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Daniel Tolomay in The Wall Street Journal: Should Investors Allocate Overseas?

With inflation skyrocketing and a potential recession looming as the world continues to grapple with the impacts of Russia’s invasion of Ukraine, 2022 has been a year of persistent volatility in global markets. To help combat this turbulence, investors are pouring capital into U.S. stocks to avoid seemingly darker seas abroad. In fact, according to Refinitive Lipper Data, investors have added money to U.S. equity-focused stock and mutual funds for four out of the past six weeks – the longest streak since 2019.

While many remain optimistic about the U.S. economy and the S&P 500 has outpaced major indexes in Europe and Asia since hitting its low for the year in mid-June, is piling into U.S. stocks truly the right path for investors? Or, should investors still consider allocating overseas? The Wall Street Journal recently turned to Daniel Tolomay, chief investment officer at Trust Company of the South, to find out.

According to Tolomay, if stock valuations in the U.S. continue to rise, investors may want to consider increasing their exposure to international equities where valuations are cheaper after years of outperformance by the U.S. The Stoxx Europe 600, for example, recently traded at 11.61 times its projected earnings over the next 12 months, according to FactSet, compared with 16.70 for the S&P 500.

“International being more attractively priced, we would expect better returns from the international market going forward,” Tolomay explains.

Click here to read the entire article in The Wall Street Journal

Getting Kicked While You’re Down

by Dan Tolomay, CFA

It was an ugly first half of 2022. The value of large US companies declined -20%. Small US companies fell a bit more at -23%. International developed markets shed -19% and international emerging markets dropped -18%. Phew.

Thank goodness for bonds. Except the bond market was down too. Domestic and international. Both were both off -10%. Cash was a relative bright spot in that it didn’t decline in value. But, with inflation numbers still coming in hot, cash’s paltry return won’t be enough for your money to grow fast enough to keep up with rising prices. So, what should be your next steps? It depends on where you’re going.

It’s always good to have an investment plan, but that’s especially true during trying times like these. An investment policy statement (IPS) is a document that spells out a portfolio’s objectives and constraints. Among the key considerations are: What is the return objective? What is the tolerance for risk? When will the funds be needed?

Generally speaking, the longer the time horizon, the greater the ability to tolerate risk/volatility. And, as risk and return are directly related, more volatility should mean a higher expected return. Below, three sample situations are presented and reviewed. As what has occurred in markets so far this year is behind us, decisions should be prospective, not reactive. However, recent events can provide some insight.

A short time horizon does not allow for volatility. That is intuitive as it pertains to stocks and their noisy near-term returns. However, bonds can be volatile, too. Below is a chart comparing year-to-date returns for Vanguard index funds that track different segments of the bond market to a money market fund and to stocks.

As can be seen in the chart, bonds were down across the board. Long bonds were down more than stocks. Many investors also were likely burned by reaching for yield in short- and intermediate-term bonds. Not only would a money market fund have avoided losses, but it would have benefitted from increases in interest rates as the Fed tightened monetary policy.

Principal protection is the goal for funds needed soon. While additional return would be great, the volatility that must be borne can cause more harm than good. If the account is short of its target value, swinging for the fences is not the answer. Delaying the target or adding more funds are the prudent actions.

An intermediate time horizon permits some volatility in a portfolio. It also introduces a new risk – inflation. Not only is the portfolio able to be more volatile, it needs to be in order to target a higher return to keep pace with rising prices over time. Again, stocks are likely to provide too uncertain of an outcome. But what have bond returns looked like over time?

As yields go up, bond prices go down. Investors saw plenty of this in the first six months of 2022, and the cause was concern about inflation. But rising interest rates are a double-edged sword. The other impact on bonds as yields rise is that interest payments also rise. This takes time to play out, but, over time, as coupon payments are received and bonds mature, that new cash is reinvested at new, higher rates.

Consider the Short- and Intermediate-Term bond funds again. Below, the charts show that the driver of bond returns is income, not price changes. Between issuance and maturity, a bond’s price will fluctuate. Absent a default, however, a bond’s value will move to face value at the end of its life.

As higher income continues to offset price declines, the likelihood of having a positive total return goes up over time.

There are a couple other takeaways from the above charts. First, a “term premium” exists. That is – the longer the term of a bond, the more time there is that an investor’s money is at risk and the higher the reward should be. (Note the scale of the line graphs above.) Second, risk and return are related. In the bar graphs, the likelihood of a negative return in intermediate-term bonds is higher than it is in short-term bonds. A higher return is expected; however, negative returns (risk) have been more common than in short-term bonds. It may take longer for intermediate-term bonds to recover from an interest rate spike.

A lengthy time horizon has the greatest ability to tolerate volatility. Longer investment periods provide more opportunities to recover from temporary losses. As more risk can be borne, more return can be sought. A return in excess of inflation can be spent to support a current need (ex. a foundation, endowment, or retiree) or it can provide for portfolio growth (ex. saving for retirement).

Stocks can and do have a role in account with lots of time on the clock. The recent pullback in equities is not uncommon. As the chart below (which we’ve dubbed “The Annual End of the World”) shows, intra-year declines in the S&P 500 are not uncommon. In fact, on average, there has been an intra-year decline of -14%. (This year, so far, it’s been -24% from 1/3 to 6/16.) There has also been, on average, an intra-year advance of +25%. (Did you know that the market was up +11% from 3/8 to 3/29?)

Again, risk and return are related. Just as bonds have returned more than cash with more volatility, so too have stocks returned a higher number than bonds but with a bumpier ride. Mixing bonds in with stocks can make that ride smoother.

Nobody knows what’s next for COVID, Ukraine, Inflation, the Fed, or if we’re headed for a recession. What is known is that these risks are well understood by global investors. Those market participants, motivated by a desire to profit, have positioned their portfolios to reflect their expectations. In aggregate, this collective wisdom drives prices of securities to fair values. The prices, in turn, set expected returns commensurate with the risk of the investment.

Rather than focus on the headlines, which we cannot control, it is more productive to revisit one’s personal situation, which can be managed. Does the asset mix match the time horizon and risk tolerance? From there, a range of returns can be estimated. If the portfolio’s contents do not match one’s situation, changes can be made.

Think of specialized labor. Let markets do what they do best – process information, set prices, and future returns. Investors should do what they do best – ensure the asset allocation matches their needs, not their emotions.

As Chief Investment Officer, Dan is responsible for developing Trust Company’s investment strategy and managing client portfolios.

Mark Twain and the 60/40 Portfolio

by M. Burke Koonce, III

One doesn’t have to be a professional investor to know that markets have been under pressure so far this year. Rising interest rates and troublingly persistent inflation have contributed to a significant re-pricing across both the equity and fixed income markets, and with the S&P 500 in a bear market, bedrock assumptions about investment strategy tend to get called into question. Among the questions percolating through the investment zeitgeist now is the future of the venerated 60/40 portfolio, which has just suffered through its worst first-half performance in 34 years. Is the standard portfolio of 60 percent equities and 40 percent bonds, considered the classic allocation for decades, still an important idea? Or is it, as it seems half the internet would like to proclaim, dead?

For decades, a 60/40 portfolio has been considered if not the cornerstone of diversified investing then certainly a major component. The 60/40 conversation is perhaps the most common starting point for any investor evaluating his or her goals, risk tolerance, and income needs. The portfolio’s usage is perhaps even more common as a baseline for endowments and foundations than it is for individuals, and it is extremely common for individuals.

The attractiveness of 60/40 was that it would capture the majority of equity returns but with the lower volatility and higher income associated with fixed income returns. While an allocation of 100 percent toward equities is theoretically the better way to build long-term wealth, not every investor is positioned to handle the volatility, especially those with shorter time horizons or with income requirements.

Unfortunately, many investors in 60/40 portfolios this year have experienced plenty of volatility in their equity allocations but with minimal protection coming from the fixed income allocation. That’s because rising rates have caused significant price declines not just in the stock market but in the bond market as well. So is now the time to make big changes?

Almost certainly not. It’s not like this is the first time the 60/40 model has come under criticism.

Those of us who are old enough to remember the 2000s recall a decade of disappointing equity returns. “The Lost Decade” in stocks started with the dot-com bust and then as an encore gave us the Great Financial Crisis. The 60/40 portfolio returned just 2.3 percent annual during that time, and market mavens proclaimed that the portfolio was going the way of the dodo. Then, as if on cue, 60/40 proceeded to return 11.1 percent annually from 2011 to 2021.

So this year, as returns are negative across the board, 60/40s critics have returned en masse. This time, it’s not because of equity underperformance but because of either the paltry yields offered up by fixed income or because of fixed income underperformance.

That’s why we think that reports of 60/40’s death are, to paraphrase Mark Twain, greatly exaggerated. First, it’s fair to point out low yields in the bond market, and it’s fair to note that bond returns have been negative this year, but it’s not entirely fair to point to both. That’s because as yields rise, bond prices fall but future returns improve. Barring default, the mark-to-market losses showing up in bond portfolios will reverse over time as bonds accrete and mature and as proceeds get reinvested at higher rates. It’s essential to remember that as long as a bond investor’s time horizon is greater than the duration of the portfolio, rising rates boost returns.

Managing duration is also an important component of equity investing, and it’s mainly accomplished by maintaining a value tilt—avoiding overexposure to stocks with exorbitant earnings multiples that require years of earnings and dividend growth to achieve adequate returns, not just on capital but of capital. Stocks normally have much higher duration than bonds, which is why it’s essential to play the long game and moreover, it’s why having an allocation to bonds, say, a 40 percent allocation, is often so desirable.

There have been many articles written this year about the growing place for alternatives in portfolios. While alternatives such as private equity and private credit are theoretically desirable for well-heeled investors, it’s not really realistic to think that converting a 60/40 portfolio to something like 33/33/33 could have been responsibly allocated within six months’ time, not to mention that moving from public equity and public credit to private equity and private credit is not going to provide a completely different risk/return profile. One of the benefits of alternatives is the forced discipline that comes with a longer time horizon, but alts investing is still going to be, at its core, equity and credit.

Again, as long as one’s time horizon is longer than one’s portfolio duration, rising rates are a godsend—allowing the investor to reinvest at higher rates in the bond market and at lower multiples in the stock market.

Lastly, another significant benefit to a balanced portfolio, it’s 60/40, 70/30 or 80/20, is that it gives the investor two important weapons to use during a significant drawdown. The first is the capability to rebalance in favor of equities during a downturn. The second is that during truly adverse conditions either in the market or during one of life’s emergencies such as a loss of employment, it is generally preferable to liquidate bonds instead of stocks and avoid either losing future gains or paying taxes on capital gains.

So, is 60/40 dead? That sounds like an exaggeration.

A Long March

by M. Burke Koonce, III

True to the proverb, March came in like a lion. As oil prices, interest rates, and geopolitical tensions each climbed higher, market volatility soared and asset prices fell. Fear was so ascendant that it caused the Fed to back away from plans to raise interest rates by 50 basis points and instead settle for just a quarter percentage point. And so, here we are at March’s end, and while the lions can still be heard roaring in the distance, there are some lambs stumbling around.

Amid all the tumult, major U.S. market indices finished the month higher. The S&P 500 finished March up 3.7 percent, while the Dow Jones finished up 2.5 percent and the tech-heavy NASDAQ closed up 3.5 percent (each on a total return basis). This rebound, in the face of perhaps the scariest geopolitical backdrop in more than a decade, is remarkable. After some indices flirted with bear market levels in February, defined by a decline of more than 20 percent, equity asset prices have rebounded strongly off the lows. While the first quarter of 2022 will go down as the first quarter of negative returns since the pandemic bear market, it felt a lot worse a few weeks ago than when it finished.

Curious Cross Currents

While the human tragedy in Ukraine is unspeakable, markets react to geopolitical events in curious ways. On February 24, news reports emerged that Russian forces had begun a “special military operation” in Eastern Ukraine. Immediately, global asset prices first fell, but then rallied hard by the close of that first day. After two additional weeks of market declines on frightening news and chilling forecasts about what had become an all-out war in Ukraine, and with oil having approached $124 per barrel, markets began to behave as if this conflict would have a more nuanced impact on the global economy, and accordingly, asset prices. There is an emerging view that some degree of higher energy costs will help prevent the economy from overheating and could convince central banks not to raise interest rates too rapidly. The yield on the 10-year Treasury, which had widened out to almost 2.5 percent (up almost 100 basis points YTD) has come back in slightly. After all, the cure for high prices is… high prices. The more bearish view is that high energy prices will further fuel inflationary forces even while the economy cools, bringing about a bout of stagflation, for which there is no easy monetary policy cure.

Speaking of monetary policy, it was just two months ago when Fed Chairman Jay Powell indicated that the Fed might be forced to raise rates more quickly to ensure inflation did not begin to impede employment. Fast forward to Powell’s remarks after the most recent Fed decision, and the tune has changed; the employment market is so hot that wage increases are increasingly seen as a bigger threat to price stability than higher prices stemming from supply chain issues. That’s another reason why baseline inflation expectations for the year have continued to creep higher. Just a month ago, the consensus forecast for U.S. CPI increase was about 5 percent—today it is above 6 percent, and the 5-year breakeven inflation rate has jumped from 2.8 percent to 3.4 percent. Yes, inflation is still widely expected to subside, but due to higher wages and higher energy costs, inflation seems likely to fall more gradually than was previously expected.

The trouble with easing inflation is that it feels like monetary tightening. Real interest rates are now at negative 4.0 percent (10-year treasury yields of 2.4% less core inflation of 6.4%). As inflation eventually subsides, the effect on real interest rates will be similar to what happens when the Fed raises rates. The market has been reacting to this tightening with volatility, especially among riskier, long-duration assets. Volatility peaked in early March, with growth stocks suffering significant losses. However, after the Fed slightly softened its stance in response to Ukraine, rates still moved higher but more gradually, and growth stocks staged a bit of a comeback. This is why we tend to view volatility spikes, all else equal, as bullish.

What’s Next?

While we have been keeping a close eye on events in Ukraine and on the broader markets in general, we have not made wholesale changes to portfolios. We believe that should the trend toward higher interest rates and higher inflation continue, value-tilted will be positioned well to outperform. That’s because portfolios with a value-tilt tend to perform relatively well in this kind of environment. Sectors such as financials and energy, which tend to be well-represented in value-oriented portfolios, benefit from these trends. Also, when earnings growth becomes more abundant, investors are less likely to chase pricey growth stocks in favor of value stocks that are also experiencing solid growth. Finally, higher rates tend to have an outsized impact on long-duration assets such as long-dated bonds and expensive growth stocks, because those future cash flows must be discounted back to the present at those higher interest rates.

Even though growth (Russell 2000 Growth Index) rallied in the latter half of March, bouncing more than 7 percent off its lows, value (Russell 2000 Value Index) did even better for the month and has outperformed growth by more than 1000 basis points so far this year.

While geopolitical turmoil is unsettling, it is a risk that has already been incorporated in our allocation models. While these specific risks are unpredictable, we know these events happen from time to time in the aggregate and accordingly they are already baked into longer-term expectations regarding overall risk and return.

While we will continue to monitor events in Ukraine and beyond, we do not anticipate much “trading” around the situation. We will maintain an eye toward rebalancing should circumstances warrant.

As always, we will continue to vigilantly monitor inflation, interest rates, geopolitical events and other market factors, and we thank you for your trust.

Burke is Trust Company’s Investment Strategist. Based in the Raleigh office, Burke works closely with the firm’s Chief Investment Officer helping develop investment strategy and communicating with clients.

Will the Next Domino Fall?

by Dan Tolomay, CFA

My sons like to play with dominoes. Specifically, they like to stand them up in rows, push the first one over, and then watch them fall one by one. The design, which is entertaining to devise and laborious to build, is satisfying to watch as it unfolds as planned. Things don’t always go as concocted, though. Sometimes a shaky hand sets the process off prematurely leading to an incomplete sequence. A fully deployed set of tiles may fail to deploy as was imagined. It’s an interesting analogy in today’s bond market. What seems like a clear sequence of events leads to assumptions about the future and how to react.

The pandemic has resulted in product shortages. The scarcity has pushed up prices. A lack of labor supply has caused employers to raise wages to entice workers to join their teams. These inflationary pressures have nudged up interest rates. Bond investors, who receive fixed payments, see the value of those payments eroded when prices rise. To adjust, they demand higher yields, which is achieved by paying lower bond prices.

At the same time, inflation forces the Federal Reserve into action to stabilize prices. The primary tool the Fed uses for this purpose is interest rate hikes. Increasing short-term rates provides an incentive to save and a disincentive to borrow and spend. The desired impact is to cool the economy down so that it doesn’t overheat.

For the three months ended February 2022, the 2-year US Treasury yield has increased 0.92% and the 10-year US Treasury has increased 0.40%. The bond market (as measured by Vanguard’s Total Bond Market Index fund) fell -4.26% during that time. With inflation still in the headlines and more potential increases in interest rates looming, what are prudent steps to take with a bond portfolio?

First, don’t just focus on the dominoes that failed. Look at what worked. The -4.26% return referenced above is only the price move. When income is included, the return improves to -2.48%.

Next, remember the dominoes don’t always fall as planned. The consensus view is that interest rates will continue to rise. This was the case on March 1, 2018, too. The market’s expectation was that rates would increase from the blue line to the red line in 3 years. What actually transpired can be seen in the gold line.

As the chart below demonstrates, sometimes the dominoes are the victim of a false start; the plan for the grand launch fizzles out abruptly. Looking back 15 years to the Financial Crisis, there are multiple examples of what was perceived at the time to surely be the bottom for interest rates. Yields rose some, then fell again – in some cases even lower.

The argument is not that rates won’t rise. They likely will; however, it’s impossible to know how much, how quickly, and exactly how different maturities will be impacted. Additionally, with the risk of further coronavirus variants, escalating geopolitical tensions in Ukraine, or some other unknown crisis, there remains the chance of a “flight to quality” event. Such an event would see flows into bonds, a rise in bond prices, and a drop in yields. Or, inflation could end up being transitory, which would reduce inflation expectations and allow the Fed to be less aggressive. This would cap yields and support bond prices.

A domino cascade may go awry but it’s still fun; there’s a silver lining. Assuming rates do rise, what does it mean for bonds? That too is a mixed bag. The bad news is that the principal value of a bond will fall. The good news is income will rise.

The extent of the price decline is determined by the bond’s duration, a measure of the timing of a bond’s cash flows and its sensitivity to interest rates. As a rule of thumb, a bond’s value will fall by its duration multiplied by the size of the rate increase. For example, a bond with a duration of 5 will decline by 5.0% for a 100 basis point (bp) or 1.00% jump in yields. (It’s important to note that – absent a default – the bond’s price will ultimately move to par at maturity.) Cash flows from interest payments and bond maturities can be reinvested at higher yields.

These forces can be seen at work in the examples below, which assume a 6.6 duration and a 1.4% beginning yield. The first set of illustrations assumes one-time jumps of 0.50% and 1.00% in yields. The second set shows annual hikes of 0.30% and 0.50%. As the price change rows show in the +1 year columns, there is a negative price change. The yield rows reflect the higher income starting at the same time, though.

One Time Shock to Rates

Annual Rate Shocks

As the tables and graphic above show, rising rates are not catastrophic for bonds. The higher income that comes with rate increases helps offset damage down by principal hits. Down bond markets and down stock markets vary widely in magnitude and frequency.

Don’t let fear of the tiles not falling your way lead to bad decisions or avoidance of the game altogether. As with the stock market, investors must resist the urge to try to sidestep danger via market timing. The temptation with bonds and rising rates is to get out, “wait until it’s over,” and get back in. This could mean going to cash or concentrating exposure in short-duration bonds. Doing so may protect principal but could lower income if rates stay low.

Whether managing dominoes or duration, a strategy is critical. How is Trust Company of the South managing the risk to bond values from higher rates?

(1)    Ensure that holdings match the time horizon – portfolios with short-term liquidity needs (< 6 months) are encouraged to utilize money market funds. These funds will hold their value and see yields increase as the Fed raises rates. Short-term bond funds, by contrast, will suffer price declines and have a deferred uptick in yield.

(2)    Shorten duration – as noted above, there is risk in consolidating all bond holdings into short-term bonds. Acknowledging the low level of rates and their likely move upward, our portfolio’s duration is marginally shorter than the benchmark.

(3)    Add credit exposure – bonds with higher yields are less sensitive to rate increases. Interest rate risk is exchanged for credit risk. Care is taken to keep the portfolio investment grade, which provides a ballast when the equity markets decline.

(4)    Diversify within markets – holding bonds with maturities across the yield curve mitigates the risk of a rate increase in a particular maturity.

(5)    Diversify across markets – international bond markets are influenced by local interest rate moves and inflation expectations. Such moves are not perfectly coordinated with the U.S. bond market. As a result, holding foreign bonds serves to hedge domestic interest rate risk.

The role that bonds play in a portfolio is to dampen volatility. For clients without the ability or willingness to tolerate volatility of an all-stock portfolio, bonds have a place in a long-term portfolio.

The best-designed waterfall of dominoes plays out perfectly in the creator’s mind. It seems so obvious that things will go exactly as planned and lead to an outcome where reality matches expectations. A mistake can quickly shatter that idyllic scenario. Similarly, making portfolio decisions based on perceived sure-things or consensus views feels comfortable at the time. It is only with perfect hindsight that it becomes clear what was off and why. Inflation, interest rates, and bond prices may all act as imagined. But, I wouldn’t count on it nor would I make a large wager on it. I’d get out the box of dominoes.

As Chief Investment Officer, Dan is responsible for developing Trust Company’s investment strategy and managing client portfolios.

When the Ride Gets Bumpy

by M. Burke Koonce, III

Last spring, my wife and I took our daughter to Disney World. We had been recently vaccinated and we were feeling empowered and brave. It helped that Disney was operating at 50 percent capacity—it was a luxury I will require for future visits. Anyway, as my daughter and I were exiting Space Mountain, my Apple watch started to vibrate and I saw I had a call coming in from 911. Startled, and a little out of breath, I answered, not really knowing what to expect. Turned out that our technological overlords had determined that based on the violent maneuvers and abrupt stopping, I might have been in a car accident, and they were calling to ask if I required assistance. I thanked them and told them I was just a middle-aged guy on a roller coaster and we all had a chuckle.

After January’s ride, I half expected my watch to start buzzing again today.

While the history books will show that the major market averages were lower for the month based on month-end pricing, they will not capture the mileage. Yes, January concluded with the Dow down 3.3 percent and S&P 500 down 5.3 percent, but those figures obscure the intra-month declines that landed the other major US index, the tech-heavy NASDAQ, well into correction territory, even though a furious rally these last two days enabled it to post just a 9 percent decline for the month.

For the majority of the overall market’s near two-year trip out of the COVID-19 crash of March 2020, the experience has been more akin to the Seven Dwarfs Mine Train than anything that would require a height minimum. That has changed. It was only three days ago that the Russell 2000 Growth Index had fallen 19 percent since year-end, a single percentage point from a bear market.

Almost right out of the gate, the markets had begun to behave differently than they had in months. Ironically, as COVID-19 finally appeared to be losing its grip on the U.S. economy, markets began to focus not on the virus, but on the side effects of the cure—not the vaccine, but the enormous fiscal and monetary stimulus intended to keep the economy afloat during the dark days of 2020 and early 2021.

Those treatments, coupled with persistent supply chain problems and an extraordinarily tight labor market, have resulted in price inflation not seen in this country since 1982. The Federal Reserve, having successfully achieved its stated goal of strengthening the job market, and then some, will now turn its focus to dampening inflation through a combination of reducing its ownership of financial assets and raising interest rates. Accordingly, the yield on the ten-year Treasury has jumped from 1.51 percent on New Year’s Eve to about 1.77 percent as of the end of January.

While markets had been expecting two rate increases in 2022, the markets are now anticipating five rate hikes before the end of the year. That’s a big difference, especially given how low rates have been, and markets quickly began to reprice assets based on that big difference.
Now, as a general rule, markets do not really like rising interest rates, especially markets for expensive assets such as “growth” stocks—you know, the kind of stocks that have been doing well for years. Investors pay more for “growth” stocks because of the promise of earnings growth that will yield big future profits for those companies. The trouble is, in an environment where we have rising interest rates (because of rising inflation) those future profits aren’t going to be worth as much. As a result, other less expensive stocks, of companies that already have strong earnings even if they’re not promising future trips to Mars, look that much more attractive. Intuitively, this makes sense, right? In an economy such as ours that’s chugging along quite nicely in which lots of companies are generating strong earnings, who wants to pay nosebleed multiples for discounted future earnings when we’re swimming in strong earnings today?

What happened in January was a giant rotation out of “growth” stocks and into “value” stocks. At one point, the Russell 2000 Value Index was outperforming the Russell 2000 Growth Index by more than 1000 basis points, or ten full percentage points in just 19 trading days.
Growth made up considerable ground during the last two trading days of the month to trail by slightly less than 8 percentage points, but that’s still a huge move.

Of course, while we as investors have had the luxury of enjoying a relatively smooth ride recently, it is actually perfectly normal for there to be a 10 percent drawdown; in fact, there’s one just about every year.

But what if this really is something more serious? What if this is an extended drawdown? That would be rare indeed—we’ve only had 12 drawdowns of more than 20 percent since 1946. They usually accompany recessions and yet American corporate balance sheets have perhaps never been stronger, but let’s just say for argument’s sake that this might be serious. What might it look like? Well, if monetary conditions tighten significantly, that’s almost certainly going to be harder on the more speculative areas of the market than the less speculative. The reality is that the Fed is going to beat down inflation, sooner or later. The trouble is, falling inflation feels a lot like rising interest rates, whether nominal rates rise or not. With the 10-year where it is and core CPI at 5.5 percent, that translates into a current real interest rate of negative 3.7 percent. As inflation subsides, it’s just hard to see how we even get back to a real interest rate of zero without some price volatility, particularly for long duration, pricier assets.

All that said, we are not in the market-predicting business. We are in the optimal long-term allocation business, with a tilt toward value (and small caps, and international, and profitable companies). Naturally, this positioning is unlikely to outperform markets when speculation and accommodative monetary policy is ascendant. However, the existence of markets such as this one, characterized by heightened volatility, is incorporated into our long-term view, and, so far anyway, the value-tilt is performing as one might expect.

One of my favorite Warren Buffett observations is that in the near-term the market is a voting machine, but in the long-term it is a weighing machine. Sooner or later, all companies must demonstrate the ability to generate earnings, not just promise it.

Because when the ride gets so bumpy that your watch starts to buzz, it will be the weight of the portfolio that counts, not the number of “likes” it has.

Burke is Trust Company’s Investment Strategist. Based in the Raleigh office, Burke works closely with the firm’s Chief Investment Officer helping develop investment strategy and communicating with clients.

Boo or Boon?

by Dan Tolomay, CFA

Darkness arrives sooner these days. The air is cooler. Our neighborhood is slowly populating with ghosts and skeletons. It is not just trick-or-treaters doing the frightening. October has been a scary month for the stock market. In 2008, the S&P 500 fell -17%. In 1929, the S&P 500 fell -20%. And, in 1987, the S&P 500 fell -22%. Should these extreme monthly returns cause us to fear the month of Halloween in the equity market? We looked at the S&P 500 back to 1928.

How volatile is the tenth month of the year? There are a few ways to answer that question. One is the range of returns (the highest minus the lowest). As noted above, the worst October was 1987 at -22%. The best October was in 1974 at +16%. So, the range of returns for the month has been 38%. Is this the widest? No. April, which experienced -20% in 1932 and +34% in 1933, is the standout. The narrowest? January, -9% in 2009 and +13% in 1987, holds that title. October is #7.

A second volatility measure is standard deviation. This calculation describes how much dispersion there has been around the average of a data set. The average October return has been 0.44%, and the month has had the second highest standard deviation at 6.06%. The most volatile month by this definition is August with an average return of 0.70% and a standard deviation of 6.11%. February has been the most docile month with an average return of -0.11% and a standard deviation of 4.26%.

As an aside, should we avoid February with its negative average return? No. Averages can be skewed by extreme observations (aka outliers). It is more useful to look at the median or midpoint of the data. This value has the same number of data points below and above it. The median return for February is 0.27%.

How often has October delivered a negative return? Forty one percent of the time. The worst success rate has been in September with 54% of observations negative. The best chance of a positive return historically has come in December when just 26% of years had negative returns.

So, is April the worst because its return range is the widest? Is August, which has the highest standard deviation to be feared? Or is September the bogeyman with the lowest historical success rate?

Volatility cuts both ways, but the focus tends to be on the downside. April has had a wide range of returns. The market was down -20% in 1932; but, trying to sidestep a potential repeat in 1933 would have foregone the +34% monthly return.

In the past, August has had the most noise around its average return of 0.70%. That noise comes from below and above average returns. Returns that come in unexpectedly above the expectations are not “risky”. August accounted for 1 of the 20 worst monthly returns (-15% in 1998) and 3 of the 20 best monthly returns (+11% in 1933, +12% in 1982, and +39% in 1932).

Lastly, simply looking at success rates doesn’t factor in the magnitude of returns. A month could post several small negative returns, which would make it seem “risky”, but missing the rare strong positive month could do more damage.

An extreme data point, sometimes known as a “black swan” event, can be defined as an observation beyond two standard deviations. Statistics tells us that approximately 4.5% of observations should meet this criterion. The average of all the months is 0.63% and the standard deviation is 5.37%. The expectation would be that 95.5% of observations would lie between 0.63% +/- (5.37%)(2) or -10.11% to +11.38%.

In fact, 49 of 1,125 observations (4.4%) meet black swan criteria. Six of the 49 (or 12%) occurred in Octobers. On this basis, October should be no scarier than March and less frightening than September. Interestingly, October is only a bit more volatile than random chance (1/12) would predict.

Assume now that October does produce a negative black swan event (as it inevitably will again sometime in the future), how long has the market needed to recover in the past? On average, a recovery from an October loss took 87 months! The median recovery time was 21 months (see above for average vs. median). The data is skewed by the 297 months it took to recover from October 1929. The fastest recovery from an October crash was 8 months (after October 1932).

The data shows that trying to use a calendar to forecast market returns won’t be productive. Investment theory has long noted this. At Trust Company of the South, market efficiency is part of the philosophy. This is the concept that security prices reflect publicly available information. The history of the S&P 500 is readily available to almost anyone. As such, trying to use this data to one’s advantage to predict a market move will be fruitless. Any value from that information has already been considered in security prices and investors’ expectations. Rather than panic or prepare for an autumn decline, enjoy the beautiful weather, and decorate for Halloween.

Going for the Silver

by Dan Tolomay, CFA

After a one-year delay due to the pandemic, the Summer Olympics are here! While things will not be exactly the same due to lingering health safety concerns, one thing will remain – national pride. Spectators around the globe will tune in to cheer on their country hoping to hear their national anthem and see their athletes take the top spot on the podium. Close your eyes and you can hear the celebratory chant, “U-S-A! U-S-A! U-S-A!”.

While a gold medal is every Olympic athlete’s goal, there is no shame in taking home silver hardware. Also, spectators often find themselves pulling for an international underdog or a foreign athlete with an inspiring story. In short, it is okay if the U.S. is not on top every time. The same is true in the investment world.

Consider the situation where the United States has bested the rest of the globe for eight of the past ten years. America’s dominance fuels optimism of additional success. Why would anyone bet against the U.S.? This describes 2021; but, global investors found themselves in that exact position at the beginning of 1999. The United States had prevailed in 80% of the prior ten years. The MSCI United States index had posted an 18.9% annualized return. The MSCI World ex USA index, by comparison, delivered only 5.6%. Who needed the other countries? U.S. investors.

Over the next nine years, the U.S. would outpace foreign shares only two times. The MSCI All Country World ex USA index generated 9.2% on average per year versus 2.8% for the MSCI United States index.

The debate is bigger than domestic versus international, though. This is because the geographic allocation decision is not mutually exclusive. It is not a matter of USA or the rest of the world. In Olympic parlance, it’s not “gold or bust”. A globally allocated (U.S. and foreign) portfolio would have been more diversified than one holding all American or all international names. When U.S. shares dominated 1989-1998, a global portfolio would have returned 10.7%; and, when shares abroad were on top from 1999-2007, an all-world allocation would have provided 6.0%. In both cases, the global portfolio trailed the leader but outpaced the laggard. This is how diversification works.

It would be wonderful to know in advance which area will outperform and load up on exposure. Of course, we cannot predict, so a focused bet could also go awry. Spreading the allocation around acknowledges two things: (1) some assets will perform better than others and (2) it is impossible to know which ones. The prudent steps to take in this scenario, respectively, are to have exposure to all assets and not allocate too much to any single asset.

Looking at country level data, an interesting dynamic can be observed. During the U.S.’s strong 1989-1998 performance, it was the top performing country only once in 1991. (It also came in last in 1993.) Similarly, from 2011-2020, another period where international lagged, American shares were on top… zero times. The best placement achieved during that period was fifth in 2011. The upshot is that there is usually a better performing market outside the United States. Having broad international exposure ensures that this return is captured.

Another takeaway from the above tables is the range of returns. The returns generated by other countries are both widely varied and independent from those produced by the U.S. Again, this is a sign of diversification working. It is desirable to have a portfolio of assets that do not move in lockstep. Having all the components move up together at the same time sounds great; however, the flip side would likely be true as well. Diversification forgoes the chance to be fully exposed to the top performer but also eliminates the risk of having a full weighting to the worst player.

Pulling for your country during the Olympic games is part of the experience. So, too, is the realization that you “can’t win ‘em all”. Global diversification admits that your country will not always take the gold. Having broad exposure, however, means that you will have some allocation to first place. Conversely, by not being all-in on one country, you’ll never come in last. Rather than going for the gold and risk taking home bronze, go for the silver.

As Chief Investment Officer, Dan is responsible for developing Trust Company’s investment strategy and managing client portfolios.

Look to Higher Ed for Higher Returns

by William Smith, CFP®

Is your email inbox cluttered with offers to magically cure a host of problems? One popped up last weekend promising to fix my slice in 15 swings. I simply needed to mimic PGA TOUR pro Rory McIlroy’s swing plane. No mention of the thousands of hours Rory has invested developing his craft, nor a nod to his rare natural talent. Nope, that’s all, just 15 swings. Although skeptical about this offer, I do believe that by following the best practices of high achievers in any field, we can improve our performance.

For struggling investors, is there a model to emulate? One that would increase their chances of keeping it in the fairway? Turns out there is.

Many of the investment industry’s leading professionals, our Rory McIlroys, manage the endowment assets of our nation’s top colleges and universities. Endowments of all sizes share a common goal: to provide a current income to support today’s priorities and invest for growth to fund tomorrow’s initiatives. They do this by establishing a “spending policy”, a percentage of the portfolio that’s available to be distributed currently, and positioning their investments to achieve a return that offsets the effects of inflation, “preserving purchasing power.” Yale University’s Nobel Prize-winning professor James Tobin eloquently described this challenge, “the trustees of endowed institutions are the guardians of the future against the claims of the present. Their task is to preserve equity among generations.”

Professor Tobin’s job description for university trustees would well suit investors wishing to draw from their portfolios to support their current lifestyles while hoping to leave a legacy for their children, grandchildren, or a favorite charity.

Were we able to study how endowments allocate their investments and set spending percentages, that might offer valuable perspective. Thanks to the folks at TIAA and NACUBO (the National Association of College and University Business Officers) who publish an annual survey, we have that information readily available.

The 2020 NACUBO-TIAA Study of Endowments covering the year ending June 30, 2020 had 705 of the nation’s top endowed institutions participate. Representing more than $600 billion in assets, managers from the likes of Harvard, Princeton and Yale, along with those closer to home from UNC Chapel Hill, Duke and Elon, all reported how their investments were allocated, how much they withdrew from their portfolios, what rate of return they achieved, along with a multitude of other data.

The portfolios of the smaller funds ($100 million and below) typically allocated their assets roughly 70% to global equities and 30% to fixed income, a shift from 60% / 40% years ago due to a decade’s long stretch of low interest rates. This cohort of endowments realized net average annual returns of 7.5% over the past 25 years. Further, they spent roughly 4.5% of their portfolios annually over that timeframe, leaving 3% net growth, enough to outpace inflation – their primary goal. These results would likely garner a passing grade in Professor Tobin’s book.

With this reference, we can model these university endowments to improve outcomes in our personal portfolios. If you’re uncertain whether you have the proper asset allocation or if you’re spending more than your portfolio can support, we would recommend an in-depth consultation with your advisor. However, a CliffsNotes summary plan might read:

1. Set a broadly diversified asset allocation you can tolerate and maintain, especially through market corrections.
2. Consider spending no more than 4.5% of your portfolio each year.
3. Rebalance when market forces cause your allocation to drift from target.

Following these 3 steps will most certainly increase the likelihood of your having a successful investment experience.

If only fixing your slice was that easy.

Bill serves as President and Chief Executive Officer of the firm as well as Chairman of the Board.  Based in the Greensboro office, he oversees client relationships, assists in new business development efforts, and works directly with many of Trust Company’s not-for-profit clients.

A Super Genius Weighs In On Inflation

by M. Burke Koonce, III

I have a friend, a hedge fund manager of course, who was filling out a job application years ago at a major Wall Street asset manager. In the section asking about special skills and abilities, he wrote “Super Genius.” I can’t remember if he got this particular job—it’s possible that he did—but I have often giggled about the look on the human resource manager’s face upon reading his application.
Now, this fellow is extremely smart, and he is also clearly not lacking in the chutzpah department. I’m not sure I would categorize him as Super Genius though. Seems a bit inflated, which brings us to a topic on the minds of not just many investors but also business owners and grocery shoppers. Inflation. Is. Here.

I’m old enough, just barely, to remember the inflation of the 1970s and the terrible impact it had on this country. Rooted at least in part in America’s departure from the gold standard and exacerbated by energy crises, inflation reached 14.5 percent by 1980, helped chase a U.S. president out of office and came to symbolize a general sense of economic malaise and even societal decay that persisted until the Volcker Fed brought it under control with higher interest rates and slower reserve growth.

According to the Labor Department, consumer prices rose 5 percent last month, the largest increase since August 2008. The 3.8 percent increase in the core number, which excludes the volatile categories of food and energy, was the largest increase since June 1992. That’s when I graduated from college. For perspective, I have a child who graduated from high school last month.

There’s no disputing these are historic increases. But before we race to the gas station and get in line, let’s take a deep breath. One reason these increases are so large is that last year prices were so depressed. Governments around the world were doing everything they could to keep prices from collapsing. So the denominator (pandemic-pressured prices last year) is juicing these price increases.

Even so, it seems fairly obvious that the economy is far, far healthier than anyone could have believed just a few months ago. Pent-up demand is meeting supply that has been constrained by supply chain problems and labor shortages, so it’s only natural that prices are rising, and it is possible, depending on what happens with consumer expectations, that some inflation continues. As Nobel laureate Gene Fama recently pointed out, the longer inflation or deflation persists, the more likely it is to persist.

Still, there is a component to these price increases that seems decidedly short-term. Generous unemployment benefits are keeping some service workers on the sidelines, but those benefits will run out by the end of the summer and in many states well before, and this ought to ease the labor crunch in the service sector. The microchip shortages that have created a frenzy in the used car market, driving prices up more than 7 percent last month and accounting for about a third of the entire increase in overall prices, will eventually be met with new supply. Globalization has been a crushing weight on inflation for decades, and the base case is that this will continue to suppress price increases.

That’s the company line at the Federal Reserve anyhow, and it’s important to remember that this is actually what Fed Chairman Jay Powell explicitly predicted last September. At that point, the central bank was still so concerned about falling prices that it indicated it would allow the economy to run a little hot instead of pre-emptively raising interest rates. Of course, at that point, there was no such thing as a COVID-19 vaccine. Fast forward to today and we have a $1.9 trillion stimulus package coursing through our veins, potentially another $2 trillion in infrastructure spending on the way, and COVID-19 is on the run. (I actually went to a party last weekend! With people!) Also, I think it’s worth noting that the globalization bandwagon has gotten a little less crowded in recent years as populist and trade protectionist forces have gathered momentum. Combined with an aging population in rich countries and in China, the relative strength of deflationary forces is strong, but not as strong as it was just a few years ago.

So far, the financial markets have taken the whiff of inflation in stride. The threat of higher rates has taken some steam out of the more speculative sectors of the market such as growth stocks and long-dated fixed income, but other areas, such as financials, commodities, and value stocks, have done extraordinarily well. Inflation is a serious threat, but it is only one factor of many that the markets are always in the process of discounting. That’s why good old-fashioned diversification is so important.

My friend might think he is a super genius, but for the rest of us mere mortals, diversification and commitment to a plan still seem to work well. How long will inflation last? No one knows for certain, and there are reasons to be watchful, but diversification and a tilt toward value has historically served investors well over time. The real genius is in mastering one’s emotions, not mastering the market.

Burke Koonce recently joined Trust Company as the firm’s Investment Strategist, working out of our Raleigh office. 

Rising Rates and Your Bond Portfolio

by Dan Tolomay, CFA

Recently, our son lost his first tooth. (Actually, it was his third lost tooth. We suspect he swallowed the other two. But this was the first instance where he would interact with the Tooth Fairy.) After we explained the mechanics of the tooth-for-treasure trade, he drifted off to sleep. My wife and I then debated the going rate for a tooth. What did we receive as children? Did those amounts still apply? Or did we need to adjust for decades of inflation?

The two of us were not the only ones thinking about rising prices. Optimism about a post-COVID recovery pushed up inflation expectations in the first quarter of 2021. Bond investors, who receive fixed coupon payments, began requiring higher yields to account for the anticipated loss of purchasing power. Higher expected demand for money in a normalizing economy also helped to nudge rates upward.

The change in interest rates was not uniform, however. Most of the action was in intermediate- and long-term yields. As short-term rates were stable, the yield curve “steepened”. It is not uncommon for different maturities to behave differently. Not long ago, there was fear that the yield curve would “invert” where short rates would exceed long rates. Normally longer bonds yield more than shorter bonds as an investors’ capital is at risk for a longer amount of time. This is known as the term premium.

It is difficult to consistently predict what rates will do, at what magnitude, and when they will do it. Making such guesses can damage your portfolio. Some investors, convinced that rates would rise, concentrated their holdings into short-term debt. This debt, which is less sensitive to rate increases, should offer protection, they reason. As noted above, though, short bonds normally yield less than their longer counterparts. So, there is a cost to this perceived safety. Additionally, the curve could “flatten” where short rates rise or long rates fall. Being concentrated in near term bonds could mean a principal loss or missed gain, respectively.

Alternatively, low interest rate environments may tempt an investor to reach for yield and hold more long-term debt as longer maturities usually mean juicier payouts. But maturities that are further away are more sensitive to rate moves (the bonds fall more in price when rates go up), and an investor could get burned by rising long-term yields.

Rather than guess what rates will do or make yield-driven bets, diversification can increase return and lower risk. Owning bonds of various maturities means exposure is spread across time and lessens the impact of rate moves in specific segments of the yield curve. Expanding holdings to various sectors of the bond market adds securities that behave differently to a portfolio. Higher coupon corporate bonds, for example, may increase credit exposure but reduce interest rate risk. Similarly, government-backed mortgage bonds comprised of adjustable-rate loans can lessen sensitivity to yield changes. Lastly, adding foreign bonds means less money is exposed to the US interest rate environment and American inflation expectations.

Periodically assessing market conditions can improve risk management without having to outsmart the market. For example, if longer-term bonds yield the same or less than short-term bonds, it may not make sense to bear the risk of a later maturity. Likewise, if less credit worthy bonds are not offering a sufficient premium to hold them versus safer alternatives, an investor can abstain until the reward becomes commensurate with the risk level.

The recent uptick in interest rates has caused some bonds to decline in value. It is important to remember that this is only one piece of the return. The coupon payments from the securities must be considered, too. This income lessens the impact of value dips due to rate increases. And, like stocks, when bond prices fall, their expected return goes up. These are silver linings to remember as bond markets adjust to new expectations. Diversifying across countries, maturities, and creditworthiness helps a portfolio reduce bumps in the road and capture return opportunities without having to know the future.

As Chief Investment Officer, Dan is responsible for developing Trust Company’s investment strategy and managing client portfolios.

Breathe Easy…You Are Not Being Squeezed

by Dan Tolomay, CFA

The broad equity market is off to a quiet start with the S&P 500 off -1% through January. The same cannot be said for a couple of stocks. GameStop and AMC Entertainment were up 1,587% and 514%, respectively. There have been many headlines about these stocks’ gains and the clashes between short sellers on Wall Street and Reddit users on Main Street. So, what’s going on and what does it mean for a portfolio?

To begin, an explanation of short selling is useful. Instead of the traditional path to profit, which entails finding an opportunity, buying low, and selling high (a.k.a. being “long”), short selling reverses the process. Rather than look for an asset that will appreciate, “shorts” seek assets that are perceived to be overvalued and will depreciate. To execute, the stock is borrowed and sold in the market. Assuming the stock depreciates, it is then bought back at a lower price and returned to the lender.

Shorting a stock is a legal way to financially express an opinion on its value. In theory, shorting helps markets. It enables those who feel that a stock is overpriced to try to push its price to fair value. Having this capability is more effective than simply abstaining from purchase. There is, admittedly, an ethical line that can be crossed when pushing a stock to fair value leads to attempts to make it worthless (which would maximize the profit for a short seller).

Shorting is not without risk, though. As a stock’s rise has no upper bound, the losses to a short seller can magnify extensively. What we see is that- when a stock rises- the short sellers unwind their positions by buying the shares back to stop losses. This phenomenon, known as a “short squeeze”, leads to further price increases. Managers know this risk and should not cry foul when markets move against them.

What’s unusual about recent market gyrations is the source of the stocks’ advances. Retail investors trying to coordinate buys via social media have driven a handful of stocks higher. Some retail investors are seeking quick profits while others have expressed a desire to inflict losses on hedge fund managers who are openly short these stocks. (Here, too, an ethical line is being crossed.) Exacerbating the issue is the expanded access to stock and option trading by retail investors homebound by the pandemic.

We’d expect markets, as they always do, to adapt. At risk of being the next target, hedge funds may close out short positions for fear of succumbing to a short squeeze. The involvement of systematic funds which use algorithmic trading to try to profit from trends, may magnify the issue in the short term. Retail investors may continue these coordinated efforts, or they may cease actions at the fear of loss or legal action. In general, though, market participants (large and small) will adjust their behavior to generate profits and avoid losses.

The situation is very fluid:

  • Trading platforms are limiting trading activity, increasing margin requirements.
  • Members of Congress are calling for investigations into why retail investors are being restricted while hedge funds are not.
  • The SEC may act if retail investors appear to be colluding or manipulating markets with false information.

The recent price swings and uptick in trading volume of these few companies have captured much attention. It does not change our advice to clients, however. Our clients are insulated from these moves by being broadly diversified. Targeting empirically-proven sources of higher return is more reliable than attempting to identify the next stocks to benefit or hedge funds to suffer from these recent actions. Having an asset mix that’s appropriate for your specific goals and executing that at a low cost are controllable factors that will lead to investment success.

As Chief Investment Officer, Dan is responsible for developing Trust Company’s investment strategy and managing client portfolios.