“It’s a dog-eat-dog world, and I’m wearing milk bone underwear.” – Norm, “Cheers”
It has been one of those years thus far. We are in a dark cloud. Inflation has come back, even though we learned this lesson in the 1970’s. We have an actual war going on, as in one nation invading another. The stock market has gone past correction and into bear market territory. More importantly, the bond market has produced historic losses.
Through Wednesday, May 11, the S&P 500 is down 17.03 percent year to date, with many areas of the stock market doing much worse. Normally in times like these the bond market would be rallying as investors fled stocks and moved into bonds to reduce risk, but not today. I know I sound like a broken record, but stocks actually do act as the best hedge against inflation in the long run. The problem thus far this year is that inflation is accompanied by fear of recession.
Bonds are usually a hedge against recession fears, but the problem this year is that recession fears are accompanied by inflation. Inflation destroys bonds; the reason for this is self-evident if we take the time to remind ourselves that bonds are simply loans. If we borrow money at 3 percent interest, our loan payments would be attractive income for an investor when inflation was nonexistent. With inflation at 8.3 percent, that 3 percent interest payment now represents a 5.3 percent loss of purchasing power. Bondholders are actually losing money when inflation is considered. So, they are selling, and as a result the U.S. aggregate bond index is down 9.5 percent year to date through May 11.
For the stock market to recover from a 17 percent drop, we would need a 20 percent rally. This happens in the stock market frequently and would be easily done. For the bond market to recover, we would need a rally of 10.5 percent. It could happen, but it is not likely. The yield on the 10-year Treasury bill is trading in the neighborhood of 3 percent. That means the most likely return on those bonds is 3 percent. In other words, stock investors are experiencing short-term pain, but will recover and move forward in all likelihood. Bond investors have no such prospects.
To add insult to injury, many bond investors are retirees who are counting on that income to fund their retirement. They have already had to settle for historically low yields, which has reduced the income possible from the traditional bond approach. Now the people who failed to adapt to the low-interest world we were living in are getting punished more than anyone else.
So where is that silver lining I mentioned in the title? Iron Capital did adapt, many years ago. Our approach to producing retirement income is unique, and it has held up well. Year to date, the average of our income portfolios is still down 6.34 percent, but that is much less than traditional income portfolios, and our approach also provides an opportunity for recovery. We build portfolios that produce the income needed, or as close as possible, while taking the least amount of risk possible; over the last several years that means we have been focusing on dividend-paying stocks. These have been in places like energy, utilities, consumer staples. The areas that have done the best in our current environment.
This was not some sort of miracle foresight; no, we just followed our process, and that process led us to portfolios that many would describe as more risky than traditional bond-heavy portfolios. That is because many are stuck defining risk as either legal structure or volatility. Risk is losing money, and our approach to investing during the most risk-sensitive time in one’s life has held up much better. That is a silver lining in this dark time.
I know, some are reading this and saying, “How does that help me, I’m still trying to accumulate for retirement.” I feel that pain, and times like this are always painful, but they will pass, and the stocks will rise again. It always happens faster than one thinks possible. Meanwhile we will do what we can to protect our client portfolios. One day you will be retiring yourself, and it is good to know that it can be done, even in an environment like today’s.
Warm regards,
Chuck Osborne, CFA
Managing Director
