We thought it would be prudent to discuss and share our thoughts on several market narratives that are gaining traction (at least from a media perspective):
- Possible recession
- The debt ceiling
- Certificates of deposit
- Pause in interest rate hikes
- Importance of having perspective as investors
We will give an update on each item, discuss potential implications, and most importantly, provide some perspective on what this could mean as investors.
Recession – Should We Fear?
Recession evokes plenty of negative emotions and fears on its own, but couple that with cleverly titled click-bait articles or CNBC's infamous red flashing “Market in Turmoil” specials and it’s no wonder people panic. For perspective, the "Market in Turmoil" TV specials is one of the only indicators with a perfect track record with an average 1-year return of ~40% post airing (see chart below).
It's true that, as a whole, the market may fall further if we enter a recession. Despite how tempting it can be to sell during periods of uncertainty, making changes in the face of volatility is often counterproductive. The plausibility of timing the market is a frequently mentioned topic in financial literature and almost always the conclusion is that it is nearly impossible to get right. What makes timing the market so tricky is that you must get it right twice - once before the market goes down and then again before the market recovers. There are numerous investment studies showing how market timers generated worse returns than if they had just held on. When you are thinking about trying to be a market timer, just remember the “hall of fame of investors” is littered with buy and hold investors, not market timers.
I think the chart below provides a great illustration for when you think about selling because “the end is near”. Yes, every time was different, but the outcomes are all the same. Market declines happen. Often market declines are quick in nature and don’t last very long in length. In this context, the saying that "markets climb a wall of worry" refers to the various concerns and uncertainties that investors may have about the economy, politics, or other factors that could potentially impact the stock market. Despite these worries, the market continues to climb higher over time.
As investors, we must consider that recessions are a normal part of the economic cycle. While they can be disruptive and cause short-term losses, it’s vitally important that we understand that the rare market decline creates a fantastic buying opportunity for long-term returns. Furthermore, by focusing on a well-planned investment strategy and keeping emotions in check, investors may be better positioned to weather short-term market turbulence and achieve their long-term financial goals.
Debt Ceiling – A Crisis In the Making?
The next fear that is gaining traction is the U.S. debt ceiling. The debt ceiling is a limit set by the U.S. Congress on the amount of debt that the U.S. government can incur. When the government approaches the debt ceiling, it must either raise the limit or face the possibility of defaulting on its debt obligations. This can be a concerning issue for investors.
In recent years, we have seen the government using the debt ceiling as leverage, a common rebuttal from the other side of the aisle is that it risks U.S. “default,” which sounds frightening. Remember, this a manufactured crisis which has become commonplace for politicians. It’s not pretty but it’s not necessarily a crisis. For all the theatrics and political brinksmanship, there has never been a default directly caused by a failure to raise the debt limit. In fact, since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit. It’s probable that we may be facing, once again, a volatile debt ceiling hiking process in the coming months. However, we have had divisive politics in America for a very long time, and yet, on the debt ceiling, politicians have always found a way to argue vocally, promise no compromise, then strike a deal. Therefore, we see it as likely the debt limit will get raised, markets will move forward, and we will find something else to worry about.
Just Move Into Money Market Funds and CDs Right? Not so fast…
While 2022 brought us higher inflation, market volatility, and investor anxiety, it also generated something positive: higher yields for those looking to put cash to work, whether in money market funds, bank certificates of deposit (CDs) or in fixed-income investments such as bonds.
A money market fund or CD can be a good place to park some money you plan to spend in the very near future on a defined purchase such as a car, wedding, or a house. However, there’s the potential that the interest rates may have peaked—or are about to peak. In contrast, bond yields adjust with changes in market conditions. As we’ll show below, in the vast majority of instances, mutual funds that hold portfolios of bonds have historically generated greater inflation-adjusted growth than CDs in periods after interest rates have peaked.
It’s important to note that bond prices are inversely related to changes in interest rates. Therefore, bonds with relatively low risk, like U.S. Treasuries, have the potential to have greater returns than CDs and money market funds if interest rates move lower. In fact, in comparing 12-month returns that followed the six peaks in CD rates since 1984, average returns across four bond fund categories exceeded the returns from CDs in a large majority of the instances.
Another way to compare performance is to show how much $250,000 deposited in CDs grew versus the same amount invested in bond funds during each of those six 12-month periods dating to 1984, as measured by fund category averages. As highlighted in green, other types of high-quality bonds significantly outperform CDs in the majority of instances.
A Pause In Interest Rates On the Horizon – What Could it Mean?
Based on recent comments from the Fed, it’s possible that we are nearing the end of interest rate hikes. A pause in Federal Reserve interest rate hikes could be seen as a positive for markets. A pause in interest rate hikes can signal that the Fed is comfortable with the state of the economy and does not see a need to raise rates further. This can boost investor confidence and encourage more risk-taking in the markets. In fact, the average historical performance of various investments post a pause in rate hikes (chart below) is very robust across both equities and fixed income. Using history as a guide, it’s possible the market could react favorably to an announced pause by the Fed, which could happen as early as the next Fed meeting in June.
At Prosperity, we construct portfolios based on a tried-and-true paradigm known as Modern Portfolio Theory (MPT). MPT emphasizes the importance of diversification or investing in a variety of assets with different risk and return characteristics. By diversifying portfolios, investors can potentially reduce the overall risk of their investments while still achieving their desired level of return.
As a result of utilizing MPT, portfolios are constructed with the benefits of diversification, knowing at times we will be facing the threat of a potential recession on the horizon. For example, consider the following chart showing hypothetical portfolio allocations and the benefits of diversification. We utilize specific risk tolerances for clients to help determine the amount of acceptable volatility (a measure of risk of temporary market decline) and the commensurate rate of potential return. A well-diversified portfolio will likely decline with the market during a recession. However, portfolio diversification can help when markets decline because it can help to reduce the overall risk of an investment portfolio. Furthermore, when investing across the full economic cycle, a diversified portfolio has shown to significantly outperform money markets or CDs. Investors who maintain a long-term perspective and a disciplined investment strategy are often better positioned to ride out market fluctuations and capture gains over time. This includes holding a diversified portfolio of investments, setting realistic investment goals and time horizons, and avoiding impulsive investment decisions based on short-term market movements.
It is commonplace for the market to face headwinds in the form of various risks and uncertainties. Despite these headwinds, the stock market has historically provided positive returns over the long term, as companies have been able to innovate, grow, and generate profits over time.
Instead of worrying about what may or may not happen in the future, we only need to take one action… that is . . . inaction. Ignore it. Go on about your life and let the equity market do equity market things. A recession may or may not be coming. Recessions are part of the process of being an investor. That’s how the equity markets are supposed to work. Scary temporary drawdowns are a part of your financial plan, and thank goodness they are, because when they come, they can present a real opportunity for the patient long-term investor to buy stocks and bonds that once were expensive and are now selling for a discount!