Disclosures        Call: (833) 666-1200     Schedule a Complimentary Consultation

Red Tortoise, LLC

Eat Well. Sleep Well.

How to Lose Money in Great Companies and the Need to Diversify Broadly to Enjoy Stock Market Returns

by

Company  Ticker  % Change (2022)  
Apple  AAPL  -27%  
Amazon  AMZN  -50%  
Microsoft  MSFT  -29%  
Tesla  TSLA  -65%  
Meta Platforms  META  -64%  
Nvidia  NVDA  -50%  
PayPal  PYPL  -62%  
Netflix  NFLX  -51%  
Walt Disney  DIS  -44%  
Salesforce  CRM  -48%  
S&P 500   -18% 
Table 1. Largest Losers in the S&P 500 in 2022

Table 1 (source: the Visual Capitalist) shows the largest losers in the S&P 500 in 2022.   The index itself lost just over 18%.     Many of these companies, if not all, would be considered great companies.   This is evidence that investors can experience significant loss even investing in great companies; and, great companies can do worse than the market average.    

2022 was a single year and perhaps an aberration.  Research from Dimensional Fund Advisors suggests that the largest companies in the U.S. may underperform in the future, though not to the degree witnessed in 2022.  

Figure 1. Largest Stocks at Start of Each Decade

Figure 1 shows the largest 10 US stocks at the start of each decade.   The evolution of names is interesting and raises some questions.   Do these largest of the large stocks tend to do better or worse than the market?   If they tended to do better, then we’d expect little turnover. The big would get even bigger on a relative basis.    

Figure 2.  Excess Return (Annualized)

Figure 2 shows the annualized return in excess of market for stocks after joining list of 10 largest US stocks from 1927–2019.  Over the longer periods these stocks tend to underperform.   

We are not anti-large companies.  We are for anti-concentrating wealth in large companies.   We are pro-diversification.   One additional piece of research supports our approach.  In his May 2018 paper, “Do Stocks Outperform Treasury bills?”, Hendrik Bessembinder of Arizona State University states that since 1926:  

  • The majority of common stocks have lifetime buy-and-hold returns that are less than one-month Treasuries.  
  • In terms of lifetime dollar wealth creation, the best-performing 4% of listed companies explain the net gain for the entire US stock market as the performance of other stocks collectively matched U.S. Treasury bills. 
  • The findings help to explain why poorly diversified active strategies most often underperform market averages. 

The concentration of wealth creation in a small percentage of companies is not widely appreciated.   The track record of active managers trying to outperform the market index is poor which is why index funds have become popular.  Table 2 shows just how poorly the vast majority of active U.S. large-cap fund managers have failed to beat the S&P 500 index over the long-term:  

1-Year 3-Year 5-Year 10-Year 15-Year 20-Year 
55% 86% 84% 90% 89% 95% 

Table 2 Failure Rate (Source: Standard & Poor’s, data through June 2022) 

If you want your portfolio to include the small percentage of companies that Bessembinder finds contribute the most to dollar wealth creation, buying all the stocks in the market will do the trick – though one obviously is kissing a lot of frogs to find a prince. 

Diversification within a portfolio is not just to reduce risk – it may contribute to return.  

Down, Not Out

by

Summary:

  • Ignore economists
  • Size your investments properly
  • Don’t time the markets

Stock and bond markets are down double digits since the start of the year.  The U.S. economy will tip into a recession next year, according to nearly seventy percent of leading academic economists polled by the Financial Times. So what’s an investor to do?

Our first piece of advice is to ignore the economists!  It’s not that economists are wrong, though they may be.  Instead, we think the market itself is a fair predictor of the economy.   Stock and bond prices rapidly reflect news about consumption, inflation, interest rates, supply chain issues, employment and such.   

It appears to us that the market is pricing in the threat of a mild recession.  

This makes sense in light of the strength of household and business balance sheets.  The financial system is not in crisis as in the 2007-2009 downturn.  The Federal Reserve is focused on both inflation and unemployment and will consider each as the future unfolds.  

Usually, unemployment rises during a recession.  The labor market is tight with 1.9 jobs available for every unemployed person.  With such a tight job market, we might see employers remove vacancies and the newly unemployed still able to find new jobs.

Stock markets can take some time to recover from their losses. The following chart helps understand past market declines. 

This chart of drawdowns of the S&P 500 index since 1950 shows the return since the previous peak.  Values of zero indicate new highs.  It is a valuable graphic showing the frequency, duration and magnitude of drawdowns.  There have been three such events when U.S. stock investors lost about one-half of their assets.  It can take years to recover even before adjusting for inflation.  

Our second piece of advice is to size one’s investment in stocks to reflect one’s tolerance for risk and time horizon.

This leads us to the risk of attempting to time the stock market.

The preceding table shows the bottoms of bear markets defined as declines of at least 20%.  Columns include the date of the bottom, the index level on that date, the previous maximum value of the index, the drawdown. The rightmost four columns show the return over the next 5, 10, 20, and 30 trading days.  Below the table we show the average of the values (“Average if Bear Bottom”, and the average of all 5, 10, 20, and 30 day periods.  

The table makes it clear that the returns immediately following a bottom are much stronger than the average across all periods.   

The investor who exits the market hoping to avoid more loss risks missing significant gains.  
This leads us to our third and final piece of advice – do not attempt to time the markets.   Successful timing requires a disciplined and effective approach to both exit and re-enter the market. There is no proven way to time the market. 

Let’s Get Real – Don’t Blame Inflation

by

Stocks: Russell 1000 Index with/Div; Bonds: Barclays Capital Aggregate Bond Composite

Year-to-date (May 2, 2022) and over the last 12 months, both stocks and bonds have lost money. Generally, we think of bonds and stocks as diversifying one another. Lately they’ve been moving in the same direction. What’s going on?

Here is what usually happens. Interest rates are the prices to borrow money and are the primary driver of bond returns. As the economy improves there’s more demand to borrow money so rates rise.  An improving economy means more growth which is good for companies and their stocks. In this scenario, bond prices fall, and stocks rise.  On the other hand, as the economy falters, as in a recession, interest rates fall so bond prices rise. As the prospects for growth diminish, the stock market weakens. These scenarios are why bonds and stocks are commonly combined to diversify portfolios. Stocks do well when there’s unexpected growth; and bonds do well when growth unexpectedly slows. Over the past 173 quarters (43 years), just eight quarters (less than 1 in 20) have experienced negative returns for both the U.S. stock market and the U.S. bond market. That happened in the first quarter of 2022 and, so far, the second quarter is tracking in the same direction.

So why isn’t that happening now? The short answer is that interest rates are rising, but growth expectations are not. Consequently, the future dividends of stocks and the future interest payments from bonds are both worth less.

That was a simple answer, and probably satisfies most readers. That real rates have risen is the more technical reason that stocks and bonds have both lost value. Real rates are rates adjusted for inflation. If inflation is 3% and an investor earns 5%, he or she has enjoyed a 2% real rate before taxes.

Real rates can be observed from the yield on Treasury Inflation Protected Securities (TIPS[1] )[1]. Currently, the real rate is 0.18% on a 10-Year TIP, up 1.15% from -0.97% at the start of the year. A negative real rate indicates investors are getting a return less than the rate of inflation as was the case at the start of the year. Today’s real rate of 0.18% indicates investors are earning a return slightly greater than inflation.

The interest rate on the 10-Year U.S. Treasury (not TIPs) jumped from 1.63% at the first of the year by 1.36% to 2.99%.  The bulk of the change in interest rates is accounted for by the 1.15% increase in real rates. Inflation expectations rising from 2.60% by 0.21% to 2.81% accounts for the remainder.

An increase in real rates hurts both stock and bond investors whereas rising inflation mainly hurts bondholders whose interest payments are fixed. When there’s inflation, companies increase prices -that’s basically what inflation is after all. Even if their expenses rise by the same rate, their profits rise. A company with revenues of $100 and expenses of $80 that experiences 10% inflation will see its profit increase 10% from $20 to $22.

Where do real rates go from here and how will bonds and stocks be affected? Our loyal fans know we don’t try to time markets and promote diversification. Based on the history in the preceding chart the rate could come down or continue to rise. We’d expect markets to suffer if the rise continues and to recover if it reverses.

Here is one scenario. How much might a 1% rise in real rates be expected to impact the stock market? A simple model provides insight. The simple model assumes that stocks (think the S&P 500) pay a dividend that will grow by some amount (g) indefinitely. Let’s assume that g is 4% or 5% which is a ballpark long-term rate for the U.S. stock market. There is some rate at which we discount future dividends to convert them into today’s dollars. For starters, let’s use 6%. The simple model says the price of the stocks will be the dividend value divided by the difference between the discount rate and the growth rate: P = D / (k – g). Some math allows us to calculate the percent change in the stock price if k increases 1% as % change = (k – g) / [(k + 0.01 – g)] – 1. Assuming a 4% growth rate with the discount rate rising from 6% to 7%, the model indicates a 33% drop in stocks (-33% = (0.02/0.03) – 1). Here are results with different assumptions:

g4%5%4%5%
k6%6%10%10%
k+1%7%7%11%11%
% Change33.3%50.0%14.3%-16.7%
% Change in Stock Prices Given Various Values of g and k

The point of the table is to show that a 1% change in the real rate can easily explain a double-digit drop in the stock market.  Given how low rates have been, we’d argue that k was likely closer to 6% than 10% at the start of the year. So, we may have gotten off lucky; otherwise, we may have more pain to endure.

It’s worth discussing what drives real rates. Demographics are a driver over the long term. The ratio between people 65 years and older and people 15 to 64 years old is an example. As people save, particularly for retirement, they increase demand for investments. Retirement spending tends to reduce demand. Higher demand reduces the real rate while lower demand increases it. In the short run, the Federal Reserve, especially with its massive bond buying, creates demand for securities. It is possible, even likely that anticipation of tightening by the Fed is pushing real rates higher. What does all this mean? There’s good news here. Whereas investors in the 10-year Treasury were expecting to lose almost 1% annually after inflation, they can now expect a positive, albeit small, inflation-adjusted return. For those who are adding to their investments, higher real rates are more attractive. Understanding that movements in interest rates can be attributed to changes in the real rate and changes in inflation expectations brings important information to light.  We also expect value stocks to outperform growth stocks when real rates rise. Here we are broadly categorizing stocks with higher earnings and dividends per dollar of market price (lower P/E, higher dividend yield) as value and higher P/E, lower dividend yield stocks as growth. Growth stocks are expected to get more of their value (earnings and dividends) farther in the future than value stocks. If real rates rise, but growth expectations do not), the valuation of growth stocks will suffer more than that of value stocks.

[1] TIPs are bonds issued by the U.S. Treasury.  The principal is adjusted by the rate of inflation and interest is paid on the adjusted principal thereby providing a return relative to inflation.

War! Russia Invades Ukraine

by

The headlines today are about Russia’s invasion into Ukraine. How does this impact our thinking about portfolios? 

Earlier this month I was at a dinner with Ian Bremmer a political scientist and founder of Eurasia Group which bills itself as ” the world’s leading political risk research and consulting firm.” He dismissed the idea of a Russian invasion as have others despite repeated warnings from Washington. Northern Trust Asset Management issued a commentary on February 14, just 10 days ago, assigning a 10% probability of full invasion. The future is hard to predict and experts often get it wrong. Our approach is to build portfolios that produce successful outcomes for our clients across a wide range of possible geopolitical and economic outcomes rather than to maximize value in the one outcome we think most likely. This leads to diversification. 

Let’s consider how markets have reacted to past geopolitical events. The Northern Trust commentary looks at 21 geopolitical events post 1940. They report that, on average, the market recovered in an average of 37 days (coincidentally, the longest recovery happened to be a Russian led event – the launch of Sputnik – which took 215 days). They observe “Historically geopolitical events do not impact financial markets for long unless the market outlook fundamentally changes.” That begs the question – What, if anything, has changed?

Until the Russia-Ukraine conflict captured the headlines, market anxiety was largely driven by rising inflation and how the Federal Reserve would respond. Now, sanctions against Russia will increase energy costs exacerbating inflation. There’s a difference between inflation created by rising demand (growth) and by a supply shock (Russia not selling its energy). The Fed can slow economic growth by raising borrowing costs which was the market’s outlook. Higher interest rates however do not increase the supply of energy. Higher energy costs caused by supply disruptions will also slow growth which may alter the Fed’s calculus. 

Core to our practice is a belief that market prices for stocks and bonds reflect expectations for growth and inflation rates. Prices change as the unexpected occurs. By its nature the unexpected can’t be predicted. At any point we could have unexpected changes in growth and inflation expectations. We expect stocks to do better when growth and inflation are unexpectedly rising and bonds to fare better when they unexpectedly fall. Our approach is to have both in portfolios but to varying degrees based on risk tolerance and time horizon. The recent events do not change our approach but reinforces our view. We believe in patience and a cautious approach to current events.

Earn 7%, Safely

by

Series I Savings Bonds are issued by the U.S. Treasury. They currently earn about 7% at an annualized rate through April 2022, are backed by the full faith and credit of the U.S. government and their redemption value cannot decline.  We’ll start with the catches –

Image: Series I Savings Bonds

The Catches:

  • You may only purchase $10,000 annually per Social Security number in a calendar year.
  • I Bonds are purchased directly from the U.S. Treasury via the TreasuryDirect website.  Neither we (Red Tortoise) nor you can  purchase them via Schwab,  other brokerage firms or financial institutions.
  • You must hold them for at least one year.
  • If redeemed before five years, you lose the previous three months’ interest.
  • The current rate is 7.12% annualized through April 2022. After that the rate will be different as explained below.
  • Income is subject to Federal income tax, but not state and local income taxes.   Using the money for higher education may allow you to avoid  paying federal income tax on your interest.

There are many benefits of owning I Bonds along with additional requirements. Visit the U.S. Government I Bond website for a complete description and explanation of the program. 

The interest on an I bond is a combination of

  • A fixed rate of return which remains the same throughout the life of the I bond. Currently that rate is 0%.
  • A rate based on the CPI-U (the non seasonally adjusted Consumer Price Index for all Urban Consumers for all items, including food and energy). The rate is calculated twice a year (March compared to September of the same year and September compared with the March of the following year). Over the six months ending September 2021 the CPI rose 3.56% which is over 7% annualized. This is the rate which will be credited through April 2022. The interest rate can’t go below zero and the redemption value of your I bonds can’t decline.

As a worst case illustration, consider purchasing this savings bond at the end of November and holding it for a year.  You will earn the current 7.12% annualized rate for the first 5 months at which time the rate resets. After that even if you earn nothing for the remaining 7 months, you will have earned about 2.9% which is higher than what you can earn on one-year CDs. 

Our expectation is that a Series I savings bond purchased at the end of November will earn more than 2.9%.  The 2.9% return assumes that there is no interest earned from May through November 2022 which would occur if there was no inflation from September 2021 through March 2022.  If prices rise from September 2021 through March 2022 (they have already risen 0.83% in October), the return will exceed the 2.9%.  If you cash in the bond after one year (e.g. December 1, 2022) you will forego the last 3 months of interest. 

This may seem too  good to be true.  Why are these savings bonds relatively attractive? Historically and theoretically, people expect interest rates to exceed the inflation rate.  The real rate is the amount of interest above the inflation rate one earns on risk-free (e.g. Treasury) securities.  In the past, if inflation were 3%, people would expect interest rates to be closer to 4% (a 1% real rate) than to 2% (a negative real rate).  Today we can observe negative real rates in the market for Treasury Inflation Protected Securities (TIPS).  But savings bonds do not allow for a negative real rate so their return is higher. 

Disclaimer: In addition to the other disclaimers on this site, this post is not an investment recommendation.  It is intended to bring attention to one opportunity.   Its suitability depends on many factors and it may not be appropriate for you. 

Recent Posts

Quick Links

Red Tortoise, LLC

(833) 666-1200

Contact