Playing Defense During Bear Markets
It is official, the S&P 500 is in a bear market. What does this mean for your portfolios?
Bear markets are normal, albeit rare, reminders that financial markets don’t always go up. Without them, speculation gets out of control. During periods such as now, the markets must reset to reflect the current interest rate environment, latest corporate profit outlook, inflation expectations, and investor sentiment. Unfortunately, all these factors are proving to be major headwinds to investors.
For the previous three years, from 2019 through 2021, portfolios that were heavily positioned in growth stocks turned out to be profitable. Today you need a different game plan. You need some defense in the portfolios to ride out this difficult market. Bonds have acted as a great buffer to the stock market in the past. However, due to rising interest rates, 30-year bonds were down as much as stocks in the first quarter of this year. Now you need to have more of a value tilt — owning companies that pay dividends and have bonds with shorter maturities and good credit quality.
What makes this market particularly hard — and, unlike the bear markets from COVID-19 in the spring of 2020 or the Great Financial Crisis in 2008-2009 — it is FED induced. This means the Federal Reserve will not save markets and cut interest rates or provide unlimited liquidity. In fact, they are doing the exact opposite by raising interest rates to kill inflation. I have never seen this before in my 38-year career. The Federal Reserve has always cut interest rates and provided liquidity in times of major market corrections or bear markets.
The Federal Reserve aims to bring inflation back down to its 2-percent target without throwing the economy into a recession, otherwise known as a “soft landing.” This is incredibly difficult to do and hasn’t happened since 1994. A more likely scenario will be a harder landing and a possible recession due to higher interest rates. If the stock, bond, and real estate markets correct 15 to 30 percent, this destruction in paper wealth will, in theory, slow things down enough to kill excessive inflation as people cancel trips, stop buying homes, and tighten their belts.
It may make more sense to own companies in the sectors that not only pay dividends but can also raise their dividends regardless of what is happening in the economy.
What Does This Mean for Your Portfolios?
Reduce risk where you can. The highest Price Earnings (PE), or growth stocks, particularly in the technology and healthcare sectors that don’t pay dividends, are the most vulnerable in a recessionary or rising interest rate environment. It may make more sense to own companies in the sectors that not only pay dividends but can also raise their dividends regardless of what is happening in the economy.
Bonds with a longer duration are more interest-rate sensitive. When interest rates go up, these bonds will lose their value much faster than individual 1-3 Year U.S. Treasury Bonds yielding almost 3 percent. Bonds are down 5 to 20 percent in 2022, so these short treasury bonds are very liquid and can be converted to cash to add back to equities when the bull market resumes. Right now, treasuries are a good place to diversify with decent income.
There is absolutely no reason to pay extra capital gains taxes in a potentially down year, especially if you can use losses in your favor. Turn lemons into lemonade.
Lastly and importantly, if you have any gains in your taxable portfolios from earlier sales this year, it may make sense to take tax losses to offset gains. A good goal is to be as tax neutral as possible by the end of the year. There is absolutely no reason to pay extra capital gains taxes in a potentially down year, especially if you can use losses in your favor. Turn lemons into lemonade.
Bear markets are like fevers — they must run their course. They do end, but only when there are no more sellers, volatility gets to extreme levels, and investor sentiment is incredibly bearish. This can happen at any time, which is why it makes it so difficult to time the markets. If you get out of the market completely, you not only lose any chance of making back what you have lost on paper but also miss out on collecting any dividends or interest while waiting it out. History has proven time and time again that going to all cash is not the best move to make. Bear markets take nerves of steel and patience, but as our CIO Michael Dow is famous for saying, volatility is the price you pay for long-term wealth.
What Lies Ahead This Summer?
Fed Chair Jerome Powell has told the markets that short-term interest rates will be raised at their June and July meetings. I suspect after their July meeting, Powell will see if they must raise rates again in September, as the FED doesn’t meet in August. The short-term pain in the markets will be worth it if the Federal Reserve can bring inflation down from over 8 percent today back to the 2-3 percent range. If they don’t, we could have a return to the painful 1970s and a period of stagflation (no growth and high interest rates). The FED wants to avoid this at all costs, as do we.
Fred Taylor is a managing director and partner of Beacon Pointe Advisors’ Denver office. He helps individuals and families build wealth, live off their wealth and leave a legacy for future generations. A former economic advisor to Governor Bill Ritter, Fred has more than 35 years of financial services experience.