taking. But if you look around, excessive risk taking was everywhere and we need to be cognizant of other potential risks. We’re not predicting an impending market crisis, but as we have said many times before, you must invest knowing that there could be more storm clouds ahead. The long-term still looks good for investors (safer investments like bonds finally offer good returns and stocks look more attractive now than they did 12 months ago), but there can always be detours along the way and you need to have the right strategy to manage through difficult markets.
What do we do now?
Well, much of the work has already been done – it pays to be proactive rather than reactive when thinking about your investments. We have been adding high quality investment grade bonds to client portfolios where it is appropriate and have proactively worked to bring stock allocations in line with the long-term targets.
By being proactive, we find ourselves in the position to be opportunistic in a challenging market. “Buy low, sell high” sounds great in theory, but it generally means buying when it doesn’t feel right and selling when excitement couldn’t be greater. The turmoil in both the stock and bond markets have opened the door to adding investment grade bonds, FDIC-insured CDs and government agency bonds with yields in the 4% to 6% range over the past year. And as we’ve mentioned in prior letters, many high-quality stocks are trading at prices that we haven’t seen in years. If you have more than a 12-month investment horizon, we are excited about the potential for future returns – even if the remainder of 2023 continues to be bumpy.
Many high-quality stocks are trading at prices that not seen in years. If you have more than a 12-month investment horizon, we are excited about the potential for future returns – even if the remainder of 2023 continues to be bumpy.
Prudent risk-taking is the name of the game, and part of getting long-term returns is accepting that there will be occasional periods of volatility. That’s why we work hard to align your investment plan and the need for long-term returns with the willingness and ability to take risk in the market. Then, sound investment selection and diversification are used to manage risk during the investment time horizon. If you want to chat about your portfolio and investment strategy, please know you can call or email anytime.
NPF Investment Advisors