Dear Clients and Friends,
As I write this letter, the stock market has risen 9% off its October 12th low, in an attempt to loosen the bear’s grip. Will it succeed? I do not know. It could be what is called a “bull trap.” This happens when bullish investors get head faked into thinking the market is entering a sustained rally, only to subsequently retreat again. That is what happened over the summer, when the market rallied 17% off its June 17th low and then gave it all back in late August through mid-October.
How can you distinguish between a bull trap and a sustained rally? You really can’t because they look the same while you are on the upswing and looking ahead, until they definitively look different in the rear view mirror. This is why market timers are likely to miss out on the real recovery: as they attempt to sidestep the bull traps, they inevitably sidestep the initial and often steepest part of the recovery.
In my summer letter I wrote about how all bear markets end and most have ended sooner rather than later. I sure wish I knew how many head fakes it would take before the real recovery kicks in. Whether it is two, three, or five it will be a finite number and I take consolation in the fact that our clients’ portfolios are dressed for the weather and don’t have short-term cash needs that need to be covered by cashing out long-term investments. As I was reminded once at a German wedding to which I did not bring rain gear: there is no such thing as bad weather just bad clothes.
Es gibt kein schlechtes wetter, nur die falsche kleidung!
So, I can’t distinguish between a bull trap and a rally that will ring in the recovery, nor can I tell you how long this bear market will last or how low it might go. Yet the number one question I am asked is: “what do you think is going to happen?” I get it. I ask myself that question too; and I pose it to others. Therefore, it is only fair that I answer that question, even if we all know that I am no oracle:
I think in terms of probabilities, so I don’t worry about picking a singular outcome, but rather a few distinct outcomes and the chances of them coming to pass:
Scenario 1. The World Comes to an End. Probability: greater than zero, but very, very small. No financial advisor needed. I would define “World Comes to an End,” as a collapse of the global financial system that renders currency useless and reverts us to a barter system. I am not talking about a strategic nuclear strike, as I have no interest or expertise to venture into that topic, other than to say that probability I asses as infinitesimally small. Just uttering the question “what would be a good portfolio in the event of a nuclear exchange with Russia?”, confirms the futility of pursuing a nuclear-proof investment strategy.
I don’t think you need to prepare your portfolio for Scenario 1. If this is within your planning spectrum, I would just focus on acquiring skills that can be traded – like growing food, making clothes, or carpentry –, building a barter network, and perhaps investing in a safe room and taking self-defense classes.
Scenario 2. We have a repeat of the Great Financial Crisis. Probability: Less than 5%. In 2008, the financial system did come close to collapse. However, because the system could be saved by people willing to save it, perhaps it was less close to imploding than it appeared. I don’t think 2022 is 2008. Or in Wall Street speak, this bear market looks more like a cyclical event than a structural event. Translation: the plumbing is working. This is not a financial crisis, but the end of an expansionary cycle, brought to its knees by higher interest rates that are designed to slow down an overheating (inflationary) economy.
History suggests that cyclical bears are shorter lived than structural bear markets. If, however, this is some version of 2008, it could make sense to rebalance more towards safe assets if you have a portfolio that needs to distribute cash and does not have at least 3 years of cash needs covered by safer assets.
Scenario 3. We exit the bear market before June 1, 2023. Probability: 50-60%. I think this is the most likely scenario. It would mean we are in a cyclical bear market brought on by rate hikes that is followed by a recession. Inflation would subside as the result of a recession, bonds would once again provide downside protection with rate hikes on ice, and stocks would find their footing well before the recession is over, as markets are forward looking. It is a subtle distinction, but markets are always forward looking, even if they don’t know what lies ahead. Eventually they get it right, which can only be confirmed after the fact. My clients’ portfolios are positioned for this likelihood, with plenty of potential upside built in and enough safe assets to last well beyond mid-2023.
S&P 500 returns subsequent to a bear market declining 25%: only 2008 saw additional losses 12-months on
Scenario 4. We exit the bear market after June 1, 2023. Probability 30-40%. Basically, this scenario implies that my base case of a quick recovery does not materialize. Inflation lingers for longer and perhaps we see stagflation, which is economic stagnation, combined with inflation. This could happen if supply chains are not repaired because Covid lockdowns in China continue, oil & gas supply continues to be constrained by the war in Ukraine and OPEC, and the semiconductor industry is hampered by US-China tensions.
A variation on Scenario 4, but less likely in the event of stagflation, is that the housing market has a deeper downturn than say 20% and consumer spending is impaired as a result of the wealth effect going into reverse. I.e., people feel less comfortable spending money because their biggest asset – their primary residence – is losing value.
If this scenario comes to pass, our client portfolios are still ok. It just means “lower for longer.” I am not more than a dabbling surfer, but the sport makes for good analogies: We do not surf waves that are so high we can’t hold our breath long enough to make it through the wipeout.
Hold your breath!
As some of my readers know from personal experience, a recent podcast, or my writing, I work with clients wishing to retire overseas. It has been a real pleasure and quite fun helping my retire-abroad clients, and I hope to follow their lead some day in the (distant) future. But your portfolio and your passport don’t have to wait for retirement to meet up. Perhaps one of your financial goals is funding a college education for your children. As it turns out, this goal might be easier met overseas. Attending schools like Paris-Sorbonne was once the exclusive domain of America’s wealthy. Today, it is a way to save on the cost of a college education. Continuing with the Sorbonne example, it will cost you $3,800 in annual tuition fees. An on-campus meal costs you EUR 3.30 and student accommodation ranges from $500-$1,000 per month. So, all in, tuition + room & board may add up to $18,000 per year, give or take. By comparison, in-state tuition at UC Davis – just to pick a random example of a reasonably affordable and reputable university – costs $15,000 and if you add in in room & board you top $30,000. That’s 50% more expensive than going to one of France’s top universities.
France is particularly juicy for Americans, as is apparent from the 50% increase of American students enrolled there for the 2021-2022 school year, compared to the prior year. In Germany tuition is free for international students, though it doesn’t appear to be as popular as France. But even the more expensive countries like the UK – the top universities have comparable tuition to the US average of $35,000, according to the Education Data Initiative – and the Netherlands ($15,000 annual tuition) have seen a strong influx of American students, with annual enrollment up 28% and 16%, respectively.
Beyond cost, it is easier to get into some of the top schools in Europe than those in the US. Harvard and Stanford have low single digit acceptance rates, whereas Oxford and St Andrews (UK) accept 14% and 41%, respectively. Moreover, the enrollment process tends to be easier. Typically, you just need to provide one cover letter, resume and transcript to all universities you apply to. Let it suffice to say, it’s a bit more cumbersome in this country.
Even if the annual cost is a break-even, say at St. Andrews in the UK, it is still cheaper if you go there for your whole college career. That’s because you can get your degree in 3 years instead of 4. However, if I have one bit of advice to incoming students: don’t try to graduate a year early, try to stretch it out a year if your parents (my clients) don’t cut you off!
Interested? The trickiest part might very well be convincing your children that it was their idea, not yours, lest they dismiss out of hand what is sure to be the experience of a lifetime.
Better Cash Returns
With higher interest rates, cash management – versus just leaving the money in your bank account – is starting to make sense. In recent newsletters, I highlighted savings/investment vehicles such as i-Bonds, shorter-term Treasuries, high yield savings accounts, and CDs. The fact remains that it can be a bit of a hassle to optimize your cash return. Moreover, the average savings products offered by the big banks tend to not be very attractive. I looked at Bank of America’s deposit interest rates for the Bay Area effective October 28th and found that savings accounts pay 0.04% and a 1-year CD pays 2.47% (APY 2.5%). Customer deposits at big banks are sticky – because of switching costs – which is why they can get away with these low deposit rates. However, if you are willing to “step out” you can probably do much better and it doesn’t mean you have to close your bank account.
I have started to offer cash management to my clients as a value-added service, at no charge. If this is of interest to you, don’t hesitate to reach out. As a general rule, I will say that optimizing for yield is only worth the effort if the dollars add up to a meaningful amount. Of course, “meaningful,” is a subjective term, but there is some friction between optimizing for return and minimizing for hassle.
Someone flipped the switch in Northern California and the late warm weather has given way to crisp mornings and the occasional sweater sighting. Lots of excitement in the air: Halloween, elections, and the prospect of a decent stock market. I don’t recommend investing based on the season, but the fourth quarter has been a positive one 80% of the time since 1950. Moreover, what is the holiday season if not hopeful anticipation.
Jan P. Schalkwijk, CFA
JPS Global Investments