I talk with dozens of investors, executives, and attorneys every month about their finances and the markets. Although it’s still anecdotal, this gives a sense for how people are feeling about their financial lives. What I’ve noticed over the last couple months is that more people seem to feel nervous over the state of the economy and markets than even last year, when the market was down more.

It’s hard to pinpoint a single cause of this, as market volatility is well within normal if you look at the last 20 to 100 years, but I think a lot of it is the cumulative effect of many forces that are outside the control of most of us. Let’s look at some of these.

Last year the market was down substantially, but this was driven mainly by growth stocks and long-term bonds doing poorly at the same time due to rising interest rates. Many people view the bond portion of their portfolio as the safety part, so it is understandably nerve-wracking to see it go down. What’s more, while growth stocks have rebounded somewhat this year, they have not recovered their high point.

In recent months, rising long-term interest rates have had a further negative effect on bond prices and have spread market weakness beyond growth stocks to other areas like dividend-oriented stocks. So the weakness is being felt by a greater spectrum of investors, including those who have not invested much in growth stocks.

Despite continuing good economic numbers, I believe there is a sense that this is artificial to some degree. Massive government deficits may prop up the economy now, but many people worry that is not a sustainable approach and we will have to pay the price later. What’s more, while the Federal Reserve has been tight over the last year and a half, there is still a large amount of newly created money sloshing through the system. It will take some time to wind that down.

On top of all that, there is an outbreak of war in the Middle East, the potential for more countries to get involved, the ongoing Ukraine war, and the possibility at some point that China will act militarily against Taiwan.

So there are a lot of things to worry about. But there are always a lot of things to worry about. It may not be as clear as it is today, but there are always risks hidden just below the surface.

The way I look at it is that most of those things are outside of our control, so I focus on what is in my control. I also keep in mind that when many people are feeling nervous, that is naturally reflected in the price of assets. This is a contrarian approach, but I believe the best opportunity to buy quality assets is when people are nervous and the riskiest time is when people are optimistic.

That said, my mantra is that you should put your personal needs before market opportunities. Your peace of mind and financial security is more important than maximizing market returns. That means figuring out an appropriate level of emergency funds and reserves in conservative assets so that you feel comfortable even if the market went through an extended downturn. With that foundation, you are more likely to stick with the long-term portion of your investments when a hard rain begins to fall.

Credit to Bob Dylan’s “A Hard Rain’s A-Gonna Fall” for the title.

Key Wealth Principles

• Invest in quality businesses at an attractive price
• Build a portfolio of good businesses in different industries
• Maintain appropriate reserves and income sources
• Consider your financial circumstances, goals, and risk exposure

Last Month’s Winners and Losers

The market continued to see widely divergent performance, with interest rate-sensitive investments such as long-term bonds and homebuilder stocks declining more sharply than the general market. Riskier sectors, such as theme stocks and biotech, also did poorly as investors fled from risk.

On the other side, short-term bonds, CDs, and money market instruments held their value. Relatively speaking, large companies that are profitable and trade at lower valuation multiples did not decline as much as riskier- and interest-sensitive companies.

Stocks

Source: FactSet as of 11/1/2023. We use the S&P 500 index as an illustration of the performance of large cap stocks, the Dow Jones U.S. Select Dividend index as an illustration of the performance of high dividend stocks, the Russell 2000 index as an illustration of the performance of small cap stocks, and the Bloomberg US Long Treasury index to illustrate the performance of treasury bonds with maturities greater than 10 years out.

Although the S&P 500 gets the headlines, most of the market is in negative territory this year, whether it be dividend-oriented stocks, small cap stocks, or long-term bonds. The S&P 500 is dominated by large growth stocks. It was down significantly more than dividend stocks in 2022, but has partially recovered this year while dividend stocks went down with rising interest rates.

I believe there are basically three sources of returns when it comes to stocks: 1) dividends paid, 2) earnings growth, and 3) the multiple investors are willing to pay for those earnings. Depending on the type of stock, earnings and dividends have mostly held up this year. What has been a negative drag has been the multiple investors are willing to pay for that, and those multiples are influenced by interest rates. In other words, when you can get 5+% on relatively safe investments, investors are not willing to pay as high a multiple for risky investments like stocks.

That’s what’s happened, in my view. The question is what to expect going forward. Assuming interest rates stay about the same, I would expect future returns to be driven by earnings and dividend growth, which I think will be fine. If long-term rates go up to 7% or 8%, there is probably another downward movement, but I do not expect that at the moment.

I think it is appropriate to be somewhat cautious, minimize debt, and maintain adequate safety reserves. I am still seeing plenty of good quality companies trading at 5-7% earnings yields and offering expected earnings growth of around 7-10% a year. At those earnings yields and growth rates, I am happy to invest for the long-term.
 

Source: FactSet as of 11/1/2023. Dividend Yield is an estimate based on the weighted average of all companies in the category (by market cap). Earnings Yield, Earnings Growth, and Return on Equity are estimates based on the median profitable company. The % Losing Money statistic represents the percent of stocks with negative earnings in the preceding 12-month period. Large Cap stocks are defined here as the stocks in the S&P 500, according to FactSet. Dividend Stocks are defined here as the stocks within the S&P 500 that pay an above-median dividend yield, according to FactSet. Small Cap stocks are defined here as U.S. stocks ranked 1,001 to 3,000 in market capitalization, according to FactSet.

* “Earnings yield” is an investor’s share of earnings for every dollar invested (i.e., earnings per share / price per share). It’s the same as the more famous Price / Earnings (P/E) ratio, but expressed as a yield rather than as a multiple. I use it to compare stocks more clearly with bonds and other asset classes.“Equity Risk Premium” equals the Earnings Yield minus the 10-year Treasury Inflation Protected Securities yield.

Artwork

“Nervous People Eating” by Ernst Ludwig Kirchner (1916). Source: WikiArt.

Income Investing

Source: Interest rates from Raymond James’ Weekly Interest Rate Monitor as of 10/31/2023 and The Wall Street Journal as of 11/1/2023. Source for the Dividend Yields is from FactSet as of 11/1/2023. Common Stocks uses the estimated weighted average dividend yield for the S&P 500. The top 25% yield is the median yield of the top quartile of dividend-paying stocks out of the largest 1,000 stocks. The next 25% yield is the median of the second quartile. Preferred Stocks is the median dividend yield of the 100 largest traded preferred stocks (by dollar volume, per FactSet). REIT and Utilities dividend yields are the median of those sector stocks included in the 1,000 largest common stocks.

Core inflation continues to be in the 3-4% range if you annualize recent months. This reduces the pressure on the Federal Reserve to raise short-term rates, and so far they seem to be doing just that: holding rates steady. The market expects around 2.4% average inflation over the next 10 years* but I am a little more cautious and am estimating a continuation of the 2-4% range, in line with long-term inflation over the last 100 years.

Long-term rates are now around 5%, which is in line with their historical average, though well above the abnormally low levels for most of the last 15 years. At these rates, I view quality bonds as holding reasonable value compared to stocks and they deserve an allocation for many conservative investors. This was not the case until very recently, and it’s reflected in historical returns: The 10-year return on long-term government bonds, including all the interest paid, is close to 0% right now. Going forward, however, I would expect the yield to roughly reflect the return on bonds held to maturity.

* Implied inflation expectations are derived from taking the 10-Year Treasury rate and subtracting the 10-Year Treasury Inflation Protected Securities (TIPS) rate. For example, if the yield on 10-year treasuries is 2.8% and the yield on 10-year TIPS is 0.4%, they are roughly equivalent investments if inflation comes in at the difference (2.8% - 0.4% = 2.4%).

The Long View

S&P 500, Jan. 1928 to Oct. 2023

Source: MacroTrends.net

For the last 20, 30, and 100 years, stocks have averaged around an 8-10% return, driven by dividend yield, reinvestment of earnings, and earnings growth. Long-term bonds have yielded about 5% on average over the last century while inflation has been about 3%.

Throughout this period, there have been major upheavals, such as the Great Depression, World War II, The Korean War, The Vietnam War, dropping the gold standard, 1970s high inflation, 1987’s Black Monday Crash, the Dot.com bust, the 9/11 terror attacks, the Global Financial Crisis, and the Covid Crash, among others.

These events led to severe market downturns about once every decade, with a median price decline of 33% and a median time to recover back to the previous high of 3.5 years. If we were to include dividends, the recovery to previous highs is actually a little faster. *

Meanwhile, a 3% inflation rate results in a 59% decline in the value of a dollar over 30 years. Meaning that people who retire at 60 years old on a fixed income face a high risk of a lower quality of life as they get further into retirement. *

The Price of Market Returns: Significant Volatility

S&P 500 Yearly Returns, 1928 to 2023. Source: MacroTrends.net

* Source: Morningstar Direct via cfainstitute.org, FactSet. Past performance is not necessarily indicative of future performance. Depreciation of the dollar: $1 / (1 + 3%)^30 = $0.41 real value 30 years later.

Market Outlook

Now I’ll put on my “Nostradamus Hat” and make some predictions, for whatever they’re worth:

• Inflation will average 2-4% over the next 10 years.
• Interest rates will fall in the 4-6% range for 10yr Treasuries over the next several years, in line with inflation and historical experience.
• The economy will grow 2-3% in real terms over the next several years, though we will probably slip into a recession this year.
• Stocks will average an 8-10% return over the next 10+ years. After subtracting inflation, this will translate into about a 5% real return. There is likely to be at least one big decline every decade or so.

From the standpoint of where you and your family will be in 30 years, none of this matters. What matters is finding good quality investments that are likely to grow over the decades. For this reason, I largely ignore my own general market forecast and invest whenever I find a business that I am confident in and that trades at an attractive valuation.

Help Secure Your Golden Years

I first began managing money in the late 1990s, right when the Dot.com boom was taking off. People who didn’t know anything about business were making money buying whatever stock was being hyped on TV. Wall Street firms were overflowing with profits by selling stocks to the public they knew were worthless. One notorious analyst earned $12 million a year, while privately putting down the stocks he was promoting.

Then it all came crashing down.

Most of the Internet stocks of that era went bankrupt or lost most of their value. The market went down for three straight years from 2000 to 2002. Millions of investors lost a huge chunk of their retirement savings.

Did people learn the right lessons? Only a few years later, we had the Great Financial Crisis from 2007 to 2009. Again, Wall Street was selling worthless financial instruments. This time it took down the real estate market too. Again, millions of investors lost a large portion of their retirement savings.

We want our clients to hold positions of real value, so we personally research all the positions in our strategies and review them regularly.

While it may surprise you, we believe this commitment to personal research and investment management sets us apart from other advisors. The vast majority of advisors outsource research to fund managers or their firm’s cookie cutter options.

Instead, we personally research each position in order to develop the confidence that it is right for you. This commitment to research develops the trust, for us, that all the strategies we recommend are the right ones for our clients, in line with their risk tolerance, time horizon, and future goals. Your finances are too important for a cookie cutter solution.

At The Birch Lane Group of Raymond James, we work as a team to provide our clients with personal service, custom financial planning, and investment management tailored to your needs. I specialize in retirement planning, executive compensation and equity interests, attorney practices, and investment management. Donna Colucci also does extensive financial planning, with expertise in life transitions, divorce planning, estate planning, and long-term care insurance. Tricia Jones works tirelessly on client service, trading, and account management.

We are dedicated to helping you achieve financial independence and a comfortable, stress-free retirement.

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