Here is our annual Q and A of questions most asked by clients:
Q When will the bear market in stocks end?
A It will be hard to know precisely when the bear market ends. Unfortunately, they don’t ring a bell when the coast is clear.
A recession looks very likely but is not inevitable. Some investors think the bear has a long way to go before the probable recession is over. But the market usually bottoms well before the economy and earnings bottom. In this cycle investors will try to anticipate when the Fed will pivot – that is, either stop tightening or even loosen monetary policy and lower rates. That may give investors the green light.
A couple of developments we look for to help mark a bottom include:
– Capitulation (when investors can’t take the pain anymore and sell en masse pushing the market down sharply – the “give up” phase). We have not had capitulation yet, in our view.
– Stocks at bargain basement levels with a low P/E ratio on the overall market. Stock valuations are much lower than the peak in January but are not yet bargains.
Our wish list of stocks (with target purchase prices) keeps growing. When our target price is reached, we consider the stock for a new purchase or upgrade possibility.
Q What is ESG investing?
A ESG investing is a complex and controversial topic we will try to succinctly summarize here.
ESG stands for environmental, social, and governance. Companies are assigned ratings for each of these three social factors. A composite number is then given to their stock which supposedly reflects the company’s social behavior and its attractiveness as an ESG investment. For example, climate change impact would be part of the environmental grade. The idea that you can rank a stock’s attractiveness by one composite number rating seems farfetched to us, especially when different rating agencies have ESG rankings all over the map.
The implicit promise of ESG investing is that you can do well and do good at the same time. Trillions of dollars have poured into environmental, social, and governance funds in recent years. Wall Street fully supports this approach. One reason may be because they can charge higher fees given the increased responsibility of screening for ESG characteristics.
Recently cracks have surfaced in this altruistic approach. First, there is no evidence that socially responsible investment ratings improve corporate behavior. Telling firms that being socially responsible will deliver higher growth, profits and value, is false advertising, in our opinion.
There is also the matter of investment returns. Two professors, Bradford Cornell of the University of California, and Aswath Damodaran of New York University, recently measured the returns of global ESG funds. Over the past five years, global ESG funds have underperformed the broader market by more than 250 basis points per year, an average 6.3% return compared with an 8.9% return. This is a stiff cost to promote stakeholder capitalism over shareholder capitalism (stakeholder capitalism believes a corporation has a financial responsibility to employees, clients, and the environment, not just to shareholders as traditionally defined).
In addition, 19 state attorneys general wrote a letter last month to Blackrock, one of the three large custodians and money managers that support ESG investing. They warned that ESG investing involves “rampant violations” of the sole interest rule, a well-established legal principle. The sole interest rule requires investment fiduciaries to act to maximize financial returns, not to promote social or political objectives. Letters were issued in some states warning state pension boards that ESG investing is likely a violation of fiduciary duty.
We do not practice ESG investing. We will not limit our investment universe in order to achieve social or political goals. Our job is to maximize investment returns given a certain level of risk assumed. Also, ESG has been shown to be costly to investors and its legality is now being questioned.
Q I plan on retiring soon, but the bear market in stocks scares me. Should I hold off?
A It isn’t always possible to time your retirement to coincide with a bull market. There are times like now when an investor is going through a bear market with high inflation, and may still want to retire.
History shows that the portfolios of people who retire in down markets can recover. Those nearing retirement right now can take some comfort in research that shows that even people who retired at the worst time to do so (1965) would have made their money last 30 years by sticking to certain rules. According to Wade Pfau, a professor at the American College of Financial Services, negative returns at the start of retirement create a problem because the combination of market losses and withdrawals can have a portfolio too depleted to last decades. “The five years after retirement are a pivotal period for determining a sustainable lifestyle in retirement,” says Pfau. Here are three steps new retirees can take to improve their odds of making their money last:
1. Cut spending when markets decline. The “4% rule” with a fixed withdrawal rate doesn’t have to be set in stone. The rule should be a flexible 4% of the current portfolio value. A down market means lower withdrawals. If you can take out even less than 4%, then do it.
2. Manage volatility. People entering retirement with 60% in stocks may want to cut that stock exposure in half for the first 3-5 years, then gradually increase back to 60%. The reduced stock exposure up front provides better downside protection in those early years when retirees are most vulnerable to financial losses.
3. Use other assets. When markets decline, rather than sell stocks at a loss, retirees may be able to withdraw from whole-life policies, or tap home equity with a reverse mortgage. There are pros and cons to these options.
Q I have heard gold is a good inflation hedge, but gold has been down sharply recently. What is going on?
A Gold is often viewed as a defensive asset class that rallies when stocks are down. But that certainly has not been the case lately as gold has collapsed from over $2000/ounce at the high just after Russia invaded Ukraine to below $1700 today. It is down 8.2% this year, on pace for its worst annual performance since 2015. The losses in gold illustrate why classifying it as a defensive asset is a mistake.
Over the long run, gold isn’t particularly correlated to equities, and even less so to inflation. The real driver of gold is not market risk appetite or inflation, but in fact real yields (yields after inflation). In fact, if gold was tracking real yields to the same degree that historically has been the case, gold would be down another 50%. In short, the yellow metal remains both a poor inflation and risk hedge.