As we close out the remainder of 2022, there is very little doubt this will be a year for the financial history books.  As we stated in our December 2021 update, the S&P 500 was “out of bounds” and needed a correction in price and time.  At GWS, we have been calling for a normalization to bond yields for several years, but had no idea the velocity of the move that would ensue. 
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The 10-Year Treasury yield began 2022 at 1.63%1, after having a low in 2020 at 0.52%.  Today, as of 11/18/22, the yield is 3.829%.  The yield has increased 148.03%.  This is the largest increase in yield recorded since data going back to 1963. 
However, what is of most concern to investors is the 2-Year Treasury has a yield of 4.531%, an inverted yield of -0.71%.  What is the significance of this inversion?  The 10-year is controlled mostly by investors and the 2-year by the Federal Reserve interest rate hikes, and very often is a signal that a recession is on the horizon.

For the first time in nearly two decades, we can now offer short-term Treasury bonds to investors currently yielding over 4%, subject to change. If you have over 100,000 account and would like to know more, please reach out for a discussion.

With inflation over 2% and the job market strong, it puts the Federal Reserve in a tough spot.  They are mandated to drop inflation even if a recession is the result.  We have been arguing that all the monetary stimulus from the FED and the government during Covid, would result in problems for the financial system.  We felt it was just a matter of time; the bubbles in crypto, the stock market, bond market and real estate would eventually start popping.  How many times in your life have you seen housing prices rise by double-digit percentage points in just a few years?  Only when monetary policy is too friendly.  At some point, the party has to end. 

What does all this mean for investors?  While the stock market can ebb and flow in the short term, it’s true colors are revealed over time.  For next year, it would make sense there could be a buying opportunity that could potentially present itself.  There are many unknowns, such as how high will the Federal Reserve raise interest rates? Will the lagging effects of the unusually high interest rate hikes present themselves as damaging the economy, resulting in a recession?  If so, will the recession be mild or deep? 

Historically, the stock market does not fare well in a stagflation environment.  If inflation falls to the 3-5% range, it still keeps investors unwilling to “pay up” for stocks, like they have over the past few years.  With that said, the bond market has become more attractive from a yield perspective and may deserve attention.  High quality dividend paying stocks could prove to be an attractive investment while the market grapples with these issues.

Through the end of the year, historically the stock market looks past all the issues and likes to put on a show.  We will see if that is the case this year, but the bottom line for us is that until the Federal Reserve makes clear they are done raising rates, the stock market is going to ebb and flow and be very difficult to navigate. 

*- https://www.macrotrends.net/2016/10-year-treasury-bond-rate-yield-chart
 

There have been very few places to hide from the volatility, and add to it the war between Ukraine and Russia.  An example?  A 60 stocks/40 bond moderate portfolio,4 offered by many financial firms, is down over -10% this year.
 
The good news, the FED is hiking interest rates.  For conservative investors, that should give us an opportunity in the coming months to get higher rates on money market and short-term bonds.
 
The chart above reflects the price of the aggregate bond index.  Rising interest rates results in falling prices, levels not seen since early 2000s.
 
In addition, as we’ve written about over the past month or two, it’s our humble opinion there could be a better opportunity to invest in high quality stocks once the market digests the rate hikes and inflation.  We also need to see how high inflation, the war in Ukraine and rate hikes affect corporate earnings.
 
Our December 23, 2021, blog post discussed how the S&P 500 was “out of bounds” and would need a rest, at the very least.  The chart below highlights an area of support, which gets the markets back into a more reasonable pattern. 
 
We will see if over time that becomes a reality or not. 

S&P 500 Index Chart – Since 2000​

Many of the name brand firms in the financial services industry use diversification to assist in reducing volatility and proving an overall total return.  Harry Markowitz in the 1950s pioneered modern portfolio theory1.  The idea of dividing a portfolio into a basket of different size companies with differing objectives, international, real estate, commodities, and bonds, was a way to reduce overall risk.  Many of the firms on Wall Street still utilize this approach.  At first glance, it still seems to make good sense; however, there are, in my opinion, a few flaws that could be improved upon.
 
One of the biggest flaws I currently see is the portion allocated to bonds.  Over the past 40 years, interest rates have fallen from the high teens to sub 1% in the 10-year Treasury2.  If you do not understand how interest rates work, think of a teeter-totter.  As rates fall, think one side of the teeter-totter, the other side goes up, which in this illustration, is the price of the bond.  Simply put, interest rates have fallen to levels never seen in the history of the bond market, and as such, the value of the bonds have risen accordingly.  If you would like to learn more, read chapter 5 of my book, “The Informed Retiree.”  It can be found at www.TheInformedRetiree.com.

With that said, bonds just do not provide enough horsepower any longer to enhance total return for a portfolio, nor do they provide enough of a cushion to offset stock declines for more conservative investors.  So, all in all, the once powerful diversification into bonds may have run its course, and thus lost its luster.  However, it could be worse than we might expect.  What if rates actually began to rise over the coming years?  What would happen?  Think of the teeter-totter illustration again.  If rates rise rather than fall, as they have for decades, then the opposite happens, price of the bond loses value. 
 
This phenomenon would have a bigger impact on bond mutual funds than individual bonds.  Why?  Individual bonds eventually have a maturity date; thus, the investor receives their investment back as long as the company fulfills its obligation.  Yet mutual funds do not have a maturity date; they are a perpetual investment, and thus continue to follow the trend of underlying interest rates - and here is the point - whether they go up or down3.  Understand, not all bonds are equally affected by interest rates.  There are other factors that may affect the value of a bond beyond just interest rates alone.  However, for the most part, interest rates drive much of the underlying performance of the bond market.
 
What are investors to do?  Look for future articles in this series to read about the potential solutions to the problem that could exist for many years.
 
If you would like to read my book, The Informed Retiree, visit my website www.TheInformedRetiree.com or send me an email to [email protected]
 
Also available on Amazon.com
 
Advisory services offered through J.W. Cole Advisors, Inc. (JWCA).  Global Wealth Solutions and JWCA are unaffiliated entities
 

1. https://www.investopedia.com/terms/m/modernportfoliotheory.asp
2. https://www.macrotrends.net/2016/10-year-treasury-bond-rate-yield-chart
3. https://www.thebalance.com/how-bond-funds-can-lose-money-2466567​

​When we consider past stock market cycles, there are occasions as noted in the graph of investor emotions, euphoria sneaks in.  Are we there now?  Hard to say, but it is a good time to look at how our 401k, Roth IRAs and other investment accounts are positioned.  How much is invested in stocks vs. bonds, International vs. Domestic and so forth.