This year has been a challenging time for many investors so I thought it would be worthwhile answering some questions and concerns that we are receiving from clients
What were expectations at the start of the year?
It is worthwhile to step back to recall how things were looking coming into the year. The TSX Index had just finished off a terrific performance in 2021 with a gain of 25.1%. It was expected that earnings would continue to grow 7% this year led by the energy sector. The MSCI USA Index was up 27% last year and the World Index was up 24.7%, which followed two years of double-digit gains.
The expectation was that central banks would start to raise rates and gradually reduce their balance sheets that had expanded because of the pandemic. Financial conditions were expected to tighten this year, with interest rates moving higher, but not to the point of jeopardizing the business cycle. Overall, equity investors had been enjoying a very strong period of returns.
What’s happening in the stock market so far in 2022?
US stock markets, which have been the standout performer over the last 3 years, have struggled thus far in 2022. The Nasdaq, which has had 3-straight years of >20% performance, is down 27% this year. The S&P 500, coming off 3 years of >16% returns, is down 18%.
The TSX Index, with the help of resources and materials stocks, is only down 3.1% on a Total Return basis. That said, the majority of stocks have unperformed the indexes. While that may not reflect the individual business performance, when investors are in a selling mode, they will tend to sell first and ask questions later which has resulted in the negative index performance.
What’s going on in the bond market?
When bond yields go up, bond prices go down (further reading). In the past, bonds have been a good way to protect a portfolio during weak stock markets. The last 8 times the S&P 500 was down in a calendar year, Bonds finished the year up. However, that has not been the case in 2022. Both stocks and bonds are down over 10%, which has never occurred.
As of May, a U.S. 60/40 stock/bond portfolio is down 14.8%. This is the worst start to a year on record. The previous worst start to the year for 60/40 investors was in 1984, where the portfolio was down 5.3% through May.
What is the cause of inflation?
This may be the most difficult question to answer as several different factors have contributed to high inflation levels.
Initially, massive government stimulus led to ultra-low interest rates for an extended period, which fueled consumer and corporate borrowing. As the economy recovered, consumers continued to spend, aided by a strong employment environment that included wage inflation resulting from a shortage of workers.
Additionally, the last 2 years have seen widespread supply chain challenges. These have led to shortages in cars, housing supplies, and many other items. Many businesses struggled to keep up with renewed demand coming out of the pandemic and were challenged to hire more employees. This demand-driven inflation has since seen a rotation from goods inflation to service inflation such as traveling and restaurants.
How are central banks reacting?
The Bank of Canada or the FOMC cannot ‘fix’ the supply chain or increase oil supplies (another multi-faceted issue), but they can slow demand by raising interest rates which increase consumer and corporate borrowing costs. Whether it is a mortgage, a business loan, or a company raising debt, the cost to borrow funds has increased. This will have an impact on spending but takes time for everyone to adjust.
With the strong employment situation in North America, consumers have continued to spend despite an increase in prices. In Canada, we have just started to see housing prices move lower, but prices of other goods remain high.
Ultimately, the task before central banks is to slow the economy so that inflation subsides, without causing a recession. The success of this "soft landing" will be the determining factor behind market performance in the coming months.
What’s an investor to do?
Having an investment plan is the result of aligning one’s financial goals with their investments, based on the long-term expected return of different asset classes. Unprepared investors may change course when the market becomes volatile. Planning gives investors the structure they need to remain confident through the market’s fluctuations. The investment plan is a personal decision, and no one plan works for all investors.
For example, in the last couple of years, a conservative investor would have lagged the strong equity markets, which is fine, because that was exactly what their plan was set up to do. Conversely, a conservative plan might be down this year but could still be outperforming the market because they would not own as many stocks and/or hold more short-term investments.
Having a plan does not mean an investor can avoid losses. The challenge is to stick to a plan that fits an investor's goals and comfort level to help see them through both good and bad markets.
Additionally, checking investment accounts too frequently and reacting emotionally to price changes is not helpful. Markets are forward-looking but they are not always efficient. Taking a long-term plan and shortening your time horizon based on today’s market activity is often a bad choice. Attempting to time the market and trade in and out of stocks, is never a good idea. It is easy to forget that investors own businesses and the business operations do not change daily or as often as the market would dictate. There is often no specific company ‘news’ moving individual stocks, but prices move based on the collective action of the markets, whether it is up or down day. There are so many reasons that move a stock, it is not worth trying to understand ‘what’ a stock is doing each day or to read too much into one day or even one week’s, movement.
It is helpful for investors to step back and remember why you own that business – and not focus too much on every short-term fluctuation.
Are there some good investment opportunities?
The old market saying is that there is always a bull market somewhere. Companies with pricing power and the ability to raise prices will benefit. Energy has held up quite well this year. Grocery stocks have done well in Canada. Pipeline and Utilities have performed well.
When we look back at past market selloffs, there have been some tremendous opportunities, but it all comes down to one’s time frame. This period will be no different and there will be some new market leaders that emerge.
What's going on with the Private Portfolios?
We have held a higher cash weight in the portfolios of between 17 and 29% (the most since April 2020) in 3 of our Private Portfolios and we have not made any purchases since early February.
At that time our SIA Equity Action Call indicator switched to a neutral zone, indicating the risks to markets were rising and so we became more defensive, not reinvesting proceeds from the sales. Similar to an investment plan, we are sticking to our pre-set rules that have served us well in the past. We have cash to re-invest and will further reposition holdings once the risk/reward improves for the market. That may also include selling positions that we have maintained to buy new companies that we believe will lead the market going forward. As of June 10, the Canadian Equity Portfolio was still positive for the year while the Global Equity Income Portfolio was only down 1% in 2022.
However, in the current market environment, without an uptrend we do not feel it is of benefit to fight the overall market trend and be aggressive. We know when the market recovers, some of our existing holdings will benefit and we can quickly make changes when markets start to reward companies with good corporate news again.
What are insiders doing?
Insiders will sell their positions for many different reasons, whether it is to simply reduce a big holding, for a new house, to pay taxes, etc. However, insiders only buy for one reason: they are optimistic about their company's future.
These days, U.S. corporate insiders are bullish. It does not mean a stock is going to up in the short term (insiders have trading restrictions which result in blackout periods and cannot regularly trade) but it does further align management with their shareholders.
Many of our Portfolio positions have high insider ownership than the broad index and this is one indicator we regularly follow. When share prices are lower (or even higher), we want to see which insiders of our companies are choosing to take advantage of the market selloff to add to their positions.
So I should change my investment strategy?
Alternative investments such as structured notes or hedge funds can provide investors with a different return, but there is no magic solution to investing.
All investments will go through tough periods, whether it’s the ‘fund of the year’, a legendary investor, or a hedge fund with a great track record. Just like other asset classes, there are pros and cons to consider beyond just looking at the potential return. The same is true with increasing trading activity in a down-trending market is not the right response. The result is someone who must be more focused on their trades and the likelihood of success is more difficult. Which can result in trades becoming an investment – which is not the plan!
One option is buying Guaranteed Investment Certificates (GICs) with your fixed income allocation. Some investors are fine to give up liquidity to lock in a rate of return. They are not worried about the possibility of higher returns elsewhere, not being able to sell that investment, or that it might lag the rate of inflation in the near term. A different, short-term option could also be a High-Interest Savings Exchange Traded Fund to earn a higher rate of return on your parked cash.
That said, wholesale changes are not recommended. It is also unwise to extrapolate how the first half of 2022 has gone and expect the second half of the year to follow the same path. Using recency bias is not a recipe for investment success.
If you’re a long-term investor, periods of panic are the times to be a buyer, not a seller. Investors tend to overreact during such times, assuming things will never get better again. This drives prices and valuations down and prospective long-term returns up. The biggest mistake an investor can make is turning temporary volatility into a permanent loss.
While the news tends to be universally negative during these periods it’s important to remember that the macro environment always looks vulnerable, and we are investing in individual companies, that want to grow.
There will always be a list of things to worry about. Many successful investors do not look at what markets are doing daily or concern themselves with the macro environment. They see a selloff as an opportunity to buy good companies at a discount and are not investing to make money next week. If they are going to own an investment for years or decades, it doesn’t matter what the market is doing or if there is a high rate of inflation at that time. In other words, they stick to their investment plan.
If there are any other questions or concerns, please do not hesitate to contact the JMRD Watson Wealth Management Team.
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