Stocks Have Worst First Half in 50 Years
There is no use trying to gloss over it, stocks had the worst first half performance in 50 years. Our quarterly statements will not look pretty.
What should we look for in the near future? What should we do? And what can we expect from the stock market and our investments during a recession?
What to Look For
After such a rough start, investors are asking what’s next? Could things get worse? Is now a good time to make new investments?
Earning Season – Watch the Numbers
Q2 earnings numbers will be reported in July. What we have seen in previous bear markets is that if earnings reports and outlooks are poor – then there may be another and further drop in the stock market.
However, if earnings are strong, that may give investors and stocks hope for better performance. According to Factset, analysts as a whole have decreased their earnings projections for Q2 – but have slightly increased their earnings projections for the second half of 2022 and for 2023. We will know more shortly as companies report on how they have done.
Federal Reserve – Continue Raising, or Reverse Course?
The Fed has been raising interest rates since March, as a result 30-year mortgage rates have almost doubled, and these rate increases seemed to have caused plenty of stock market volatility. The Fed has dual mandates; to keep prices stable, and to maximize employment. The Fed has been raising rates to try and stabilize prices (beat inflation) but if unemployment suddenly gets worse, they might need to re-evaluate. They have been communicating that they plan to continue with rate increases, perhaps into next year, and both the bond and stock markets have responded poorly. As I wrote in an earlier newsletter, stocks tend to have a rough time for the first 6-12 months after the first rate increase, but tend to perform better after that. If the Fed stays their course, perhaps that is what we might expect.
However, the economy has had a strong adverse reaction to the Fed’s actions. For example, the US GDP was in the 6+% range for most of 2021, but -1.6% for Q1 of 2022, a dramatic turnaround. Some think that the Fed has done too much too soon. If the pressure mounts on the Fed to stop, or even reverse their course on their actions, it is possible that the markets might rally in response.
Valuations Cheap Now…but might get Cheaper?
Value investors and those who like to get good deals start to get excited when prices drop this much. US stocks as measured by price to earnings ratio are fairly valued now and look more enticing for new money, then only a few months ago when prices and those ratios were higher.
However, a principle of the stock market is that often tends to “overshoot” both to the upside and downside. Stocks could get even cheaper and a better valuation than now, which of course means that the markets have dropped more. Investors with new money to invest might want to dollar-cost average, just in case that the markets drop more in the near term.
Are we in a Recession?
The NBER, the official scorekeeper of US recessions, will designate it if we have 2 consecutive quarters of negative GDP. By the time you read this, you will probably know if Q2 was negative.
Three things investors need to remember about recessions:
- They tend to be short – average length since 1953 is a little over ten months.
- They happen frequently, about a dozen since 1953.
- The stock market tends to recover BEFORE the recession is over, usually 6 months prior to the recession ending, and that recovery tends to be robust and when investors make a lot of their wealth.
US Stock Market Returns Before, During and After a Recession
Source: Ben Carson, CFA/Ritzholz Wealth Management
What Should I Do?
We like to say, “You can’t time the market, but you can time your income.”
Our investors, at least many of them, raised cash late last year for their 2022 income needs. In retrospect that worked beautifully as it both lowered risk in their portfolios during a down market, and it allowed them to avoid selling investments during this market downturn.
If the Fed reverses course and sparks another rally, that might be a good window of opportunity to raise cash again for future income needs. We should be projecting our future income need from our portfolio and have a plan in place for when and where to draw that from.
We also made some minor portfolio shifts earlier in the year, by reducing tech and slightly increasing food commodities and agricultural stocks in the hopes of taking advantage of inflationary pressures on food prices.
Dividend investments are having a (relatively) better year. Although every stock sector is down YTD, Value/Dividend paying stocks are down much less. Most of our clients are benefitting from that as portfolios tend to have a healthy dividend weighting. You may want to evaluate your own participation in dividend paying investments and consider if you should increase it.
Other Action Items – Roth, Tax-Loss Harvesting, Rebalancing, and New Money
Roth IRA Conversions are one strategy to make some lemonade out of the lemons that the markets are giving us now. When stock prices are depressed, you may be able to move shares from your conventional IRA to a Roth IRA, via a conversion, for a lower tax cost. When the market eventually recovers (take heart, it will!) the growth of those shares you converted may be now tax-free inside the very tax-friendly container of the Roth. So, the conversion to the Roth IRA costs you less in taxes because your investments are lower in value, and all future growth may then be tax-free.
Our clients that have been actively pursuing a Roth IRA conversion strategy each year will find some solace in that dropping stock prices will make their conversion more powerful and potentially profitable. If you have not done a conversion before, we are happy to analyze and review the potential tax benefits to see if it might make sense in your personal situation.
Tax-Loss Harvesting is another lemonade strategy. If you have investments in a non-tax deferred account that have unrealized losses, you may want to consider a strategy to harvest those losses. Tax losses might be used to reduce your ordinary income tax and capital gains taxes, and the bonus is that you can “carry-forward” those losses for the rest of your life and use those losses in future years when you do have capital gains. You can also harvest a loss and simultaneously maintain a position in the market to avoid missing out on a future recovery. Realizing tax losses may reduce your tax bill both now and, in the future, and put cash back in your pocket.
There are multiple strategies that an investor can take advantage of to harvest losses including; sell/wait and re-purchase, sell and move to proxy, sell/gift and repurchase. We will be reviewing tax loss strategies with all our clients.
Note for perspective’s sake – the Dow Jones Industrial Average crested 30,000 for the first time in late November 2020, only 20 months ago. In other words, the markets have retreated back about a year and a half. If you have owned investments for a much longer time, tax-loss harvesting may not apply to you.
You may want to consult with your CPA regarding both Roth conversions and tax-loss harvesting strategies. We work closely with our client’s tax professionals as we try to help optimize their tax situation and try to reduce tax liability.
Rebalancing is simple, but often overlooked and underutilized by investors. Many studies have suggested that frequent rebalancing might enhance returns. For example, Vanguard’s landmark study suggested that rebalancing might add about 26 basis points annually to a portfolio’s return. At a time of heightened volatility, rebalancing can be especially important. We are using this current down market to rebalance portfolios as appropriate. We can review our rebalancing parameters and practices with you at our next review meeting.
As mentioned above, the steep drop in stock prices should be wonderful news to anyone who has new money to invest. This might be a great time evaluate your cash and see if you have excess that you might be able to reposition for that purpose. We are reviewing how, when and where to add new money to a portfolio in a volatile market as part of our recent review meetings. Money invested during the depth of a recessionary down market might be a great wealth builder for the future. You can see many examples of that from the following graph, when stock market returns measured from the start of a recession through the following 24 months are usually quite good. (Notable exceptions during the Great Depression and the Great Financial Crisis.)