Stock Selloff Continues in Second Quarter; Alternatives Shine Brightly

Market Declines, Though Unnerving, Are Also Normal—and Temporary

Stocks suffered their worst first half in over 50 years. High inflation not seen in decades and uncertainty about a possible recession fueled a stock market selloff that began in the first quarter and gathered momentum in the second. The Federal Reserve embarked on an aggressive campaign to tame inflation by raising interest rates, in the hopes of reducing corporate and consumer borrowing and spending. It is unclear whether this can be done without triggering a recession, or instead lead to a more desirable soft landing for the economy. All of this has led to very disappointing returns for investors, as U.S. and foreign stocks declined -20.18% for the year as of June 30.

Stock ownership has been enormously rewarding over the long term, but it has come with a built-in cost. Along the way, stocks have experienced tremendous volatility, including some painful downturns. Fortunately, these erosions of wealth have proved temporary. As you can see from the chart below, the stock market has seen many ups and downs over the years.

Markets are cyclical by nature, and bear markets (arbitrarily defined as declines of at least 20% from their most recent high) are an inherent part of investing. Since the Great Depression of the late 1920s, the U.S. stock market has experienced 26 bear markets (the most severe of which are highlighted in red in the chart above), including a few with plunges of 50% or more. What’s the recovery rate been for these bear markets? 26 for 26 so far, and today’s high inflation and recession concerns do not remotely approach the serious economic conditions associated with many prior declines, which have also coincided with severe recessions, wars and terrorism, and even global pandemics.

We expect our clients’ stock portfolios to continue to deliver excellent long-term results, but they, too, will experience volatility in both directions. Our clients’ core stock portfolios will continue to track the markets fairly closely through thick and thin (as they’ve done again this year), with the long-term benefits of broad diversification, tax efficiency, and extremely low cost.

Bonds: The Market is Getting Crushed, But Our Bond Portfolios Were Prepared For These Conditions

While headlines tend to focus on stocks during turbulent markets, close observers know that the bigger news is what’s taking place in the bond market. As the Federal Reserve has already raised short-term rates by 1.50% this year and telegraphed a possible additional increase of 2.00% by year-end, the bond market has sold off massively. The chart below plots the return of the bond market each year dating back to 1977. While most years produce positive single digit returns, 2022 has so far been unlike any other year. Through June 30, the bond market is down -10.35%, representing the worst first half in over 40 years.

As you may recall from previous Quarter Notes, we have been anticipating high inflation and a rising interest rate environment. To prepare for this scenario, which is typically detrimental for bond values, we have kept our clients’ bond maturities short and identified more attractive niche segments within the bond market. These moves were designed to reduce the price erosion that occurs when interest rates rise. We made two additional trades this year to further reduce the bonds’ interest rate sensitivity and to increase their credit quality. This strategy has enabled our clients’ bond portfolios to weather the storm that hit the bond market this year. Down approximately -3.66% in the first half, our clients’ bonds have outperformed the bond market by around 6.69%.

Alternatives: Shining Brightly In Turbulent Times

While nearly all major asset categories are down sharply this year, one of the few positive performers is the private credit market (which consists primarily of asset classes like private corporate and real estate lending). We have noted the performance of this market segment over the past few Quarter Notes, as its return has been consistent and robust.

Beginning in the summer of 2020, we altered the composition of our alternative asset portfolio to consist almost entirely of private credit opportunities. This move has paid off handsomely, as this allocation has provided exposure to a very valuable asset class that is not correlated to the rest of the market and has delivered solid positive returns at a time of massive declines in the traditional stock and bond markets.