2022 was one of the worst calendar years for the stock market. The 18.15% drop in the S&P 500 (including dividends and index fund fees) was the seventh worst annual hit since the 1920s. This in itself is not that remarkable. The interesting part was that the bond market was also down 13.25% – essentially the worst year in history for the bond market.
Our favorite overall benchmark (because it is globally balanced at roughly 60% stocks 40% bonds, with low fees) is Vanguard Star Fund (VGSTX), and this moderate risk fund was down 17.99% in 2022. The only year previously that this fund had been down more than 10% since 1987 was in 2008, when it had a return of -25.1%. So, the only good thing we can say is that both our portfolios beat this fund by falling less, which is also what happened in 2008.
It is hard to find a balanced total portfolio fund that has fallen by less than 15% in 2022, highlighting what a tough year it has been for lower-risk investors. The best performing Vanguard total portfolio fund from 2022 was the low-risk and low-fee Vanguard Target Retirement Income fund (VTINX). This fund is for those in retirement looking for income and is comprised of 67% bonds, 3% cash and 30% stocks. It was down 12.74% in 2022. Factor in near 10% inflation and this was a bad year for those in retirement.
The Vanguard Balanced Index (VBINX) has been around since 1993. This year it was down 16.97%. The only other time this fund has been down by more than 10% was in 2008, when it fell by 22.21%. The key difference is that in 2008 the stock market was down just over 37% and it was the second-worst calendar year on record for stocks, after 1931. What makes this year unusually bad is not that stocks were down by around 18%, but that because of the poor performance of the bond market, balanced ‘safe’ portfolios were hit almost as hard as in 2008 when stocks were down almost 40% (and investment-grade bonds were up).
The Vanguard Total Bond Index (VBMFX) was launched in 1986. Until this year’s 13.25% drop, the worst year for that fund had been a -2.66% return in 1994. Vanguard Long-Term Investment-Grade Inv (VWESX) invests in longer-term, more rate-sensitive bonds. Launched in the 1970s, its previous worst year was 1999 when the Fed raised rates to sink the dotcom bubble, sending the fund down 6.23%. This year the fund was down 25.62% – and that is after a rebound late in the year as rates slipped on recession fears. In late October this fund was down 32.8%! Many bond funds now have near-zero 10-year total returns – also a first by a wide margin.
Fortunately, we have cut back somewhat on longer-term bond funds in recent years, but the lower-duration bond funds we had added were still down by double digits. We should have just kept the funds in cash and accepted the 0% returns (which are now over 4%), but the fear of earning nothing with near 10% inflation, and the ‘knowledge’ that these safer bond funds ‘never’ fall by more than 10% proved a disaster of sorts.
Speaking of disasters, the twin disasters for the bond market were the Fed raising rates much faster than in the past to stop the multi-decades-high inflation, partially if not largely, created by the loose monetary policy of low rates and new money creation, AND a low starting yield. In other words, if rates had been 4% and the Fed had raised them to 6% relatively quickly, the price hit would have been partially offset by the 3% and rising yields. However, the starting yield was 1.7% in January for 10-year government bonds so the move to 3.7% (and briefly over 4%) was all price pain and little yield gain.
Note that the broad ‘bond market’ in index funds is investment-grade (no junk bonds) debt and since most bonds have less than 10 years to maturity, the bond market index is low risk in terms of rising rates and default risk. The bond market has a duration of less than 7, meaning that with a 1% rise in rates you lose around 7% in price. The average credit rating is AA as half the bonds are government-backed.
Rising rates ultimately hit stocks (and eventually real estate) because a company that earns 5% a year (20 P/E ratio) and pays out a 2% dividend isn’t as valuable when you can buy a safe 5% bond with essentially no default risk. A rental property that yields 2%-3% after expenses isn’t a very compelling investment if you can get inflation plus 2% in a no-default-risk bond. Note that currently even with a price pull-back of about 25% in 2022, the Vanguard REIT Index fund (VGSLX) yields just 2.2%, not including capital gains from property sales and return of capital.
The scary part is no longer bonds (or at least investment grade bonds), but stocks (and real estate). The current dividend yield on stocks after a top-10 bad year is STILL just 1.7%. Considering that riskier stocks and recent IPOs and cryptocurrencies are down 40%-90%+ across the board, with the Nasdaq index down 33% in 2022, the fact that stocks are still this pricy is remarkable.
Meanwhile, no-risk T-bills pay 4.3%. Investors are basically betting that rates will go back down soon and stocks are reasonably priced for the near-future sub-2% rates. The same ‘logic’ is being applied in the property market, which hasn’t yet taken a big hit. Sellers and some buyers are assuming that sub-4% mortgages are just around the corner, so why mark down the price by 20% to adjust for high rates? In the few deals happening in an otherwise frozen market, buyers probably think, ‘No problem, we’ll just refinance in a few years at a lower rate’. It is possible, but such speculation is just the kind the Fed is trying to end in the economy to bring down inflation. More likely to support the property market than 3% mortgages being just around the corner, is inflation not dipping below 4% and rent increases supporting the currently high property prices. Another problem with the 'buy now, refi at 3% later' mentality is 3% mortgages will likely occur during the next mini financial crisis and your recently bought 7% mortgage property may be down 30% in price and ineligible for a refi without a 2009 grade Government program to allow underwater refis.
We’ve seen much harder hits to stocks over more than a calendar year. The 2000 bubble really broke down over three years, with the Nasdaq down over 20% each year for three years in a row, amounting to a total loss of almost 80%. Could it happen again? Probably not for the tech index as a whole, as many of these companies are now established and make money; it is unlikely a capitalization-weighted index of companies including Apple (AAPL) and Microsoft (MSFT) would fall by 80% again.
‘Junky’ growth and bubble stocks are already down by 80%. A more likely worst-case scenario is a 50% top-to-bottom Nasdaq slide and a 90%+ slide in formerly popular stocks of the future (with many worth zero). This relates to innovation stocks such as those in the still (remarkably) popular ARK Innovation ETF (ARKK), which was down 67% in 2022, after a 23% drop in 2021; a total drop from the 2021 peak to the end of 2022 of around 80%, just as happened with the Nasdaq in 2000–2003. In recent months even the mighty Tesla (TSLA) bubble has finally popped, sending its stock down 65% in 2022. We’ve been waiting for these bubbles to pop and are glad to see the froth leave the market. Unfortunately, investors’ enthusiasm for these busted boom stocks is still too high.
It is likely our focus on foreign stocks would have helped somewhat this year had it not been for the war in Ukraine and the ensuing troubles in European economies, which resulted in a fast-rising US dollar that has only recently cooled off. Even with the recent rebound, we took some bruising hits abroad, with a 28.06% drop in Franklin FTSE South Korea (FLKR) and 24.72% drop in Franklin FTSE Germany (FLGR). China was at one point down over 40%, but a year-end sharp rebound has left us with just a 22.78% drop in Franklin FTSE China (FLCH). The stock winners were short funds, led by a 66.3% gain in ProShares UltraShort QQQ (QID), a perennial loser except when tech stocks tank, which we’ve been waiting for since the Covid stock bubble. Value oriented stocks did fine, with Vanguard Value Index (VTV) down just 2.1% for the year. VanEck Vectors Pharma. (PPH) was up 2.61% and Franklin FTSE Brazil (FLBR) scored a 10.78% year, being a beneficiary of rising commodity prices. Homestead Value Fund (HOVLX) was down just 5.5% for the year. Value stocks are no longer such a good deal relative to growth stocks.
Our biggest hits were actually in bonds, with a near 40% drop in Vanguard Extended Duration Treasury (EDV) and a 26.93% hit to Vanguard Long-Term Bond Index ETF (BLV). More frustrating were our losses in recently exited mortgage bonds, which only fell slightly less in 2022 than the inflation-adjusted bond funds we dumped for being over-priced as inflation increased. Former holding, Vanguard Mortgage-Backed Secs ETF Vanguard Mortgage-Backed Securities (VMBS) was down 11.9% in 2022, only slightly better than the former holding (sold in early 2021) of Schwab US TIPS Schwab US TIPS (SCHP) which was down 12.02% in 2022. We should have just gone to 0% yield cash.
Surprisingly, riskier bonds didn’t perform much worse than investment-grade bonds – the whole crash was primarily a rate adjustment rather than a credit risk one; risky bonds did not fall hard while safe bonds did well, as is more typical of a weakening economy. Our best performing bond fund was iShares JP Morgan Em. Bond (LEMB), down just 10.73% in 2022, despite being significantly riskier than the intermediate-term top-rated government-backed mortgages, which fell more in 2022. Part of this was due to the high-dividend yield on the emerging-market bonds offered some counter to the decline in bond prices, unlike low-yield investment-grade bonds this year. The rising US dollar slipping near the end of the year helped this fund recover.
One thing investors should learn from 2022 is that more directly ‘inflation’-oriented investments can do well during rising inflation, but often become over-priced and tank when inflation fears subside. This is why we recommended the Series I bonds purchased direct from the US Government last year – they don’t trade at a premium during periods of inflationary fear. Incidentally, exchange-traded TIPS are now as good or even better priced, with a guaranteed return above inflation (not just matching) over 5-10 years, though there is still market price risk that could cause another 10%+ drop if rates go up more or inflation expectations drop which could happen in a sharp economic decline.
The only really hot area in 2022 was energy and other commodities (though not gold as precious metals category funds were down around 15% for the year). The fund we sold way too soon in late November 2021, Vanguard Energy (VDE), was up an astounding 62.86% in 2022 (after a 56.21% return in 2021). So much for fossil fuels dying out as an energy source. We could really have used that boost in 2022.
But enough about the past. The new investing game for stocks and bonds has become speculating on when the Fed will go back to the world we had all become too used to – 0% to 2% rates at or below inflation that made property and stocks the only game in town. The answer is probably quite a bit longer than anyone expects. The Fed isn’t going to cause a second boom in inflation by going back to the old game of low rates too soon, after being asleep at the wheel when inflation took off. That said, what could lead the Fed to reverse course is some sort of panic in the debt markets – stocks and property falling alone won’t do it. Such a panic would likely happen at significantly lower stock prices, so at that time, getting ahead of the next money-creation wave could be a possibility.
In the meantime, 4%+ safe yields are a good deal. The real question is how far out should these rates be locked in? T-bills at 4.3% are a welcome improvement after a decade plus of essentially no return on such investments, but they may only last two years (but not 6 months as some expect) before returning to sub-2%. The risk of buying 10-year or longer bonds (which have already come down in yield from the peaks of a few months ago) is that higher rates could mean another 10%-20% drop in bond prices.
At some point when a real recession hits, bond yields will fall, boosting bond prices and creating a good opportunity to shift to stocks that will likely be at lower prices than today.
On a positive note, the future for lower risk investors should be brighter. The trailing 10 year annualized return on a bond index fund is 0.9% — which is a little higher than money market funds and T-bills at roughly 0.6%. For most of this period inflation was low but we've still had 2.6% per year inflation largely thanks to recent trends. In other words, investors seeking safety and yield have lost 2% a year to inflation, or about 20% of their purchasing power.
December 2022 Performance Review
2022 was one of the worst calendar years for the stock market. The 18.15% drop in the S&P 500 (including dividends and index fund fees) was the seventh worst annual hit since the 1920s. This in itself is not that remarkable. The interesting part was that the bond market was also down 13.25% – essentially the worst year in history for the bond market.
For the month, our Conservative portfolio fell by 1.30%, while our Aggressive portfolio dropped by 1.21%. Benchmark Vanguard funds for December 2022 were as follows: Vanguard 500 Index Fund (VFINX) down 5.77%; Vanguard Total Bond Index (VBMFX) down 0.61%; Vanguard Developed Mkts Index (VTMGX) down 2.16%; Vanguard Emerging Mkts Index (VEIEX) down 2.10%; and Vanguard Star Fund (VGSTX), a complete global balanced portfolio, down 3.40%.
For the year, our Aggressive portfolio was down 11.36% or around 62% of the stock market’s downside, while our more bond-heavy Conservative portfolio slid a whopping 15.31%, representing almost 85% of the stock market decline. There was no help from abroad as Vanguard Developed Mkts Index (VTMGX) was down 15.32% and Vanguard Emerging Mkts Index (VEIEX) was down 17.90%.
Our favorite overall benchmark (because it is globally balanced at roughly 60% stocks 40% bonds, with low fees) is Vanguard Star Fund (VGSTX), and this moderate risk fund was down 17.99% in 2022. The only year previously that this fund had been down more than 10% since 1987 was in 2008, when it had a return of -25.1%. So, the only good thing we can say is that both our portfolios beat this fund by falling less, which is also what happened in 2008.
It is hard to find a balanced total portfolio fund that has fallen by less than 15% in 2022, highlighting what a tough year it has been for lower-risk investors. The best performing Vanguard total portfolio fund from 2022 was the low-risk and low-fee Vanguard Target Retirement Income fund (VTINX). This fund is for those in retirement looking for income and is comprised of 67% bonds, 3% cash and 30% stocks. It was down 12.74% in 2022. Factor in near 10% inflation and this was a bad year for those in retirement.
The Vanguard Balanced Index (VBINX) has been around since 1993. This year it was down 16.97%. The only other time this fund has been down by more than 10% was in 2008, when it fell by 22.21%. The key difference is that in 2008 the stock market was down just over 37% and it was the second-worst calendar year on record for stocks, after 1931. What makes this year unusually bad is not that stocks were down by around 18%, but that because of the poor performance of the bond market, balanced ‘safe’ portfolios were hit almost as hard as in 2008 when stocks were down almost 40% (and investment-grade bonds were up).
The Vanguard Total Bond Index (VBMFX) was launched in 1986. Until this year’s 13.25% drop, the worst year for that fund had been a -2.66% return in 1994. Vanguard Long-Term Investment-Grade Inv (VWESX) invests in longer-term, more rate-sensitive bonds. Launched in the 1970s, its previous worst year was 1999 when the Fed raised rates to sink the dotcom bubble, sending the fund down 6.23%. This year the fund was down 25.62% – and that is after a rebound late in the year as rates slipped on recession fears. In late October this fund was down 32.8%! Many bond funds now have near-zero 10-year total returns – also a first by a wide margin.
Fortunately, we have cut back somewhat on longer-term bond funds in recent years, but the lower-duration bond funds we had added were still down by double digits. We should have just kept the funds in cash and accepted the 0% returns (which are now over 4%), but the fear of earning nothing with near 10% inflation, and the ‘knowledge’ that these safer bond funds ‘never’ fall by more than 10% proved a disaster of sorts.
Speaking of disasters, the twin disasters for the bond market were the Fed raising rates much faster than in the past to stop the multi-decades-high inflation, partially if not largely, created by the loose monetary policy of low rates and new money creation, AND a low starting yield. In other words, if rates had been 4% and the Fed had raised them to 6% relatively quickly, the price hit would have been partially offset by the 3% and rising yields. However, the starting yield was 1.7% in January for 10-year government bonds so the move to 3.7% (and briefly over 4%) was all price pain and little yield gain.
Note that the broad ‘bond market’ in index funds is investment-grade (no junk bonds) debt and since most bonds have less than 10 years to maturity, the bond market index is low risk in terms of rising rates and default risk. The bond market has a duration of less than 7, meaning that with a 1% rise in rates you lose around 7% in price. The average credit rating is AA as half the bonds are government-backed.
Rising rates ultimately hit stocks (and eventually real estate) because a company that earns 5% a year (20 P/E ratio) and pays out a 2% dividend isn’t as valuable when you can buy a safe 5% bond with essentially no default risk. A rental property that yields 2%-3% after expenses isn’t a very compelling investment if you can get inflation plus 2% in a no-default-risk bond. Note that currently even with a price pull-back of about 25% in 2022, the Vanguard REIT Index fund (VGSLX) yields just 2.2%, not including capital gains from property sales and return of capital.
The scary part is no longer bonds (or at least investment grade bonds), but stocks (and real estate). The current dividend yield on stocks after a top-10 bad year is STILL just 1.7%. Considering that riskier stocks and recent IPOs and cryptocurrencies are down 40%-90%+ across the board, with the Nasdaq index down 33% in 2022, the fact that stocks are still this pricy is remarkable.
Meanwhile, no-risk T-bills pay 4.3%. Investors are basically betting that rates will go back down soon and stocks are reasonably priced for the near-future sub-2% rates. The same ‘logic’ is being applied in the property market, which hasn’t yet taken a big hit. Sellers and some buyers are assuming that sub-4% mortgages are just around the corner, so why mark down the price by 20% to adjust for high rates? In the few deals happening in an otherwise frozen market, buyers probably think, ‘No problem, we’ll just refinance in a few years at a lower rate’. It is possible, but such speculation is just the kind the Fed is trying to end in the economy to bring down inflation. More likely to support the property market than 3% mortgages being just around the corner, is inflation not dipping below 4% and rent increases supporting the currently high property prices. Another problem with the 'buy now, refi at 3% later' mentality is 3% mortgages will likely occur during the next mini financial crisis and your recently bought 7% mortgage property may be down 30% in price and ineligible for a refi without a 2009 grade Government program to allow underwater refis.
We’ve seen much harder hits to stocks over more than a calendar year. The 2000 bubble really broke down over three years, with the Nasdaq down over 20% each year for three years in a row, amounting to a total loss of almost 80%. Could it happen again? Probably not for the tech index as a whole, as many of these companies are now established and make money; it is unlikely a capitalization-weighted index of companies including Apple (AAPL) and Microsoft (MSFT) would fall by 80% again.
‘Junky’ growth and bubble stocks are already down by 80%. A more likely worst-case scenario is a 50% top-to-bottom Nasdaq slide and a 90%+ slide in formerly popular stocks of the future (with many worth zero). This relates to innovation stocks such as those in the still (remarkably) popular ARK Innovation ETF (ARKK), which was down 67% in 2022, after a 23% drop in 2021; a total drop from the 2021 peak to the end of 2022 of around 80%, just as happened with the Nasdaq in 2000–2003. In recent months even the mighty Tesla (TSLA) bubble has finally popped, sending its stock down 65% in 2022. We’ve been waiting for these bubbles to pop and are glad to see the froth leave the market. Unfortunately, investors’ enthusiasm for these busted boom stocks is still too high.
It is likely our focus on foreign stocks would have helped somewhat this year had it not been for the war in Ukraine and the ensuing troubles in European economies, which resulted in a fast-rising US dollar that has only recently cooled off. Even with the recent rebound, we took some bruising hits abroad, with a 28.06% drop in Franklin FTSE South Korea (FLKR) and 24.72% drop in Franklin FTSE Germany (FLGR). China was at one point down over 40%, but a year-end sharp rebound has left us with just a 22.78% drop in Franklin FTSE China (FLCH). The stock winners were short funds, led by a 66.3% gain in ProShares UltraShort QQQ (QID), a perennial loser except when tech stocks tank, which we’ve been waiting for since the Covid stock bubble. Value oriented stocks did fine, with Vanguard Value Index (VTV) down just 2.1% for the year. VanEck Vectors Pharma. (PPH) was up 2.61% and Franklin FTSE Brazil (FLBR) scored a 10.78% year, being a beneficiary of rising commodity prices. Homestead Value Fund (HOVLX) was down just 5.5% for the year. Value stocks are no longer such a good deal relative to growth stocks.
Our biggest hits were actually in bonds, with a near 40% drop in Vanguard Extended Duration Treasury (EDV) and a 26.93% hit to Vanguard Long-Term Bond Index ETF (BLV). More frustrating were our losses in recently exited mortgage bonds, which only fell slightly less in 2022 than the inflation-adjusted bond funds we dumped for being over-priced as inflation increased. Former holding, Vanguard Mortgage-Backed Secs ETF Vanguard Mortgage-Backed Securities (VMBS) was down 11.9% in 2022, only slightly better than the former holding (sold in early 2021) of Schwab US TIPS Schwab US TIPS (SCHP) which was down 12.02% in 2022. We should have just gone to 0% yield cash.
Surprisingly, riskier bonds didn’t perform much worse than investment-grade bonds – the whole crash was primarily a rate adjustment rather than a credit risk one; risky bonds did not fall hard while safe bonds did well, as is more typical of a weakening economy. Our best performing bond fund was iShares JP Morgan Em. Bond (LEMB), down just 10.73% in 2022, despite being significantly riskier than the intermediate-term top-rated government-backed mortgages, which fell more in 2022. Part of this was due to the high-dividend yield on the emerging-market bonds offered some counter to the decline in bond prices, unlike low-yield investment-grade bonds this year. The rising US dollar slipping near the end of the year helped this fund recover.
One thing investors should learn from 2022 is that more directly ‘inflation’-oriented investments can do well during rising inflation, but often become over-priced and tank when inflation fears subside. This is why we recommended the Series I bonds purchased direct from the US Government last year – they don’t trade at a premium during periods of inflationary fear. Incidentally, exchange-traded TIPS are now as good or even better priced, with a guaranteed return above inflation (not just matching) over 5-10 years, though there is still market price risk that could cause another 10%+ drop if rates go up more or inflation expectations drop which could happen in a sharp economic decline.
The only really hot area in 2022 was energy and other commodities (though not gold as precious metals category funds were down around 15% for the year). The fund we sold way too soon in late November 2021, Vanguard Energy (VDE), was up an astounding 62.86% in 2022 (after a 56.21% return in 2021). So much for fossil fuels dying out as an energy source. We could really have used that boost in 2022.
But enough about the past. The new investing game for stocks and bonds has become speculating on when the Fed will go back to the world we had all become too used to – 0% to 2% rates at or below inflation that made property and stocks the only game in town. The answer is probably quite a bit longer than anyone expects. The Fed isn’t going to cause a second boom in inflation by going back to the old game of low rates too soon, after being asleep at the wheel when inflation took off. That said, what could lead the Fed to reverse course is some sort of panic in the debt markets – stocks and property falling alone won’t do it. Such a panic would likely happen at significantly lower stock prices, so at that time, getting ahead of the next money-creation wave could be a possibility.
In the meantime, 4%+ safe yields are a good deal. The real question is how far out should these rates be locked in? T-bills at 4.3% are a welcome improvement after a decade plus of essentially no return on such investments, but they may only last two years (but not 6 months as some expect) before returning to sub-2%. The risk of buying 10-year or longer bonds (which have already come down in yield from the peaks of a few months ago) is that higher rates could mean another 10%-20% drop in bond prices.
At some point when a real recession hits, bond yields will fall, boosting bond prices and creating a good opportunity to shift to stocks that will likely be at lower prices than today.
On a positive note, the future for lower risk investors should be brighter. The trailing 10 year annualized return on a bond index fund is 0.9% — which is a little higher than money market funds and T-bills at roughly 0.6%. For most of this period inflation was low but we've still had 2.6% per year inflation largely thanks to recent trends. In other words, investors seeking safety and yield have lost 2% a year to inflation, or about 20% of their purchasing power.