The investment landscape is currently undergoing a massive shift. Although it’s true the market fluctuates, returns on a normally reliable 60/40 portfolio of stocks and bonds declined by 17% during 2022. The last time the return of a balanced portfolio was well into the negatives was in 1931, two years into the Great Depression.
These returns are just one sign that we are not going through simple market volatility — but rather, we are seeing tectonic shifts in the financial markets. In our view, a prudent investor’s approach needs to change as a result. In this piece, we will discuss:
- Key changes that have impacted the current investment landscape
- What we can learn from similar historic slumps
- An investment strategy guide for changing advisors or investment approaches
- When to get a new financial advisor
- Long-term strategies investors should consider moving forward
Signs of the Times
Many financial advisors will tell you that market highs and lows are a normal part of the investment process. But several warning signs in the current financial climate indicate a long-term, permanent market shift rather than temporary volatility.
For example, over the last decade, tech stocks have trounced the market, while interest rates and commodity prices have declined. In 2022, these trends indicated the beginning of an important and significant reversal. The energy sector outperformed all other sectors, while tech has significantly underperformed as interest rates have risen. We have moved from disinflation to inflation and, as a result, from declining interest rates to increasing interest rates. These trends suggest a change in market leadership that may last for years and has many people wondering when to change investment strategy.
We are also moving out of a long period of increased globalization into a period of de-globalization. Nationalism is on the rise, supply chain fragility was exposed by the pandemic, and global demographics are changing. Even Tesla CEO Elon Musk has expressed concerns for the company’s future in the face of supply chain issues.
These factors are all leading to the re-shoring of labor and manufacturing that will likely lead to structurally higher prices, persistent inflation, and a shift in the relative performance of different assets.
Investing During Market Volatility Can Be Counterintuitive
With inflation elevated and interest rates rising, we believe passive index fund investment isn’t enough. For example, technology stocks currently represent 27% of the S&P 500 Index, while energy stocks represent only 5%. In 2022, the largest industry sector, technology, performed the worst, while the smallest industry sector, energy, performed the best. Put simply, it no longer pays to own the market if 2022 trends continue. We believe the key to long-term success in this environment, which should last for the next decade in our view, will be a) active management, b) value-oriented investment selections, and c) risk management.
The traditional “60/40 portfolio” (i.e., a portfolio of 60% stocks and 40% bonds) is not likely to perform as it has historically. The rationale behind this portfolio is that stocks and bonds are historically uncorrelated, providing a diversification effect when one or the other asset class declines. However, in a period of high inflation and rising bond yields, the historical relationship between these asset classes is unlikely to hold. We have seen that already, with both stocks and bonds down in 2022. Bonds (especially bonds with long maturities) have not provided the kind of protection that many investors assumed they would provide; if inflation persists, that is likely to continue.
“Buying the dip” (i.e., purchasing an asset after it has dropped in price — sort of like buying something on sale) has been a great strategy over the past decade or so. Each market pullback provided a good opportunity to buy assets at reduced prices before markets went up again. However, that investment strategy guidance may not be prudent right now. The assumption that markets will simply recover quickly and resume their upward march may be wishful thinking because the fundamental drivers of the market have changed, as noted above. Buying dips and expecting to make money when the stocks go back up in price may no longer work in this environment.
How We Got Here
This isn’t the first time we’ve seen a slump like this, and it won’t be the last. For instance, this slump is similar to:
- The tech bubble popping during the 2000-2002 bear market.
- The 2008 bear market, in that structured products represented a major systemic risk.
- The combination of rising interest rates and inflation during the 1973-1974 bear market.
Importantly, the 1970s and the 2000s were terrible decades to own a passive investment in U.S. stocks, as returns adjusted for inflation were negative during both of these decades.
Investing during market volatility requires prudence and discipline. Historical slumps have taught us to plan ahead for bubbles bursting, understand the bottom-up (company-specific) and top-down (macroeconomic) risks of our investments, and beware of the power of inflation on stock and bond prices.
While every slump has similarities and differences compared to other slumps in history, unlike other slumps, U.S. government debt levels have never been so high. While a good U.S. historical analog might not exist, the current situation might be somewhat similar to Europe in the 1920s and 1930s, where unsustainable sovereign debts resulted in extremely high inflation rates.
Where We’re Headed
A number of factors have created the unique financial climate in which we now find ourselves. From de-globalization to inadequate investment in commodity production, each factor contributes a slightly different patina to today’s economy.
- A Shift Toward De-Globalization
As a result of the pandemic, Russia’s invasion of Ukraine, and deteriorating relations between the United States and China, the weaknesses of hyper-globalization have become apparent. Supply chains are a mess as countries have become vulnerable to energy shortages, semiconductor shortages, and critical medical supply shortages. In response, the U.S. government is incentivizing re-shoring in critical industries, and companies are increasingly moving production closer to home.
The movement to re-shore production will result in increased security and more resilient supply chains, which would be a positive development, but it will also result in higher prices and persistent inflationary pressures.
- A Shift Toward De-Dollarization.
The U.S. dollar is currently the world’s reserve currency, and it will remain a reserve currency for many years to come. However, it is a fact that foreign central banks are no longer supporting the dollar by purchasing U.S. Treasury bonds. It is also a fact that a consortium of countries — including but not limited to Russia, China, Brazil, Saudi Arabia, and India — are trying to develop the means to conduct trade in local currencies where trade imbalances are settled using a neutral reserve asset such as gold.
The implications of these developments are important. It means less foreign official demand for U.S. Treasury bonds and less support generally for the U.S. dollar. It also means that gold may return to the center of the global financial system as a reserve asset.
- Unsustainable Sovereign Debts
The debt-to-GDP ratio for the U.S. government is higher than it has ever been, exceeding the unsustainable debt ratio that the United States faced in the aftermath of fighting World War II. Europe and Japan are facing the same problem in that their debts are unsustainably large. Moreover, the Congressional Budget Office is projecting the debt/GDP ratio in the United States to increase substantially over the next two decades as Baby Boomers retire and begin receiving Medicare benefits and Social Security payments.
Based on policy papers that we have read, the U.S. government is likely to pursue a set of economic policies called “financial repression” which includes, among other things, persistently high levels of inflation and keeping U.S. Treasury interest rates capped well below the inflation rate. The United States pursued financially repressive policies successfully following World War II, and U.S. government debt levels gradually declined over the following 35 years.
- Rising Commodity Prices
Rising commodity prices are one of the most detrimental and pervasive effects of inflation. And unfortunately, inflation doesn’t seem to be going anywhere soon. Commodity producers have underinvested in future production during the past 10 years, which likely means that a limited supply will be rationed through higher prices.
As commodity prices rise over time, consumers are left with reduced purchasing power and a lower standard of living. As consumers spend a larger share of their money on groceries, filling up the gas tank, and heating their homes, they must inevitably spend less on other discretionary purchases.
- Investment Bubbles Popping and Valuation Levels Normalizing
When we talk about economic “bubbles,” we’re referring to situations where the price of a stock, bond, or another asset becomes fundamentally overvalued. The bubble asset’s values are based on speculative demand rather than the intrinsic value determined by cash flows, meaning the bubbles always eventually pop. In many cases, the pop is dramatic and causes prices to decline due to massive selloffs.
During 2022, stocks, bonds, cryptocurrencies, and real estate declined in price — in some cases significantly. While 2022 was a difficult year for many investors, we have good reasons to believe that U.S. stocks generally and U.S. tech stocks in particular remain significantly undervalued. Our expectation is that the S&P 500 Index is likely to generate flattish returns over the next decade as valuations gradually return to more normal levels.
In the coming decade, it is likely to be a stock picker’s market, not a passive investor’s market. We also think the coming decade will be one of underperformance by U.S. stocks as compared to foreign developed market stocks and emerging market stocks.
In summary, we are expecting persistently high inflation, persistently challenged financial markets, and a weaker dollar. Navigating this new environment as an investor is going to be much more challenging until some of these structural challenges are resolved.
When to Get a New Financial Advisor
With all of these significant changes happening in the broader economy, it’s critical to work with a financial advisor who will actively take the time to understand the nuances of today’s financial landscape and adjust strategy accordingly. If you’re wondering when to change your investment strategy, the answer is now.
For those people who are cutting their losses and moving forward with a new advisor or investment strategy guide, look for an advisor who does their own research to understand what is driving the economic and market fundamentals. Unfortunately, most advisors are asset gatherers who rely on index funds and index ETFs to generate a market return rather than doing their own research and investing in what will outperform in the environment we have described. The right advisor, on the other hand, will take it upon themself to understand what assets, such as cash and real estate, will or won’t perform in today’s environment and invest accordingly.
It’s better to work with an advisor who is actually an investment advisor in the real sense of the term and who can discuss the risks and opportunities that exist today which have not existed for multiple generations. Good advisors are astute investors who are also students of history. Advisors who don’t understand the history of long bond cycles or who cannot figure out what makes the current landscape different than the 2010s will likely fare poorly during the investment era ahead.
While no advisor has a crystal ball, a good advisor should be an active portfolio manager who understands the current set of macroeconomic risks, knows how to read and analyze a financial statement, and has the capability to value a company. An active advisor should bring the experience, prudence, and discipline necessary to help you navigate this distinctive, challenging financial climate. In summary, an advisor that is pursuing a passive index fund approach is probably not going to be helpful.
This article is prepared by Pekin Hardy Strauss, Inc. (“Pekin Hardy,” dba Pekin Hardy Strauss Wealth Management) for informational purposes only and is not intended as an offer or solicitation for business. The information and data in this article does not constitute legal, tax, accounting, investment, or other professional advice. The views expressed are those of the author(s) as of the date of publication of this article and are subject to change at any time due to changes in market or economic conditions. Pekin Hardy cannot assure that the strategies discussed herein will outperform any other investment strategy in the future.