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Diversification When Everything Seems to be Down

Diversification When Everything Seems to be Down

September 16, 2022
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Diversification When Everything Seems to be Down

OK, well this week sucked. 

And things had appeared to be going so much better for a while. 

In just this week, both stocks and bonds have given back most of the rather substantial gains they had enjoyed in July and August.  The stock market is again down about 19% on the year (as measured by the Morningstar Total Stock Index) while the bond market (as measured by the Ishares Aggregate Bond Index) is off by over 12%.

Of course, it continues to be all about the market’s expectations for higher interest rates and inflation.  When inflation this week came in hotter than expected, the market upped its expectations regarding how high interest rates will have to go in order to eventually lick inflation.  That in turn caused a significant sell off (again) in both stocks and bonds this week.  Closely tied with higher inflation expectations is a higher perceived risk of recession.

Should investors be afraid of a recession?  Not really.  Once a recession has been widely anticipated (and it has been by now) the damage to investments has already been done.  Further losses would only come if markets increased their view of how SEVERE or LONGLASTING this future recession will be.  In fact, during past recessions, including the “big one” of 2008, stocks started to rebound strongly shortly after the recession was officially declared?  Why?  Because markets are forward-looking!  Stocks generally start to rebound on expectations of recovery even before there is any evidence of that recovery actually happening.  

Is there any GOOD NEWS out there?  Is there ANY WAY TO MAKE MONEY UNDER THESE CONDITIONS? 

We have found some diamonds in the rough this year when it comes to investment strategies.  Systematic trend following funds as a category have done quite well.  The Pimco Trends Managed Futures fund which we use in many client portfolios has done well, having posted double digit gains this year. (it also had a good year in 2021 before we picked it up).  And Catalyst’s Warrington fund has provided steady modest positive returns through this year (continuing a similar pattern of high single digit returns that has persisted for most of the last 2 years).   Both funds have been good diversifiers and have helped buffer and contain losses for our clients this year.  Here is a look at the results from this year.  

Investment

YTD return

3 year return (annualized)

1 year return

Vanguard Total Stock Mkt

-18.07%

10.3%

-13.83%

Vanguard Total Bond Mkt

-12.38%

-2.07%

-13.49%

Pimco Trends Managed Futures

15.96%

14.15%

17.13%

Warrington Fund

5.29%

4.15%

9.14%

Returns from Morningstar.com. 

This chart shows how important it has been this year to expand your investment horizon beyond stocks and bonds to achieve strong diversification!  It is also comforting to note that stocks have still returned double digit annual returns for the last 3 years, despite all of this year’s challenges!  (bonds…well not so much comfort there…)

Past performance admittedly is pointless.  I don’t know if these funds will be helpful diversifiers over the coming year or not.  Conditions may be favorable for them – or they may not.  This is why we maintain broad diversification, including stocks and even bond funds.  We just don’t know what conditions we will face next year, or which funds will find tomorrow’s conditions favorable.  So we put our eggs in as many baskets as possible.  

Always striving toward optimism, there is actually good news regarding interest rates.  While rising rates have punished bond funds this year – there is also the very pleasant side effect of decent yields on CDs.  I used to build “bond ladders” in my retired client portfolios using brokerage CD’s (FDIC insured).  The idea was to take somewhere between 2 to 5 years worth of retirement income distributions and put them in CDs with staggered maturity dates.  The maturing CDs would fund needed distributions (without having to sell investments, in the event the market is down).   With interest rates of 3.5 to over 4% now available on 1-5 year CDs I will be likely be resurrecting this practice for certain clients in the near future.   (don’t try to find these kinds of yields at your local bank by the way…retail banks are still being very stingy!

Meanwhile, annuity products, particularly commission free equity indexed annuities, are sporting much more attractive interest rates and terms.  Higher interest rates and increased volatility are both favorable for the insurance companies who issue these products, which can provide investors exposure to future market returns along with some form of protection from market losses.  

Past performance does not guarantee future results.  Above is NOT a recommendation to buy or sell any security or securities.  All investments have risks which need to be carefully considered before investing.  Diversification does not prevent losses, and does not work equally well under all market conditions.