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Since the very beginning of this podcast, I've repeated over and over again how critical it is to regularly evaluate your asset allocation to ensure that it is appropriate.
Not because I'm an alarmist or trying to scare you, but because it's normal for markets to go through difficult time periods and making material changes to our investments or our asset allocation while we're in the middle of a downturn is not typically the most ideal time.
The analogy that I've long used is to think about and to treat your retirement investments like you would your primary home. That if the value of your home dropped by 20, 30, 40% or more, you probably wouldn't race out to hire a realtor and put your home up for sale. You would probably buckle down, maybe make some changes to other areas of your financial life if needed, and stay committed to the home that you purchased.
When the home value is finally recovered, you might then consider making some big changes. Maybe at that time you decide it's time to downsize or move to a different city or maybe ditch homeownership altogether. Those decisions are not small. And so we want to try to avoid making them during a challenging time period, which can sometimes lead to us making irrational or emotional decisions that can be harmful to our long-term goals.
The same can be said about our retirement investments. Now is not the time to race out and put our portfolios up for sale. Now is the time to buckle down, to stay the course and stay committed to the plan that you and maybe your trusted advisors have worked so hard to put into place.
In some cases, you might have to make changes to other areas of your financial life in order to do that, in order to stay the course. For example, if you're in the withdrawal phase of life and you follow a dynamic distribution strategy like a lot of our clients, those changes might mean taking a smaller withdrawal from your investments for a short period of time. It might also mean delaying that home remodel or maybe scaling back on that annual vacation.
In other cases, you might not need to make any changes at all. You might already be living below your means, making it much easier to stay the course and potentially even take advantage of investing more money at lower prices. None of this is to say that it's easy to be an investor at the moment. It's not. It's difficult. It's challenging. It's unnerving. And it's scary.
And it's okay to be concerned and worried. In fact, it's normal. So give yourself permission to express your feelings. We all know that the right answer right now is to stay the course. But sometimes knowing that and believing that makes us feel like we have to bury our emotions and act like everything is fine.
Everything is not fine. Inflation is at 40 year highs. Mortgage rates have crossed 7%. Stocks are down. Bonds are down. We're in a difficult, strange environment. It's scary and concerning. And I think it's okay to acknowledge that. In fact, I think we should acknowledge it.
I just don't think we should react to it. So to help prevent you from reacting and maybe calm some nerves along the way, my goal today is to explain three things. Number one, what is actually happening in the markets and the economy and how did we get here? Number two, how could things get even worse before they get better? And number three, four reasons that investors can be optimistic right now.
For all the links and resources mentioned in today's episode, just head over to youstaywealthy.com forward slash 169. Okay, so what is actually happening in the markets in the economy? And to preface here, we're not trying to understand what's happening right now so we can outsmart the markets or make a prediction about the future. We're trying to understand what's happening to avoid reacting or we're letting our emotions drive us to make potentially harmful decisions with our investments.
Many times when we know what is happening or why it's happening, we can make better, more informed decisions and behave better in the moment. Kind of like my kids wanting to know why bedtime is at 8 p.m. or why they can't eat candy for breakfast. Sometimes a simple, logical explanation can help prevent an outburst or a tantrum and lead them to exhibit better behavior. Because I said so or I don't know doesn't usually provide much comfort.
So what's happening? Why does the Fed continue to raise interest rates? Why does the S&P 500 down 25% this year? Why are intermediate bonds also down double digits? And why are 30-year mortgages over 7%? Let's break this all down. If I had to sum this all up into one sentence, it would be because the Fed...
wants to avoid a 1970s type of environment at all costs. I'll say that again, because the Fed, i.e. Jerome Powell, Jerome Powell and the Fed wants to avoid a 1970s type of environment at all costs.
The following is what I shared about the 1970s in February of this year on episode number 143. I said, most people bring up the 1970s when sharing concerns about inflation and what might lie ahead for this country. Because from 1970 to 1980, when inflation bounced between 6% and 15%, the S&P 500 had an average return of $1.5 billion.
after inflation of less than 1% per year. So from 1970 to 1980, when inflation was high, the S&P 500 had an average return after inflation of less than 1% per year. Now, your bank account grew pretty significantly because returns were healthy, but adjusted for inflation, you barely broke even.
In addition to high inflation, the 1970s also witnessed record high unemployment and a recession. It was a disaster and a disaster that nobody wants to be responsible for causing again. So as inflation ramped up and hit 40 year highs earlier this year, the Fed became convinced that prices would not cool down on their own and that intervention was required in order to prevent a 1970s style event.
To intervene and help drive inflation down, the Fed has rapidly hiked interest rates, or more precisely, the Fed funds rate. The Fed has rapidly hiked the Fed funds rate five times this year.
So why does the Fed think that hiking rates will cool inflation? Well, when the Fed hikes interest rates, aka the Fed funds rate, it becomes more expensive for banks to borrow money to fund their day-to-day operations. And that's because the Fed funds rate is the rate at which banks borrow and lend their excess reserves to each other overnight.
When borrowing becomes more expensive for banks, what do you think they do? They pass those higher borrowing costs down to the consumer and it gets more expensive for people like you and me to borrow money.
When it becomes more expensive for the general public to borrow money, they spend less. And when consumers spend less, demand for goods and services decline, and eventually so do prices. Lower prices leads to lower inflation rates. To recap that, higher interest rates lead to a decline in consumer spending, a decline in demand, and eventually a decline in prices.
Inflation is measured by the change in prices for goods and services. So if prices go down, so does inflation.
Now, on the surface, this all sounds reasonable and logical. So why would the recent rate hikes be causing so much turmoil in the markets at the moment? Well, because the Fed is late to the party. Many people were shouting from the rooftops in 2020, stating that inflation was going to be an obvious result of large government stimulus, coupled with the supply chain issues and pent up demand coming out of covid. No,
Knowing inflation would likely appear and knowing that we can't keep interest rates at 0% forever, the Fed likely should have started raising rates in late 2020 or early 2021, as many people were suggesting.
Instead of being proactive, the Fed is now being reactive, aggressively reacting to things that happened in the past. And this aggressive reaction is shocking the system. It's shocking our economy. And even those that have long defended Jerome Powell and the Fed are in agreement that we're experiencing a major or potentially experiencing a major policy mistake happen right in front of our eyes.
It's one of the fastest rate hikes in history. It feels reckless and careless, and it's left many people scratching their heads, including Jeremy Siegel, professor of finance at the Wharton School, who took to CNBC last week to vent. It's quite rare that I watch CNBC and even more rare that I share a clip of it on this show, but I do think it puts a lot of the current frustration and head scratching into perspective.
And before I play a short clip of Jeremy's interview, I just want to clear up a couple of things he says just to avoid any confusion. When he says he, he's referring to Jerome Powell, the head of the Federal Reserve, who's responsible for setting interest rates.
And when he talks about tightening, he's referring to the Fed raising interest rates. The opposite of tightening would be easing or lowering interest rates. OK, here's a short clip from Jeremy Siegel on CNBC a couple of weeks ago, and I'll link to the full interview in the show notes if you want to watch it all. I don't know. They basically said, you know, repeat the statement you made at the beginning. There's so many things I ask him. What is he actually looking at? He's looking at
three-month annualized core inflation that is a lag. Well, we all look at market. I mean, look at what is the stock market? It looks at market-oriented data. And that's what the Fed should be looking at. I don't know that I've seen you this animated. You seem down and angry at...
Yes, I am. I am. I I'm afraid that's like a pendulum. They were way too easy, as I've told you and many others through 2020, 2021. And now, oh, my God, you know, we're going to be real tough guys until we crush the economy. I mean, that that is just to me, absolutely poor monetary policy would be an understatement.
To sum this all up, in late 2020, early 2021, the market was showing clear signs that inflation was going to be a result of government stimulus, supply chain issues, and pent-up consumer demand. The Fed ignored those signs, inflation arrived, and just as we're starting to see signs of inflation cooling, the Fed decides to step in and aggressively play catch-up.
This aggressive catch-up is shocking the markets, markets outside of just traditional stocks and bonds, and markets outside of the United States. So with this baseline understanding of what's going on in the markets and the economy and how we got here, we can now try to make some sense of why asset classes are behaving the way they are.
U.S. stocks are down about 25% this year because the current policy response looks to be steering us towards higher unemployment and a recession. As noted, the Fed appears to be willing to do anything to avoid a repeat of the 1970s, even if it means people losing their jobs.
Bonds are down 10 plus percent as well. And that's because of the sharp rise in interest rates. Most are aware that bonds and interest rates have this inverse relationship that when rates increase, bond prices experience a short-term drop in price. 30-year fixed mortgage rates are sitting around 7.5% for the same reason. With the Fed raising the Fed funds rate, it's more expensive for banks to borrow money. And in turn, they're passing those higher borrowing costs to consumers.
And the one asset class we really haven't touched yet is real estate. Real estate data takes a little longer to work itself to the surface, but with 7.5% mortgage rates, it's basically impossible to expect residential home prices to remain unaffected. In fact, home prices would have to drop by about 40% in order to adjust for the increase in mortgage rates.
If I said this another way, if one year ago you secured a 30-year mortgage on a $1 million home at 3%, you would have the same monthly payment as someone buying a $600,000 home today with a 7.5% rate mortgage. The math just doesn't work. Something has to give.
And while home prices are almost certain to give, we could also witness the Fed reverse course and execute an emergency interest rate cut. That's a real possibility to keep an eye out for if things continue to get worse without any clear path to recovery.
Speaking of getting worse, what does getting worse actually look like? How could things get even worse from here? Well, while we're on the topic, the housing market is certainly one of those things that could cause things to get worse from here. As we've talked about before on the show, the housing market here in the U.S. is the economy. So housing prices starting to tumble would be one example of what getting worse might look and feel like. And it's already starting to happen.
For the last two months, we've seen home prices decline. And according to Bloomberg, it's the biggest monthly drop in prices that we've seen since 2009. Two things to add here. If you've seen this headline floating around one monthly median home prices, if you read the article, we're down about 1% in August and 1% in July.
And 1% doesn't sound like much, but that's just a one month change, similar to how a monthly inflation is reported. So multiply 1% correction by 12, and you're looking at a 12% price correction if the trend continues. If the trend, the monthly trend gets worse, well, the annual percentage loss, of course, gets worse as well.
Number two, much like 08 and 09, and I'm not suggesting that's where we're headed at all, but much like 08, 09, the real estate market impacts states and cities differently. For example, the sharpest correction in August here in 2022 was in San Jose, California, down 13% from its peak this year, followed by San Francisco at almost 11% down and Seattle down 10%. So just because we haven't seen widespread change
national home prices plummet month over month doesn't mean that some cities aren't already feeling some pain.
One interesting thing I'm thinking about, and partly why I say I don't think this is 08, 09, or I'm not suggesting that, but one interesting thing I've been thinking about is how many homeowners have locked in 30-year fixed mortgages at 3% interest rates under much, much stricter lending standards? In other words, we have a higher percentage of qualified borrowers who have locked in a record low fixed mortgage and don't need to panic sell their home.
I'll be curious to see how that impacts inventory and if in turn helps to protect home values, even in a high interest rate environment.
Then again, if unemployment gets out of control and people are without work and their investments are losing money, a 3% mortgage rate may not even matter. And in case you're wondering how many adjustable mortgages are outstanding, through my research, I was glad to see that only about 10% of mortgages in the US are currently adjustable. And that's down from about 35% in 2005, which...
again, tells me that most homeowners were smart enough to lock in record low fixed rate mortgages over the last several years. And we don't have a large percentage of mortgage rate adjustments hitting people right as unemployment might spike. So we'll have to watch closely to see how this all plays out. But again, it feels almost impossible for real estate to remain unaffected. And since real estate is a major influence to our economy at large,
a significant drop in home prices would likely contribute to things getting worse before they get better.
In addition to real estate, the rapid increase in interest rates also impacts government debt. I mentioned earlier that when the Fed raises the Fed funds rate, it makes it more costly for banks to borrow money. But an increase in interest rates also makes it more costly for our government to borrow money. Ben Carlson over at A Wealth of Common Sense noted last week that, quote, a 3% jump in government borrowing costs would send the debt service expense from about $300 billion to $1 trillion. That's a lot of money.
That's more than we spend on defense and about the same that we spend on social security each year. With the trillions of dollars in stimulus issued during the pandemic, it was hard to imagine how the government could absorb higher interest rates and higher borrowing costs, leading to many to expect an extended period of low rates. But it was also hard for people to imagine the current inflationary environment and the Fed's delayed aggressive reaction to it.
A recent report from the Committee for a Responsible Federal Budget estimated that the recent rate hike, just the recent one, will add about $2 trillion to government deficit due to the increase in borrowing costs. I've talked about the misconceptions of government debt here on the podcast before, and yes, we can and likely will continue to print more money. But as
But as Ben pointed out in his article, at what point do the politicians begin worrying about how much federal spending is going towards interest expenses? At what point do citizens become concerned that other services will be harmed because so much money is being paid to service our debt? Will higher interest rates make it politically unviable to invest in things like infrastructure?
So as it stands today, all eyes are on the Fed and inflation. And while I remain an optimist, I also think it's smart to expect things to get worse before they get better.
Nobody has a crystal ball, and we're going through a unique, unprecedented time at the moment. On a positive note, we have to remind ourselves that challenging investing environments are always unprecedented. It's always different. But the fact that it's always different can also help bring some peace of mind to the situation because while bear markets and recessions and catastrophic events are always different, the reward for long-term patient investors is always the same.
The current downturn can last five more days, five more months, or five more years. I don't know. But if you've constructed your retirement plan properly, you have short-term investments earmarked for short-term needs and long-term investments earmarked for long-term needs. You don't have to know exactly when things will improve or even how they'll improve. You just need to stick to the plan that you worked so hard to put together, the plan that accounted for ups, downs, and everything in between.
Speaking of ups, I want to end today's episode on a positive note by sharing four reasons to be optimistic or four reasons that I'm optimistic about the current investing environment.
Number one, lower prices mean higher future expected returns. I've talked about this a lot on the show and as hard as it is, the worse things get, the more optimistic we should become. And I've grabbed a couple of data sets to help put this into perspective for you today. First, if you dig up the worst years in stock market history, going all the way back to 1928,
you'll see calendar losses ranging from down 10%, like we saw in 1957, all the way down to 44%, the Great Depression in the 30s. If we ended the year today here in 2022, we'd be right in the middle of the pack. But in the years following the worst annual returns in stock market history, the average return three years later was a positive 35%. The average return five years later was a positive 80%.
The other data set, the Wilshire 5000, another popular US stock market index, is down about 26% in just the last nine months. It's one of the worst nine months for the index in the last 50 years. But after these historically terrible nine-month return periods, the average return for the index one year later was a positive 12%.
Three years later, similar to the other data I just shared, the index was up 41% on average. In other words, when stocks drop in price this significantly, it's just about impossible to find any data that says selling everything is a good strategy. Historically, it really hasn't taken much time for smart investors to be rewarded for staying the course.
The second reason to be optimistic, one year ago, cash in the bank, you probably remember, cash in the bank was paying 0% and US stocks were considered overvalued by most measures. Today, stock valuations sit around their 30-year historical average and well below their five-year average. And short-term cash and bonds are yielding upwards of 4%. So more attractive valuations for stocks and better future returns for cash and bonds.
Given a choice, most investors would probably prefer today's environment as a starting point than one year ago. And I think that's something to be optimistic about. Number three, while we spent some time today talking about how things could get worse before they get better, that doesn't necessarily mean that stocks and bonds have to suffer as well.
The stock market is forward-looking and is digesting daily information and pricing in where we might be in six or 12 months from now. So barring any new catastrophic information, it's possible, it's possible the stock market is closer to the bottom than the daily headlines might be leading us to believe. The bond market is even more predictable since the starting yield of a bond is the best predictor of its future returns. In fact, it's a really good indicator of its future returns.
So with starting yields higher, we can expect higher future returns from bonds, which is a good thing for income starved investors. And yes, that includes those investing in bond funds as well. As those lower yielding bonds mature in the bond fund, you'll benefit from the new higher yielding bonds. One of the benefits to owning thousands of different bonds instead of just five or 10.
And then lastly, number four, believe it or not, we've never had both stocks and bonds suffer losses three quarters in a row. We've had bonds being down three consecutive quarters. We've had stocks down for three consecutive quarters, but we've never had both asset classes in negative territory for three quarters in a row at the same time.
Now, it might seem counterintuitive, but these extremely rare and overly negative situations often bring me comfort. As Michael Guyad recently stated on Twitter, quote, I'm bullish because the bear case is so extreme.
In a similar vein, CNN's fear greed indicator, which measures stock market behavior and attempts to capture investor sentiment, currently sits at extreme fear. So once again, the fact that so many people think the world is ending often causes me to hit the pause button and question if maybe the opposite is true.
So to recap the four reasons to be optimistic or why I'm optimistic, number one, lower prices mean higher future expected returns. Number two, stock market valuations are back to their 30-year average and cash and bonds are yielding upwards of 4%. Number three, just because things could get worse in the economy doesn't mean asset prices also have to get worse. And then number four, the bear case is so extreme that it could be a case to be bullish.
There are still so many unanswered questions, and I hope today's episode doesn't get misinterpreted as me pretending to have all the answers or discount what's going on right now. Things could get worse. I don't know how long this downturn will last or how much of the future is already priced into the markets.
But it's a constructive exercise, I think, to go through the different possibilities and to study history. In the end, long-term investors, smart, prudent, long-term investors who have a plan in place should remain confident and should remain relatively unaffected. Once again, if you've constructed your retirement plan properly, you have short-term investments earmarked for short-term needs and long-term investments earmarked for long-term needs. You don't have to know exactly when things will improve or even how they'll improve.
You just need to stick to the plan that you and or your trusted advisors worked so hard to put together. Yes, it's scary and concerning and certainly not enjoyable. But as my kids play their favorite song from Lego Movie 2 over and over and over again, I'm reminded lately that we can't expect things to be awesome all the time. Sometimes,
things are not awesome. As the song that will live in my head forever goes, everything is not awesome, but that doesn't mean it's hopeless and bleak that in my heart, I believe we can make things better if we stick together. So on that note, let's all stick together. Everything is not awesome right now, and I'm here to help and support in any way I can. If you have questions, concerns, or just need to vent, shoot me an email at podcast at you stay wealthy.com. And
Once again, to grab the links and resources mentioned in today's episode, just head over to youstaywealthy.com forward slash 169. Thank you as always for listening, and I will see you back here next week. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.