Recently, I took some time to get my ASA sailing certification. Spending 5 nights on a 40-foot catamaran with an instructor and a few other students was quite the experience. We all knew our end destination, but how we were going to get there was up to the students to determine. I worked with the others to review the charts, assess the weather, and deliver our plan to the captain. As it turns out, we were spot on with the plan that the captain had already prepared for us. Surely there was a sense of pride in succeeding in this new skill and preparing accordingly. In many ways, charting the course and creating a plan of navigation is the role that I fill for my clients with respect to their personal financial plan and investment management.
Things have evolved over the past few years. The impacts associated with the COVID-19 Pandemic and shutdown of the domestic and global economies have been tremendous. The government stimulus led to increases in M2 money supply at unprecedented levels, growing over 42% since February 2020. One of my favorite economists, Brian Wesbury, likes to simply describe the current inflationary situation as follows: “Imagine a world with only $10 and ten apples, each apple is priced at $1. Now imagine, that there is $14, and still only ten apples, each apple is priced at $1.40.” While it may be oversimplified, this explains our present economic situation and what has transpired since the beginning of 2020. The supply chain issues that were created from shutdowns across the globe will ultimately subside, however, the money that was added into the system will not be going away. Thus, we shouldn’t expect prices to return to the pre-pandemic levels. I believe we are operating in the new normal with elevated pricing levels on most goods and services.
In hindsight, it’s clear to see that investments were pushed up in price due to the stimulus efforts of our government. In February of 2020, the market was still excited about the lower taxes and higher GDP growth. The forward Price to Earnings (“P/E”) ratio of the S&P 500 was at 19.2. After the pandemic hit the artificially low interest rate environment combined with the newly created demand for products and investments (much of which was driven from excess stimulus) drove the P/E ratio in the to 21.4x by year end 2021. With the 2022 agenda of managing inflation, the Federal Reserve has begun to unwind the stimulus with the reduction of quantitative easing and increases in the Federal Funds Rate. The forward P/E levels fell to 15 in June after digesting a 9.1% inflation figure and the associated rate hikes by the Federal Reserve. By contrast, our 25-year average is a P/E ratio around 16.86 and we presently sit at 16.98.
With valuations beginning to normalize, I expect that future growth in equities to primarily be driven by earnings growth. However, with a recession potentially looming, earnings growth may slow as the economy slows down. Major stimulative efforts like we have seen in the past such as tax reductions or large government spending programs could push valuation levels up. However, we don’t expect those types of actions anytime soon. In fact, while the corporate tax cuts of 2017 Tax Cuts and Jobs Act were permanent, the personal tax cuts expire after 2025.
We actively work to adjust our heading while considering many factors including the present policy climate, market valuations, interest rates, and future growth expectations. The environment has changed; however, we believe that positive returns can still be realized in this environment, but it will require more effort. We anticipate the continued use of and increased allocation to investments that include features of loss mitigation, current income, and leveraged/triggered returns. Strategies that incorporate option writing, income generation, dividend growth, and systematic buffers are all very attractive to me at this stage in the cycle. Fixed income investments are being considered. CD rates and US Treasuries of one year are yielding just over 3%. I think that some of the biggest tools that we can use in this market are structured notes and some select annuities. These types of investments can complement the overall portfolio by providing additional upside leverage and minimizing negative market impacts. We believe that this is an excellent time to rebalance portfolios and revisit legacy holdings to determine if they are still positioned appropriately for the next market cycle.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
Structured products typically have two components; a note and a derivative and a fixed maturity. They are complicated investments intended for a “buy and hold” strategy and offer protection from downside risk in exchange for forgoing some upside potential to achieve that protection. Principal protection may vary from partial to 100 percent.
Investing in structured notes is not equivalent to investing directly in the underlying securities or index and carry risks such as loss of principal and the possibility that you may own the referenced asset at a lower price, due to economic and market factors that my either offset or magnify each other. At maturity, if the derivative turns out to be valuable, the investor can gain exposure to the upside of that index.
Fixed and Variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.