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It’s STILL All About Interest Rates

May 14, 2022

Last quarter, my topic was "It's All About Interest Rates." This quarter, I could just say “Ditto.” Oh, you’re not going to let me off the hook that easily?

Well, it is still all about interest rates. But actually, a lot has unfolded in the last few months. Previously, we were speculating about what could happen if interest rates went up as expected. Now we are looking at a market environment that has unfolded because interest rates went up. Interest rates have actually gone up a bit more than expected a few months ago, so the market reaction has been more severe. But still, the markets behaved as they should in a rising rate environment.

Since asset values tend to move opposite interest rates, we have experienced quite a significant decline in the prices of all major investment asset classes so far in 2022:

The S&P 500 index, the most widely referenced measure of stock market performance, is down 17% as of this writing. The more tech-heavy NASDAQ is down 27%. Europe is down 21%, Japan is down the 18%, etc. For now, there has been nowhere to hide (except commodities, though even gold is only up 1% this year so far).

The market declines, especially in stocks, have prompted this question from several clients recently: “Do you think it’s time to buy?” My answer is no, not in my opinion, for three reasons:

First, we are primarily long-term passive investors and do not attempt to jump in and out of the market. That said, when market movements become large enough, portfolio rebalancing is necessary to keep clients in their desired risk ranges. So at some point, the declines could become large enough to warrant buying more equities (stocks) to bring that allocation up to where it should be. But not yet.

Second, stocks are still expensive by virtually all traditional measures, such as price-to-earnings, price-to-book, price-to-sales, market-capitalization-to-GDP, etc. In fact, by most of those measures, today’s stock prices are still comparable to those right before the financial crisis and dot-com collapse. Today’s Wall Street Journal Headline summed it up well: "Stocks are way down. They're still expensive." I should note, though, that by most of these measures, non-U.S. stocks are much more reasonably priced.

Third, despite the widespread price declines, we are not even technically in a bear market yet, at least as traditionally measured by the S&P 500 index. (A 20% decline or more is typically considered a bear market.) If this downturn does officially become a bear market (it was a hair away from it briefly last week), then portfolio rebalancing may be necessary for some clients. But we are not to that point.

In the last 65 years, there have been 15 bear markets, with the average market decline being 30% and the average bear market length being 12 months. There have been a few doozies, though, with market declines as large as 49% in the market that accompanied the dot-com collapse in 2000-2002 and a 56% decline in the market associated with the global financial crisis in 2007-2009. So in summary, the saying is “never try to catch a falling knife.” The markets could still have farther to fall.

That brings up the other question that often comes up and may be on your mind, too: “Shouldn’t we just get out of the market and get back in when the markets settle down?” Again, no, and here’s why:

First, market timing is extremely difficult. To successfully pull this off, an investor must both know when to get out, and more importantly, when to get back in. Market rebounds from the bottoms tend to be extremely rapid and forceful. If you are not still invested in the market at the bottom (whenever that is), you may miss the largest part of the rebound. In fact, the largest daily market increases of all time have tended to occur with such unexpected vigor that to time them successfully would literally mean picking the exact day of the market bottom. This recent CNBC article says it well: "You May Miss the Market's Best Days if You Sell Amid High Volatility."

Second, even if you are tempted to be an active investor, Warren Buffett’s wisdom, and probably most famous saying, should come to mind: “Be greedy when others are fearful, and be fearful when others are greedy.” Joining the masses in a panic for the exits is generally not a path to successful investment returns. In fact, good investors do the opposite. The time to adjust risk is in calm times. It is too late to do that once a downturn is in progress. It’s like jumping off the ship in the middle of the storm. Instead, it is much better to weather the storm and ride it out. If a client’s risk tolerance was set appropriately, the best thing to do in a market downturn is absolutely nothing. At least until the downturn becomes so significant that it is time to “be greedy.”

Third, and this is the most important thing, market downturns are temporary. Money is not permanently “lost” in a downturn. There has never been a downturn from which the markets have not recovered. It is not a case of “what goes up must come down” or “trees don’t grow to the sky.” Those are inaccurate analogies when applied to the investment markets, at least collectively. Sure, individual companies and even countries have failed, but not markets collectively.

This was not obvious to me early in my career, but investments go up over the long run for a very fundamental and logical reason: As companies sell products and services, they generate profits that, when completely or partially retained, increase the value of the business. That is not always true for individual businesses, but business in general will continue to sell products and services and build the value of the collective enterprises. It does not require good luck, and it does not even require significant economic or business growth. This constant creation of value through retained profits is an extremely powerful force, mathematically. Stock prices (loosely) follow the value of the underlying companies, especially over the long run. As companies make profits and retain earnings, investments become more valuable. Again, maybe that seems obvious, but the math of it wasn’t obvious to me until I was fairly far along in my investing career. This constant creation of value is a very strong tailwind for the long-term investor.

Finally, if the 2022 market declines seem disheartening, please keep today’s “blip” of a downturn in perspective in comparison to all of the other market declines throughout history, as well as the long-term power of value creation:

S&P 500 Index


Until next time…


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