Stay the Course

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So far 2022 has been tough for investors:

  • S&P 500 index is down about 13% YTD
  • US Aggregate Bond index (corporate investment grade bonds) down about 9% YTD
  • Bitcoin down about 35% YTD
  • EAFE index (developed international stocks) down about 12%
  • EEM index (emerging markets stocks) down about 12%

Now is the time when many question their investments. People wonder why they put hard earned cash into investments that fall month after month. It’s defeating. Even conservative investments like bonds are negative. And supposed alternative investments like Bitcoin haven’t provided diversification from stocks. What should investors do? Here’s what I’m doing.

Financial Policy Statement

Reviewing our Family Financial Policy Statement. Focusing on the Investment Strategy section. A couple important points from ours:

  • Keep at least 70% of our portfolio in S&P 500 index funds even during more conservative retirement years. (Core and satellite investment approach)

We are passive U.S. equity index fund investors. We won’t stray from this proven strategy, no matter how the market performs. This is due to the low cost and self-cleansing nature of index funds. And large US-based companies are globally diversified enough for us. Read my deep dive on the S&P 500 for more info.

We trust the resilience and innovation of companies in competition. Industries and companies rise and fall. But there will always be upstart competitors to take market share and make huge profits. US equity performance is enough to meet our long-term return needs.

Sarah and I agreed that the time to make allocation changes is not when the market is down. In my previous career as a financial advisor, market downturns were always difficult. Clients called in concerned about their portfolios. Asking about dumping strategies that were down. This is the time to stay the course. You chose the strategy for various reasons. Now you should review why, how it fits into your long-term plan and Stay the Course.

Unfortunately, sometimes investors are unable to Stay the Course. During these times we find out how well we grasped the plan and understood the risks. Early in my life I learned a valuable, but expensive, investing lesson. Read my cautionary tale of market timing during the Great Recession. I have now determined not make allocation changes during downturns. But it still hurts to see losses. How do you overcome the feeling of wanting to do something? Here’s what I’m considering.

Stock Market Valuations

Stocks were expensive, now they’re on sale as measured by PE (Price to Earnings) ratios:

Source: S&P 500 PE Ratio by Year (multpl.com)

PE ratios measure how expensive stocks are relative to earnings. With a PE ratio of 20, at its current price and annual earnings, it would take 20 years of earnings (net income) to recoup company’s market value today. In the table above you can see that the S&P 500 PE ratio is back to levels not seen since 2015. Down 44% since 1/1/2021! Today’s S&P 500 PE is much more in line with historical averages:

We are nowhere near the go-go years of the late 1990s or the early 2000s. The frothy high PE ratios contributed to steep market declines in 2008-2009. Year after year of PE ratios in the high 20s, 30s and beyond. And then the party ended. We may be experiencing that now. But the good news is that the PE ratios weren’t as high for as long this time. I’m optimistic the crash won’t be as steep or as long either.

For every dollar we invest in the S&P 500, we’re paying 45% less for those company earnings than in January 2021. If you found 45% off an item you planned to buy, how would you feel?

Time Horizon

Another reason I’m feeling ok these days is Time Horizon.

Markets ebb and flow. As long as you don’t need the money right now, you can ride the waves. The boat is a little rocky right now, but sturdy. Don’t jump off!

Our family is 10 years from using intermediate term money and longer for most retirement assets. So, changes in PE ratios and market downturns don’t worry me much in the short term. Who knows where PE ratios and markets will be in 10 years? Your guess is as good as mine. If we were within 3 years of using the money, I’d be a lot more concerned. Invest understanding the risks and with appropriate Time Horizon.

Increase Your Savings Rate

Now is a great time to increase your savings rate if possible. Any dollars invested when the market is down 15-20% are far more valuable to you in the future. They smooth out contributions made during higher markets, lowering your average purchase price.

The job market remains strong with record low unemployment. Currently, widespread layoffs aren’t happening. Baby boomers are retiring. Major US companies have performed strong with great quarters. So far, much of this market correction is based on mean reversion of PE ratios to lower multiples. High current inflation could be accelerating this mean reversion. Growth companies (reinvesting most profits back into growing their business) have high PE ratios. Investors hope future company earnings escalate. But with high inflation, current income is worth more than future income. Future dollars will have much lower purchasing power.

These are my thoughts on the current situation and why I’m feeling ok about the markets right now. If you feel very concerned, I urge you to review your investment strategy. And if you haven’t created an investment strategy, you need one for the next market correction. Review time horizon for the different investment buckets you might have. If you don’t have buckets with different time horizons, consider it. We use a 3-bucket strategy:

  • cash
  • intermediate term investments (5-15 years)
  • long-term investments (15+ years)

Try to relax. Remind yourself of the good things in your life. And listen to this video.

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