The rebound in stocks that started in mid-June ended in mid-August, and we’re almost back to square one – a bear market. The rebound was strong – a near 20% move up, but the drop is looking just as fast. As of September 6, the S&P 500 with dividends is down around 16.8% for the year, while the bond market is down a more surprising 11% – a big hit for bonds. Foreign stocks as a group are down over 20%; some much more.
Our Aggressive portfolio is down 11.37% for the year, which compares fairly well to the stock market, particularly foreign markets. For reference, at the end of August the global balanced Vanguard STAR was down 16.81% year to date. Our Conservative portfolio had a poor month and is now down 16% for the year under the weight of foreign stocks and longer-term bonds, both down in the 20%–30% range. That said, most low-credit-risk bonds likely can’t fall that much more from here, unlike stocks, which could easily drop another 20%+ if the Fed has to engineer a recession.
What likely ended the stock rebound this summer was interest rates heading back up from the end of July. Stocks and real estate are heavily dependent on low rates. High rates cut into the profitability of companies and real estate as interest costs have to be deducted from revenues, but the more immediate problem is just relative valuation. If you can get 5% in a government bond or 4% in cash and CDs, levels we are approaching if rate increases keep up, why mess around with risky stocks?
There is a lot of focus on the troubles in Europe, but there is not enough focus on the potential troubles in our own housing market.
Europe has made a series of miscalculations that seem to be coming home to roost. Cutting back on nuclear energy because solar and wind are more popular (and don’t produce radioactive waste), magnified by the nuclear disaster in Japan, was a bad call for a region short on non-Russian energy.
Some of the sanctions seemed more designed to shame Russia and don’t do significant economic damage that could reduce the money flow into Russia that is used to finance the costly war in Ukraine. Shutting down McDonald’s doesn't hurt Russia. We took a US-owned asset that was drawing profits out and essentially gave it to Russia.
The main thing that needed to get done was lowering the price of oil and natural gas to reduce the flow of money to Russia. The West didn’t take the tough steps that would have caused a crash in oil – engineering a recession by raising taxes on energy temporarily. Instead, various states in the US reduced gas taxes or, in the case of California, are sending checks out under the guise of “inflation relief." The Federal Government just extended the pause on student loans and is planning on eliminating $10,000 of student debt per borrower.
The trouble is, these things will increase energy consumption and prices compared to doing nothing. It may seem counter-intuitive to raise prices with energy taxes, but with a supply-and-demand imbalance, the price is going to go higher anyway with the excess profits going to those that sell energy – like Russia. Since Europe already has near 10% inflation, slowing the economy down by driving energy demand down would have served two goals: reducing demand for Russian energy, and reducing inflation as any new tax would do sucking money out of the system (so long as it’s not spent on some sort of half-baked relief).
By deficit spending during high inflation, governments are kicking the can to central bankers (who don't have to face reelection) to solve the problems. We spent it, Fed; you unspend it because we don’t have the political will to take money away from crazed consumers.
The Fed has essentially three ways to reduce inflation: 1) scare people into speculating and spending less by talking about all the economic damage they are going to do; 2) raise shorter-term rates, which pushes up all sorts of consumer and business debt costs; 3) burn the trillions of newly created money they used to buy the debt that funded mortgages and PPP loans, also known as qualitative tightening or QT.
The Fed is trying #1 and #2 fairly aggressively, but #3 is next, and that is the one that scares investors the most. As it is, mortgage rates are going to head back up to 6% after a brief drop in recent weeks. If we go to 7% mortgages, in all likelihood we’ll have a recession and mini crash in real estate of 20%.
Home prices are as high as the last bubble, adjusting for incomes and payments. The Fed is likely aware of this and is scared to get too aggressive and would likely prefer inflation to drift down over a few years than risk a collapse in the real estate market. The best thing going for real estate and stocks now is the high inflation as rents and earnings are going up with everything else – rationalizing current high prices. If inflation runs at 8% a year for a few more years, and stocks and real estate prices remain the same, they will both be bargains, especially if mortgages remain at lower rates than inflation.
It is possible the falling stock and bond market will discourage the Fed from taking more aggressive action. It is likely if the recent rebound in stocks kept up to the old highs, the Fed would already be burning the new money, which they do by selling the bonds they bought for cash then erasing that cash from the world – the opposite of QE, or quantitative easing.
Gold, commodities, and even stupid crypto have been heading down again recently, which is what would be expected if inflation had peaked and is on the way back down.
The best case is what happened post WW2 when we had fairly massive inflation that didn’t last more than a few years, unlike the 1970s. The Fed didn’t do anything, and bond investors took the hit as inflation ate away at their investment and everything else was peachy for the next few decades.
The worst case is ugly: inflation doesn't ebb and global central banks, in an effort to prevent another 1970s, takes even more aggressive action and we go right back to a 2008 style asset crash.
August 2022 Performance Review
The rebound in stocks that started in mid-June ended in mid-August, and we’re almost back to square one – a bear market. The rebound was strong – a near 20% move up, but the drop is looking just as fast. As of September 6, the S&P 500 with dividends is down around 16.8% for the year, while the bond market is down a more surprising 11% – a big hit for bonds. Foreign stocks as a group are down over 20%; some much more.
Our Conservative portfolio declined 4.06% , and our Aggressive portfolio declined 2.35%. Benchmark Vanguard funds for August 2022 were as follows: Vanguard 500 Index Fund (VFINX), down 4.08%; Vanguard Total Bond Index (VBMFX), down 2.77%; Vanguard Developed Mkts Index (VTMGX), down 5.52%; Vanguard Emerging Mkts Index (VEIEX), up 0.23%; and Vanguard Star Fund (VGSTX), a total global balanced portfolio, down 3.61%.
Our Aggressive portfolio is down 11.37% for the year, which compares fairly well to the stock market, particularly foreign markets. For reference, at the end of August the global balanced Vanguard STAR was down 16.81% year to date. Our Conservative portfolio had a poor month and is now down 16% for the year under the weight of foreign stocks and longer-term bonds, both down in the 20%–30% range. That said, most low-credit-risk bonds likely can’t fall that much more from here, unlike stocks, which could easily drop another 20%+ if the Fed has to engineer a recession.
Some of our safer stock funds were the hardest hit in August. VanEck Vectors Pharma. (PPH) dropped 8%, while Franklin FTSE Germany (FLGR) fell 7.34%. Meanwhile, risky emerging market funds did okay, with Franklin FTSE Brazil (FLBR) up 6.47%, as Latin American funds were the #1 category last month of any fund types and one of only a handful of categories in positive territory in August. Our recently added or increased shorts helped our Aggressive portfolio offset losses. Proshares Short Bitcoin (BITI) was up 16.75% and Proshares Short High Yld (SJB) was up 4.28%, while UltraShort Bloom. Crude Oil (SCO) was up 8.72%. LeatherBack L/S Alt. Yld. (LBAY), which does some shorting, was down less than 1%.
What likely ended the stock rebound this summer was interest rates heading back up from the end of July. Stocks and real estate are heavily dependent on low rates. High rates cut into the profitability of companies and real estate as interest costs have to be deducted from revenues, but the more immediate problem is just relative valuation. If you can get 5% in a government bond or 4% in cash and CDs, levels we are approaching if rate increases keep up, why mess around with risky stocks?
There is a lot of focus on the troubles in Europe, but there is not enough focus on the potential troubles in our own housing market.
Europe has made a series of miscalculations that seem to be coming home to roost. Cutting back on nuclear energy because solar and wind are more popular (and don’t produce radioactive waste), magnified by the nuclear disaster in Japan, was a bad call for a region short on non-Russian energy.
Some of the sanctions seemed more designed to shame Russia and don’t do significant economic damage that could reduce the money flow into Russia that is used to finance the costly war in Ukraine. Shutting down McDonald’s doesn't hurt Russia. We took a US-owned asset that was drawing profits out and essentially gave it to Russia.
The main thing that needed to get done was lowering the price of oil and natural gas to reduce the flow of money to Russia. The West didn’t take the tough steps that would have caused a crash in oil – engineering a recession by raising taxes on energy temporarily. Instead, various states in the US reduced gas taxes or, in the case of California, are sending checks out under the guise of “inflation relief." The Federal Government just extended the pause on student loans and is planning on eliminating $10,000 of student debt per borrower.
The trouble is, these things will increase energy consumption and prices compared to doing nothing. It may seem counter-intuitive to raise prices with energy taxes, but with a supply-and-demand imbalance, the price is going to go higher anyway with the excess profits going to those that sell energy – like Russia. Since Europe already has near 10% inflation, slowing the economy down by driving energy demand down would have served two goals: reducing demand for Russian energy, and reducing inflation as any new tax would do sucking money out of the system (so long as it’s not spent on some sort of half-baked relief).
By deficit spending during high inflation, governments are kicking the can to central bankers (who don't have to face reelection) to solve the problems. We spent it, Fed; you unspend it because we don’t have the political will to take money away from crazed consumers.
The Fed has essentially three ways to reduce inflation: 1) scare people into speculating and spending less by talking about all the economic damage they are going to do; 2) raise shorter-term rates, which pushes up all sorts of consumer and business debt costs; 3) burn the trillions of newly created money they used to buy the debt that funded mortgages and PPP loans, also known as qualitative tightening or QT.
The Fed is trying #1 and #2 fairly aggressively, but #3 is next, and that is the one that scares investors the most. As it is, mortgage rates are going to head back up to 6% after a brief drop in recent weeks. If we go to 7% mortgages, in all likelihood we’ll have a recession and mini crash in real estate of 20%.
Home prices are as high as the last bubble, adjusting for incomes and payments. The Fed is likely aware of this and is scared to get too aggressive and would likely prefer inflation to drift down over a few years than risk a collapse in the real estate market. The best thing going for real estate and stocks now is the high inflation as rents and earnings are going up with everything else – rationalizing current high prices. If inflation runs at 8% a year for a few more years, and stocks and real estate prices remain the same, they will both be bargains, especially if mortgages remain at lower rates than inflation.
It is possible the falling stock and bond market will discourage the Fed from taking more aggressive action. It is likely if the recent rebound in stocks kept up to the old highs, the Fed would already be burning the new money, which they do by selling the bonds they bought for cash then erasing that cash from the world – the opposite of QE, or quantitative easing.
Gold, commodities, and even stupid crypto have been heading down again recently, which is what would be expected if inflation had peaked and is on the way back down.
The best case is what happened post WW2 when we had fairly massive inflation that didn’t last more than a few years, unlike the 1970s. The Fed didn’t do anything, and bond investors took the hit as inflation ate away at their investment and everything else was peachy for the next few decades.
The worst case is ugly: inflation doesn't ebb and global central banks, in an effort to prevent another 1970s, takes even more aggressive action and we go right back to a 2008 style asset crash.