Responding to the Challenging Investment Environment
The recent decline in the stock market is a stark reminder that drawdowns and even bear markets, defined as a 20% decline from a market high, occur in the normal course of events. Unlike recent corrections, this drop has been accompanied by the highest inflation rate in 40 years and the Federal Reserve’s attempt to reign it in by raising short term interest rates.
One does not need to look far to understand why the investment environment has turned sour. When the stock market experienced the 35% precipitous decline in a matter of a few weeks at the onset of COVID, the federal government and Federal Reserve stepped in and provided unprecedented liquidity to the economy. As workers were laid off, they received stimulus checks and both state and federal unemployment. Conditioned for decades by strong market returns by buying stocks on market dips, many individuals invested these excess funds in the stock market. Furthermore, they expanded their universe of investment options by investing in the so-called meme stocks such as Game Stop and Blackberry, companies on the verge of bankruptcy. The historically low interest rates also turbo charged growth stocks, particularly technology and biotech. As invariably occurs in these overly exuberant markets, this delirium has suddenly dissipated largely triggered by this burst of inflation.
Over the past 40 years, bonds have been the ballast that would offset declines in the stock market. As the focus of the Federal Reserve is concentrated on suppressing inflation, they have quickly begun to raise interest rates which has depressed bond prices. The classic 60/40 investment model portfolio comprised of 60% stocks and 40% bonds has been derailed. As a result, the current environment represents the most challenging market in decades.
Despite the dual headwinds of rising interest rates and a declining stock market, there are opportunities to be had. Inflation sensitive investments such as commodities and real estate represent sectors that typically thrive during periods of high inflation and high dividend paying stocks, particularly those with increasing dividends, as well as certain sectors such as consumer staples and manufacturing are very attractive. In the bond market, inflation sensitive government bonds, short term bonds, and floating rate/bank loan funds should successfully cushion the portfolio from drastic declines resulting from interest rates hikes.
Over the course of my 40 year plus career, I have experienced many bear or down markets. While each one is different, one common theme emerges. These market declines represent buying opportunities for patient investors. While it is likely that this trend will not end soon, eventually the market reaches a point where it overshoots on the downside and becomes undervalued. An inflection point occurs when astute investors recognize and invest in these deep discounted equities and the stock market rises suddenly and unexpectedly. Recently, Warren Buffet has been deploying significant idle cash to buy companies he views as bargains. He executed a similar strategy in 2008 that generated huge returns for investors in Berkshire Hathaway. His famous time tested advice is to be “fearful when others are greedy and greedy when others are fearful”. We may be experiencing one of those moments.
Clifford L. Caplan, CFP®, AIF®
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