As we all know, 2022 was a tough one for investors. Both stocks and bonds declined significantly. In fact, it was the worst year ever recorded for bonds. When times get tough, the statistics tell us investors are prone to making more mistakes due to emotions. It’s therefore helpful to remember what guides us in our financial planning and investing decisions to stay patient and disciplined. Here are the general principles you and I are following:
Why We Follow Principles
- We do not believe the economy can be forecast with much precision. Covid was the ultimate example of this. Even the Federal Reserve, with over 400 Ph.D. economists on staff, was embarrassingly mistaken on its forecast of “transitory” inflation.
- Likewise, investment markets cannot be consistently timed. We’re therefore convinced that the most reliable way to capture the long-term return of stocks (over 10% annually) is to ride out their periodic declines. In inflation-adjusted terms, stocks have outperformed bonds and cash by a wide margin – the math is powerful over time.
- Stock ownership is the only asset class that truly captures the upside of human ingenuity and creativity. We know that the engine of wealth building in stocks is the compounding effect. We must never unnecessarily interrupt the compounding.
- Individual investors historically have underperformed their own investments because they oftentimes buy and sell based on emotions. As my long-term mentor, Nick Murray, says, “Stocks are returned to their rightful owners during bear markets.” Never forget: for every pessimist/seller, there is an optimist/buyer for that stock trading hands.
- We believe in continuously acting on a rational plan versus reacting to current events. Reacting most likely means that our emotions are involved. Unless our goals have changed, there is generally little reason to make significant changes to our investments.
- The historical data underscore my conviction that the essential challenge to long-term successful investing is not intellectual, but temperamental. It is how one reacts, or chooses not to react, to stock market declines.
How We Do It
- Planning. You and I are long-term, goal-focused, planning-driven investors. The best method to stay focused is to formulate a detailed financial plan and to build diversified investment portfolios that match the goals set forth in our plans. We do not develop portfolios based on headlines, what’s “hot”, market movements, or some pundit’s view of the economy. This helps us understand that short-term price movements in markets are irrelevant to our long-term goals.
- Diversify. We diversify by investing in a variety of stocks that include small and mid-sized companies, foreign companies, bonds, real estate, and commodities. Though diversification was challenged last year, it’s generally effective because it helps us stay invested by smoothing out the highs and the lows of investment markets.
- Cash and bonds for short-term goals. We always make sure that we have enough cash (and bonds) for near-term expenses not covered by other (retirement) income. This helps us ride out the periodic stock market declines.
Current Observations
- Inflation peaked over the summer months and is now retreating in key areas. The money supply (called M2) exploded in 2020-21 when the government injected funds into a shut-down economy. Combined with supply-chain and other issues caused from Covid, this led to significant inflation (too many dollars chasing too few goods and services). But M2 has actually been shrinking since last spring – this is unusual but a necessary development if we are to get inflation under control.[1] The Fed was late, but at least they’re committed to arresting inflation. And this they must do, for inflation is an economic cancer that affects all of society and distorts how capital is invested. The impact of M2 takes about a year, so naturally we are now seeing inflation retreat – just as it took about a year from the M2 explosion to see inflation.
- We’re all at least vaguely aware of the basic economics principle that prices are determined by supply and demand. To force down demand, the Federal Reserve has raised interest rates aggressively and relentlessly for nearly a year. We all think twice about financing the purchase of a new car or home when interest rates are higher. However, supply is different. The Federal Reserve cannot create more energy, more food, or anything else that is in short supply. In fact, the Fed should be careful on raising rates too high because that will eventually reduce supply. If you’re running a business, you’ll be reluctant to borrow money to create that supply.
- The financial media is screaming recession for 2023 every chance they get as predicted by the “inverted yield curve” – this means that short-term interest rates are higher than long-term interest rates. Well, this could happen. If it does, so be it. I’m pretty sure an inverted curve has predicted eight of the last five recessions – or something like that. So we’ll just have to see how it plays out. In the meantime, I don’t see any reason to make wholesale changes to investment portfolios.
- Inflation for goods has eased significantly. But inflation remains stubbornly high for services due to the tight labor market. Significant numbers of workers have not come back to the labor force post-Covid – and perhaps they never will. In the meantime, businesses must find ways with technology to improve productivity to get more production from their work forces. I remain optimistic that robotics, automation, artificial intelligence, and other technologies will play a key role here.
- Earnings during 2022 mostly held up for the S&P 500 companies – and this ultimately drives stocks prices. When we receive the 4th quarter numbers, earnings should be up around 4% overall versus 2021. Clearly some sectors performed better than others, but the overall earnings picture for 2022 was an upside surprise considering the inflationary pressures. More importantly, earnings estimates for 2023 are expected to be positive again (though analysts believe earnings will contract slightly in the first half 2023).[2]
- We now have a divided Congress. As an investor, I hope you regard this a firm positive. We tend to get more sensible legislation when both political parties work together. Markets like certainty, and it now appears that tax increases will not be enacted the next two years. Yes, some tax damage was done the last two years, but it could have been worse.[3]
Looking Ahead to 2023
If you’ve stuck with me to this point, I hope it’s clear that patience and discipline through planning is the key to long-term success – not the events that rock markets periodically. As I like to say – and, well, I stole this from somewhere – bad news happens fast while good news happens slow. And the media will make darn sure you get every bit of the bad news.
Regardless of what happens to financial markets in 2023, it will most likely have no impact on whether you reach your goals as long as we’ve done the proper planning and we stick to the plan. Regardless, such developments are not within our control. We can control how hard we work, how much we save, and how much we spend. Beyond that – and the planning – events are outside of our control.
But setting all that aside, here is how I think about things from a larger perspective: as long as we can freely own property, as long as the business community can write and enforce contracts in our court systems, as long as we remain relatively free from government intervention, and as long as people and businesses are rewarded for implementing great ideas to make our lives better, then I remain confident that our investments will carry us to
our goals.[4] So stated by your humble Optimist!
Thank you for your continued trust and confidence. It is a privilege and a genuine pleasure to serve you. As always, I welcome your comments, questions, and concerns if you would like to speak. We wish you and your family a Happy New Year!
