Locally based CPA firm since 1956

2023 February 1:

Williams Steinert Mask knows that as we enter the year 2023, we are dealing with inflation and its impacts on central banks that were behind the curve and forced to firmly react on growth which put recession in question and put pressure on risk assets aka the stock market. We contend that as inflation abates, and we see through the tunnel to the other side of the expected recession, the larger trend sure to shape the year ahead are China’s continued evolution and President Xi’s goals.

For January, the NASDAQ finished positive 10.68%, the S&P 500 was positive 6.18% and Dow gained 2.83%. These averages only tell part of the story. The only S&P sector that was positive was Transportation (planes, trains, and automobiles) gaining a tad over 9%.

Today, February 1, the Fed raised rates ¼ of 1%. The market seems to be telling us that the Fed will raise rates a couple of times, then hold for a while and then lower rates in the second half of the year. My question is, what would the world need to look like to make that happen, and is that a realistic expectation? If the Fed normalizes rates by 2024, it could well be in response to recession, as is currently signaled by the yield curve. But if that is the case, it is unlikely earnings will hold up, at least in real terms. In fact, 100% of revenue growth year-over-year has been due to inflation. If inflation abates, then revenue and earnings will go down. It is a catch-22, and the markets are caught in the middle. The bottom line is the greatest headwind in 2023 should be lower profits.

In our opinion, in an environment lower earnings because of higher for longer interest rates, equity prices do not have much, if any, opportunity to improve. We expect equity returns in that environment to be more muted and simply put, dividends will make up a much larger percentage of the total return over the next several years.

I do want to mention typical recovery times for the stock market. Modern Portfolio Theory defines risk in terms of volatility (or the standard deviation of returns), and defines success based on performance relative to a market benchmark. But the reality that individual investors and financial advisors live in is far messier. Most investors have multiple goals, such as setting up an emergency fund, buying a house, funding a child’s college education, making a major purchase such as a car or vacation, and saving for retirement. Each goal has a different time horizon and a different level of importance to the individual investor. And while investors might find volatility unpleasant, the real risk they face is not having enough assets available to meet their goals.

One way to manage this potential shortfall risk is to consider historical recovery times for different types of investments. The longer the time to recovery, the greater the risk that a holding will be in negative territory when the time arrives to liquidate assets to fund a specific goal.

Reviewing historical times to recovery can help investors determine an appropriate holding period for types of funds. Historically the average time for recovery is about 1.6 years according to a study published by Morningstar. However, in several cycles the historical recover took many years for the stock market and longer for the bond market. That said, we consider 10 years a reasonable minimum holding period for equity-focused portfolios. While stocks have typically bounced back over much shorter periods, it’s better to err on the side of caution. If you do not have 10 years until you need access to your money, you may want to consider how much of that nest egg you have exposed to the stock market.

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Have a question? Let me know! Email me at kcompton@wcmtexas.com.