Coping with Market Volatility: Cash Can Help Manage Your Mindset
Holding an appropriate amount of cash in a portfolio can be the financial equivalent of taking deep breaths to relax. It could enhance your ability to make thoughtful investment decisions instead of impulsive ones. Having a cash position coupled with a disciplined investing strategy can change your perspective on market volatility. Knowing that you’re positioned to take advantage of a downturn by picking up bargains may increase your ability to be patient.
That doesn’t mean you should convert your portfolio to cash. Selling during a down market locks in any investment losses, and a period of extreme market volatility can make it even more difficult to choose the right time to make a large-scale move. Watching the market move up after you’ve abandoned it can be almost as painful as watching the market go down. Finally, be mindful that cash may not keep pace with inflation over time; if you have long-term goals, you need to consider the impact of a major change on your ability to achieve them.
Having a cash cushion in your portfolio isn’t necessarily the same as having a financial cushion to help cover emergencies such as medical problems or a job loss. An appropriate asset allocation that takes into account your time horizon and risk tolerance may help you avoid having to sell stocks at an inopportune time to meet ordinary expenses.
Remember that we’re here to help and to answer any questions you may have.
All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy will be successful.
Asset allocation is a method used to help manage investment risk; it does not guarantee a profit or protect against investment loss.
Although there is no assurance that working with a financial professional will improve investment results, a professional can evaluate your objectives and available resources and help you consider appropriate long-term financial strategies.
Coping with Market Volatility: Could This Be a Chance to Rebalance at a Discount?
In a volatile market, it’s easy to allow your emotions to influence your investment decisions. But if you can keep your cool while those around you are losing theirs, you may be able to take advantage of potential opportunities.
One way to do that is by reviewing your portfolio to determine if it’s time to rebalance your asset allocation or modify your level of diversification.
Rebalancing means adjusting your portfolio to get it back to your original target allocation. In today’s market, it often makes sense to first determine whether that original target is still appropriate for your needs. If it makes sense to return to your original allocation or establish a new one, there are two ways to proceed. You can sell securities in some asset classes and invest the proceeds in others, and/or redirect new investment dollars into selected asset classes until the target allocation is reached.
If your current allocation is appropriate, but there are concerns with your overall level of diversification, it’s possible to shift some investments within a given asset class. Keep in mind that selling securities can have tax consequences, depending on account type.
Asset allocation and diversification can help manage investment risk and might better position your portfolio for the future. The silver lining to broad-based market turmoil is that you may be able to acquire some investments at a discount relative to what you would have paid when the market was up.
The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Asset allocation and diversification are methods used to help manage investment risk; they do not guarantee a profit or protect against investment loss.
Although there is no assurance that working with a financial professional will improve investment results, a professional can evaluate your objectives and available resources and help you consider appropriate long-term financial strategies.
Coping with Market Volatility: Continuing to Invest May Help You Stay on Course
In the current market environment, the value of your holdings may be fluctuating widely — and it’s natural to feel tentative about further investment. But regularly adding to an account that’s designed for a long-term goal may cushion the emotional impact of market swings. If losses are offset even in part by new savings, the bottom-line number on your statement might not be quite so discouraging. And a basic principle of investing is that buying during a down market may help your portfolio grow when the market turns upward again.
If you are investing a specific amount regularly regardless of fluctuating price levels (as in a typical workplace retirement plan), you are practicing dollar-cost averaging. Using this approach, you may be getting a bargain by continuing to buy when prices are down. However, you should consider your financial and psychological ability to continue purchases through periods of fluctuating price levels or economic distress; dollar-cost averaging loses much of its benefit if you stop just when prices are reduced. And it can’t guarantee a profit or protect against a loss.
If you can’t bring yourself to invest during this period of uncertainty, try not to let the volatility derail your savings program completely. If necessary, to help address your concerns, you could continue to save, but direct new savings into a cash-alternative investment until your comfort level rises. Though you might not be buying at a discount, you could be accumulating cash reserves that could be invested when you’re ready. The key is not to let short-term anxiety make you forget your long-term plan. I am here to help and to answer any questions you may have.
All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy will be successful.
Stay Safe,
Joseph A. Smith, CPA/PFS, J.D., AEP®
Member
Bear Markets Come and Go
The longest bull market in history lasted almost 11 years before coronavirus fears and the realities of a seriously disrupted U.S. economy brought it to an end.
If you are losing sleep over volatility driven by a cascade of disheartening news, it may help to remember that the stock market is historically cyclical. There have been 10 bear markets (prior to this one) since 1950, and the market has recovered eventually every time.
Bear markets are typically defined as declines of 20% or more from the most recent high, and bull markets are increases of 20% or more from the bear market low. But there is no official declaration, so in some cases there are different interpretations regarding when these cycles begin and end.
On average, bull markets lasted longer (1,955 days) than bear markets (431 days) over this period, and the average bull market advance (172.0%) was greater than the average bear market decline (-34.2%).
| Bear Markets Since 1950 | Calendar Days to Bottom | U.S. Stock Market Decline (S&P 500 Index) |
| August 1956 to October 1957 | 446 | -21.5% |
| December 1961 to June 1962 | 196 | -28.0% |
| February 1966 to October 1966 | 240 | -22.2% |
| November 1968 to May 1970 | 543 | -36.1% |
| January 1973 to October 1974 | 630 | -48.2% |
| November 1980 to August 1982 | 622 | -27.1% |
| August 1987 to December 1987 | 101 | -33.5% |
| July 1990 to October 1990 | 87 | -19.9%* |
| March 2000 to October 2002 | 929 | -49.1% |
| October 2007 to March 2009 | 517 | -56.8% |
*The intraday low marked a decline of -20.2%, so this cycle is often considered a bear market.
The bottom line is that neither the ups nor the downs last forever, even if they feel as though they will. During the worst downturns, there were short-term rallies and buying opportunities. And in some cases, people have profited over time by investing carefully just when things seemed bleakest.
If you’re reconsidering your current investment strategy, a volatile market is probably the worst time to turn your portfolio inside out. Dramatic price swings can magnify the impact of a wholesale restructuring if the timing of that move is a little off. A well-thought-out asset allocation and diversification strategy is still the fundamental basis of good investment planning. Changes in your portfolio don’t necessarily need to happen all at once. Try not to let fear derail your long-term goals.
The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Asset allocation and diversification are methods used to help manage investment risk; they do not guarantee a profit or protect against investment loss.
The S&P 500 is an unmanaged group of securities that is considered to be representative of the U.S. stock market in general. The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Past performance is not a guarantee of future results. Actual results will vary.
Source: Yahoo! Finance, 2020 (data for the period 6/13/1949 to 3/12/2020)
If you are losing sleep over volatility driven by a cascade of disheartening news, it may help to remember that the stock market is historically cyclical.
The Coronavirus and the Global Economy
As of February 26, 2020, the death toll from COVID-19 — the official name of the coronavirus first reported in Wuhan, China — passed 2,700, while the number of confirmed cases exceeded 80,000. Almost all were in China, most of them in Wuhan and the surrounding Hubei province. But more than 2,500 cases, including 46 deaths, had been reported in almost 40 other countries. A surge of cases and deaths in South Korea, Italy, and Iran caused new concern that the virus may be difficult to contain.1
Cities under lockdown
By mid-February, at least 150 million people in China were under restrictions affecting when they could leave their homes, and more than 760 million — about 10% of the world’s population — lived in communities under some form of travel restriction.2 Most global airlines cancelled service to and from China, disrupting tourism and business travel.3
The Chinese government enacted restrictions around the time of the Lunar New Year celebration, during which many businesses were closed, lessening the immediate impact. However, as factories and other businesses remained closed after the holiday, the loss of Chinese production and consumer spending began to take a toll on global businesses.4
Lost supply and demand
Many U.S. technology companies have manufacturing operations in China while also selling to Chinese businesses and/or consumers. Companies with substantial exposure to the slowdown in China include big tech brands such as Apple, Dell, Hewlett Packard, Intel, and Qualcomm, as well as many smaller tech businesses.5-6
Vehicle manufacturers throughout the world rely on Chinese-made parts, and many have plants in China. General Motors (which sells more cars in China than in the United States), Ford, Toyota, BMW, Honda, Nissan, Tesla, and Volkswagen all suspended operations in China, while Hyundai and Renault closed plants in South Korea, and Fiat Chrysler closed a plant in Serbia, all due to parts issues.7-9
Global retailers including Apple, Ikea, Levi Strauss, McDonald’s, KFC, and Starbucks temporarily closed stores in China.10-11
In addition to disruptions in the global supply chain and Chinese consumer market, the tourism industry in the United States, Europe, and other Asian countries may be hard hit by the absence of Chinese tourists. One estimate suggests a loss of almost $6 billion in U.S. airfares and tourist spending.12
Although it is too early to measure the full effect on global business, a private report released on February 21 indicated that U.S. business activity had slowed in February to the lowest level in six years, with the biggest hit to the service sector, where travel and tourism are major components. The report also indicated a sharp drop in Japanese business due to lost tourism and export orders. Exports were down in Germany, but the initial impact on the eurozone was minimal.13
Oil pressure
China is the world’s largest importer of crude oil, and Wuhan is a key center of its oil and gas industry. The prospect of lower demand drove oil prices into bear-market territory — defined as a drop of 20% from a recent high — in early February. Prices rose later in the month but dropped again with news that the virus may be spreading. Natural gas prices have also been hit by the prospect of lower growth in Asia. While lower prices may be good for U.S. consumers, oil-exporting nations, including the United States, will face lower revenues, and energy companies that are already on rocky ground may struggle.14-17
Market reaction
In late January, the Dow Jones Industrial Average lost 3.7%, due in large part to concerns about the virus, wiping out gains for the year.18 The market bounced back quickly and set new records in February, but weak business news and a rash of cases outside of China sent it plunging, with a loss of almost 8% from February 19 to 25.19-20 This suggests that the market may be volatile for some time and that future direction might depend on the progress of disease control and emerging information on the impact of the virus on U.S. and global businesses.
Global growth outlook
Anything that affects China, the world’s second-largest economy, can have a powerful ripple effect around the globe. An early February report by Moody’s Analytics estimated that every 1 percentage point reduction in China’s real gross domestic product (GDP) will reduce global GDP outside China by 0.4%. The report projected that disruption caused by the virus would cut more than 2 percentage points off China’s GDP growth in the first quarter of 2020 and result in a loss of 0.8% growth for the year. This in turn would cause a loss of about 0.3% in annual global GDP growth outside China and about 0.15% in the United States. Moody’s lowered its projection for 2020 global growth from around 2.8% to 2.5%.21
In a February 16 forum, Kristalina Georgieva, managing director of the International Monetary Fund, was more optimistic, suggesting that the virus might shave 0.1% to 0.2% off the IMF’s 2020 global growth projection of 3.3%. Georgieva cautioned that there was still a “great deal of uncertainty” and emphasized that the economic damage depends on the length of the disruption. If the disease “is contained rapidly,” she said, “there can be a sharp drop and a very rapid rebound.”22
The immediate concerns are to combat the virus on a human level and normalize business activity, but the outbreak could accelerate the shift of U.S. and European manufacturing away from China, creating a more diversified global supply chain.23-24 The situation remains in flux, so you may want to keep an eye on further developments.
All investments are subject to market volatility and loss of principal. Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.
1) South China Morning Post, February 26, 2020
2) The New York Times, February 18, 2020
3-4, 21) Moody’s Analytics, February 2020
5, 23) The Wall Street Journal, February 18, 2020
6, 10) Los Angeles Times, February 4, 2020
7) Forbes, February 12, 2020
8) Car and Driver, February 4, 2020
9) The Wall Street Journal, February 14, 2020
11-12, 14-15, 18) The Wall Street Journal, February 3, 2020
13) The Wall Street Journal, February 21, 2020
16, 20) The Wall Street Journal, February 25, 2020
17) The Wall Street Journal, February 7, 2020
19) The New York Times, February 20, 2020
22) Bangkok Post, February 17, 2020
24) South China Morning Post, February 18, 2020
Upside Down: What Does the Yield Curve Suggest About Growth?
On August 14, 2019, the Dow Jones Industrial Avenue plunged 800 points, losing 3% of its value in its biggest drop of the year. The Nasdaq Composite also lost 3%, while the S&P 500 lost 2.9%.1
The slide started with bad economic news from Germany and China, which triggered a flight to the relative safety of U.S. Treasury securities. High demand briefly pushed the yield on the benchmark 10-year Treasury note below the two-year note for the first time since 2007.2 This is referred to as a yield curve inversion, which has been a reliable predictor of past recessions. The short-lived inversion spooked the stock market, which recovered only to see the curve begin a series of inversions a week later.3
From short to long
Yield relates to the return on capital invested in a bond. When prices rise due to increased demand, yields fall and vice versa. The yield curve is a graph with the daily yields of U.S. Treasury securities plotted by maturity. The slope of the curve represents the difference between yields on short-dated bonds and long-dated bonds. Normally, it curves upward as investors demand higher yields to compensate for the risk of lending money over a longer period. This suggests that investors expect stronger growth in the future, with the prospect of rising inflation and higher interest rates.
The curve flattens when the rates converge because investors are willing to accept lower rates to keep their money invested in Treasuries for longer terms. A flat yield curve suggests that inflation and interest rates are expected to stay low for an extended period of time, signaling economic weakness.
Parts of the curve started inverting in late 2018, so the recent inversions were not completely unexpected. However, investors tend to focus on the spread between the broadly traded two-year and 10-year notes.4
Inversion as an indicator
An inversion of the two-year and 10-year notes has occurred before each recession over the past 50 years, with only one “false positive” in that time. It does not indicate timing or severity but has reliably predicted a recession within the next one to two years. A recent Federal Reserve study suggested that an inversion of the three-month and 10-year Treasuries — which occurred in March and May 2019 — is an even more reliable indicator, predicting a recession in about 12 months.5
Is it different this time?
Some analysts believe that the yield curve may no longer be a reliable indicator due to the Federal Reserve’s unprecedented balance sheet of Treasury securities — originally built to increase the money supply as an antidote to the Great Recession. Although the Fed has trimmed the balance sheet, it continues to buy bonds in large quantities to replace maturing securities. This reduces the supply of Treasuries and increases pressure on yields when demand rises, as it has in recent months.6
At the same time, the Fed has consistently raised its benchmark federal funds rate over the last three years in response to a stronger U.S. economy, while other central banks have kept their policy rates near or below zero in an effort to stimulate their sluggish economies. This has raised yields on short-term Treasuries, which are more directly affected by the funds rate, while increasing global demand for longer-term Treasuries. Even at lower rates, U.S. Treasuries offer relatively safe yields that cannot be obtained elsewhere.7
The Fed lowered the federal funds rate by 0.25% in late July, the first drop in more than a decade. While this slightly reduced short-term Treasury yields, it contributed to the demand for long-term bonds as investors anticipated declining interest rates. When interest rates fall, prices on existing bonds rise and yields decline. So the potential for further action by the Fed led investors to lock in long-term yields at current prices.8
Economic headwinds
Even if these technical factors are distorting the yield curve, the high demand for longer-term Treasuries represents a flight to safety — a shift of investment dollars into low-risk government securities — and a pessimistic economic outlook. One day after the initial two-year/10-year inversion, the yield on the 30-year Treasury bond fell below 2% for the first time. This suggests that investors see decades of low inflation and tepid growth.9
The flight to safety is being driven by many factors, including the U.S.-China trade war and a global economic slowdown. Five of the world’s largest economies — Germany, Britain, Italy, Brazil, and Mexico — are at risk of a recession and others are struggling.10
Although the United States remains strong by comparison, there are concerns about weak business investment and a manufacturing slowdown, both weighed down by the uncertainty of the trade war and costs of the tariffs.11 Inflation has been persistently low since the last recession, generally staying below the 2% rate that the Fed considers optimal for economic growth. On the positive side, unemployment remains low and consumer spending continues to drive the economy, but it remains to be seen how long consumers can carry the economic weight.12
Market bounceback
Regardless of further movement of the yield curve, there are likely to be market ups and downs for many other reasons in the coming months. Historically, the stock market has rallied in the period between an inversion and the beginning of a recession, so investors who overreacted lost out on potential gains.13 Of course, past performance does not guarantee future results. While economic indicators can be helpful, it’s important to make investment decisions based on your own risk tolerance, financial goals, and time horizon.
U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest. The principal value of Treasury securities fluctuates with market conditions. If not held to maturity, they could be worth more or less than the original amount paid. The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. The performance of an unmanaged index is not indicative of the performance of any specific security. Individuals cannot invest directly in any index.
1-2, 13) The Wall Street Journal, August 14, 2019
3) CNBC.com, August 23, 2019
4-5) Reuters, August 13, 2019
6) Forbes.com, August 16, 2019
7-9) The Wall Street Journal, August 16, 2019
10, 12) CNN, August 14 and 18, 2019
11) Reuters, July 1, 2019
Prioritizing Savings for College and/or Retirement
The November 2018 AAII Journal, American Association of Individual Investors, included an interview with Harold Pollack. The discussion was about “The Index Card: Why Personal Finance Doesn’t Have to Be Complicated” (Portfolio, 2016). He wrote it with Helaine Olen.
The following passage is from a response to a question about prioritizing where to direct money.
“There are different ways that people can do this. You should match your method with what gives you the mojo to actually do it.” … “Suppose I’m a young parent and I’m choosing between prioritizing my retirement and savings for my kid’s college. Mathematically, retirement tends to be the answer for most people, but your kid’s college gives you mojo in a different way. If you’re walking with your seven-year-old daughter in a store and you see a sweet $500 camera lens, you can point to it, and tell your daughter: “I really want that lens, I’m going to put that $500 toward paying for your college. Maybe some day you’ll do that for your daughter.’ That’s powerful and motivating.”
2018 Nov.Beyond-the-Index-Card-Implement
2018 Year-end opportunity
The end of the year presents a unique opportunity to look at your overall personal financial situation. With factors like tax reform, life changes or just working towards your goals, end of year is an especially important time to review things. Weaving together your prior planning, subsequent changes and revised goals helps you stay on course. Following are some things you consider before the year ends.
Income Tax Planning –Ensure you are implementing tax reduction strategies like maximizing your retirement plan contributions, tax loss harvesting in portfolios and making charitable contributions can all help reduce current and future tax bills. It is also good to review your current year tax projection based on your income and deductions year to date and how that may be different from before.
Estate Planning – Examine your current estate plan to visualize what would happen to each of your assets and how the current estate tax law will impact you. Be sure that your estate planning documents are up to date – not just your will, but also your power of attorney, health care documents, and any trust agreements and beneficiary designations are in line with your desires. If you have recently been through a significant life event such as marriage, divorce or the death of a spouse, this is especially important right now.
Investment Strategy– The recent market volatility has some people feeling uncomfortable. Market declines are a natural part of investing, and understanding the importance of maintaining discipline during these times is imperative. Regular portfolio rebalancing will allow you to maintain the appropriate amount of risk in your portfolio. And, if you are retired and living off your portfolio, you also want to maintain an appropriate cash reserve to cover living expenses for a certain period of time so that you do not have to sell equities in a down market.
Charitable Giving – There are many ways to be tax efficient when making charitable gifts. For example, donating appreciated stock could make sense in order to avoid paying capital gains taxes. Further, you may want to consider bunching charitable deductions by deferring donations to next year or making your planned 2019 donations ahead of time. If the numbers are large enough, you might even consider a private foundation or donor advised fund for your charitable giving. If you are at least 70.5 you may want to consider Qualified Charitable Distributions (QCD) from your IRA.
Retirement Planning –Think about your future when working becomes optional. Whether you expect a typical full retirement or a career change to something different, determining an appropriate balance between spending and saving, both now and in the future is important. There are many options available for saving for retirement, and we can help you understand which option is best for you. If you are at least 70.5 you should be sure your 2018 Required Minimum Distributions (RMD) from your IRAs are paid before year-end. Qualified Charitable Contributions, up to $100,000, will be treated as part of your RMD but not taxed.
Cash Flow Planning – Review your 2018 spending and plan ahead for next year. Understanding your cash flow needs is an important aspect of determining if you have sufficient assets to meet your goals. If you are retired, it is particularly important to maintain a tax efficient withdrawal strategy to cover your spending needs. If you have not yet reached age 70.5, it is prudent to ensure you are making tax-efficient withdrawal decisions. If you are over age 70.5 make sure you are taking your RMDs because the penalties are significant if you don’t.
Risk Management – It is always a good idea to periodically review your insurance coverages in various areas. Recent catastrophic events like hurricanes serve as a powerful reminder to make sure your property insurance coverage is right for your needs. If you are in a Federal disaster area, there are additional steps necessary to recover what you can and explore the tax treatment of casualty losses. Other areas of risk management that may need to be revisited include life and disability insurance.
Education Funding – Funding education costs for children or grandchildren is important to many people. While the increase in college costs have slowed some lately, this is still a major expense for most families. It is important to know the many different ways you can save for education to determine the optimal strategy. Often, funding a 529 plan comes with tax benefits, so making contributions before the end of the year is key. With the added flexibility of funding k-12 years (set at a $10,000 limit), 529 accounts become even more advantageous.
Elder Planning – There are many financial planning elements to consider as you age, and it is important to consider these things before it’s too late. Having a plan in place for who will handle your financial affairs should you suffer cognitive decline is critical. Making sure your spouse and/or family understands your plans will help reduce future family conflicts and ensure your wishes are considered.
The decisions you make each year with your personal finances will have a lasting impact. I hope this has begun to generate some insight to areas of your personal finance that need attention. Please contact me if you have any comments or questions.
Changing Market: Municipal Bonds After Tax Reform
January is typically a strong month for the municipal bond market, but 2018 began with the worst January performance since 1981, driven by rising interest rates and uncertainty over changes in the Tax Cuts and Jobs Act (TCJA).1 The muni market stabilized through April 2018, but uncertainty remains.2 The tax law changed the playing field for these investments, which could affect supply and demand.
When considering these dynamics, keep in mind that bond prices and yields have an inverse relationship, so increased demand generally drives bond prices higher and yields lower, and vice versa. Any such changes directly affect the secondary market for bonds and might also influence new-issue bonds. If you hold bonds to maturity, you should receive the principal and interest unless the bond issuer defaults.
Tax rates and deduction limits
Municipal bonds are issued by state and local governments to help fund ongoing expenses and finance public projects such as roads, water systems, schools, and stadiums. The primary appeal of these bonds is that the interest is generally exempt from federal income tax, as well as from state and local taxes if you live in the state where the bond was issued. Because of this tax advantage, a muni with a lower yield might offer greater value than a taxable bond with a higher yield, especially for investors in higher tax brackets.
The lower federal income tax rates established by the new tax law would cut into this added value, but the difference is relatively small and unlikely to affect demand. Many taxpayers, especially in high-tax states, may find munis even more appealing to help replace deductions lost to other TCJA provisions, including the $10,000 cap for deductions of state and local taxes.3 Tax-free muni interest can help lower taxable income regardless of whether you itemize deductions.
The large corporate tax reduction from a top rate of 35% to 21% is likely to have a more significant effect on demand for munis. Corporations, which own a little less than 30% of the muni market, may hold on to bonds they currently own but become more selective in purchasing future bonds.4
A tightening market
The supply of new municipal bonds dropped after the fiscal crisis as local governments became more cautious about borrowing. The TCJA further tightened the market by eliminating “advanced refunding” bonds, issued to replace older bonds at lower interest rates, which have accounted for about 15% of new issues.5
This is expected to reduce the supply of bonds for the next three years or so, but the long-term effects are unclear. If interest rates continue to climb, there is less to gain by replacing older bonds, but local governments may issue taxable bonds if they see an opportunity to reduce interest payments. There may also be changes to the structure of future muni issues.6
Risk and rising interest rates
Munis are considered less risky than corporate bonds and less sensitive to changing interest rates than Treasuries, making them an appealing middle ground for many investors. For the period 2007 to 2016, which includes the recession, the five-year default rate for municipal bonds was 0.15%, compared with 6.92% for corporate bonds. Most of those defaults were related to severe fiscal situations such as those in Detroit and Puerto Rico. The five-year default rate for investment-grade bonds (rated AAA to BBB/Baa) was just 0.05%.7
Treasuries, which are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, are considered the most stable fixed-income investment, and rising Treasury yields, as occurred in early 2018, tend to put downward pressure on munis.8 However, Treasuries are more sensitive to interest rate changes, and stock market volatility makes both Treasuries and munis appealing to investors looking for stability.
Bond funds
The most convenient way to add municipal bonds to your portfolio is through mutual funds, which also provide diversification that can be difficult to create with individual bonds. Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against investment loss.
Muni funds focused on a single state offer the added value of tax deductibility for residents of those states, but smaller state funds may not offer the level of diversification found in larger states. It’s also important to consider the holdings and credit risks of any bond fund, including those dedicated to a specific state. For example, in October 2017, many state funds still held Puerto Rico bonds, which are generally exempt from state income tax but carry high credit risk.9
If a bond was issued by a municipality outside the state in which you reside, the interest may be subject to state and local income taxes. If you sell a municipal bond at a profit, you could incur capital gains taxes. Some municipal bond interest may be subject to the alternative minimum tax.
The return and principal value of bonds and bond fund shares fluctuate with changes in market conditions. When redeemed, they may be worth more or less than their original cost. Bond funds are subject to the same inflation, interest rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund’s performance. Investments offering the potential for higher rates of return involve a higher degree of risk.
Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
1, 8) CNBC, February 28, 2018
2) Bloomberg, 2018 (Bloomberg Barclays U.S. Municipal Index for the period 1/1/2018 to 4/16/2018)
3-4, 6) The Bond Buyer, February 12, 2018
5) The New York Times, February 23, 2018
7) Moody’s Investors Service, 2017
9) CNBC, October 10, 2017
Correction Time: The Market Takes a Hit
After reaching all-time highs on January 26, 2018, the Dow Jones Industrial Average and the S&P 500 went into a two-week slide that saw both stock indexes drop by more than 10%, a decline that is typically considered a market correction.1
Analysts have been saying for several years that the long, booming bull market was overvalued and due for a correction, so the drop was not a surprise in the big picture.2 And even after the 10% plunge, the Dow was up 19% over the previous 12 months, and the S&P 500 was up 12.5%.3
It’s natural to be concerned about this kind of shift, but more important to maintain perspective and focus on your long-term goals. It may be helpful to consider some of the reasons behind the surge of market volatility.
Too Much of a Good Thing?
The initial trigger for the downturn was a better-than-expected jobs report on February 2, that helped drive the Dow down more than 2.5%, a significant decline considering the unusually low volatility in 2017 and the beginning of 2018. The economy added 200,000 jobs in January, marking the 88th straight month of job creation, the longest such run in U.S. history. Wages rose by 2.9% over the previous January, the highest year-over-year increase since the end of the recession in June 2009. And the unemployment rate held steady at 4.1% for the fourth straight month, the lowest level in 17 years.4
Although the report was great news for U.S. workers, on Wall Street the rosy jobs picture generated fears of higher inflation that might drive the Federal Reserve to raise interest rates more quickly than anticipated. At its December 2017 meeting, the Federal Open Market Committee signaled its intention to raise the benchmark federal funds rate three times in 2018, bringing it up to a range of 2.0% to 2.25%. Theoretically, these changes have been priced into the market, but the strong jobs report made it more likely that the Fed will follow through on its projection and possibly execute further increases if inflation heats up.5
Stocks, Bonds, and U.S. Debt
Higher interest rates rattle the stock market because investors are more likely to move assets out of risky stocks and into more stable bonds as fixed-income yields become more attractive. Higher rates not only mean increased yields on new bonds but also on existing bonds, as prices are pushed downward to make yields competitive. In addition, the prospect of inflation tends to push bond prices lower and yields higher, because inflation erodes the purchasing power of fixed-income payments.
One reason for the initial reaction to the January jobs report expanding into a full-blown correction is that bond yields were already rising due to other factors. The yield on the 10-year Treasury note — a bedrock of global financial markets — has been rising since tax legislation was proposed in the fall of 2017, and the yield reached a four-year high of 2.85% the day the jobs report was released.6-7 Although the Tax Cuts and Jobs Act was generally welcomed on Wall Street, bond traders have been concerned that increased Treasury sales to pay for the $1.5 trillion tax cuts will erode bond prices. This concern was exacerbated by the bipartisan budget deal that further increased deficit spending.8
The Treasury is working to finance higher debt at the same time the Federal Reserve is unwinding its recession-era bond-buying program. With the Fed reducing its bond portfolio, the Treasury must sell more bonds to the public to cover growing deficits. The Treasury recently announced the first increase in bond sales since 2009.9
The question is who will buy these bonds and what are they willing to pay for them? A weak dollar has made Treasuries less appealing to foreign governments, which hold more than 44% of U.S. government debt. With the Treasury market depending more on U.S. investors, supply may be outpacing demand — illustrated by a tepid Treasury auction on February 7.10
The Long View
Although mounting government debt is a serious concern, the stock and bond markets are both driven in the long term by the economy, and the United States looks to be hitting its stride after a long, slow recovery. The global economy, which has been even slower to recover, is coming back as well.
A correction may be disturbing, but it can strengthen the market in the long term by returning equity values to levels that are more in line with corporate earnings and less dependent on investor exuberance. A corrected market may also be less vulnerable to overreaction. On February 14, the Dow and the S&P 500 closed up more than 1.2%, despite a consumer report that showed higher-than-expected inflation. Even with higher prices in January, core inflation (which excludes food and energy prices) is running at only 1.8%, still below the Fed’s 2% target rate.11
Of course, no one can predict the future, and you might see volatility for some time. The wisest course may be to remain patient and avoid making portfolio decisions based on emotion.
The return and principal value of stocks and bonds fluctuate with changes in market conditions. Shares, when sold, and bonds redeemed prior to maturity may be worth more or less than their original cost. U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest.
The S&P 500 is an unmanaged group of securities that is considered representative of the U.S. stock market in general. The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Past performance is no guarantee of future results. Actual results will vary.
1, 3) Yahoo! Finance, 2018, Dow Jones Industrial Average and S&P 500 index for the period 2/8/2017 to 2/8/2018
2) Bloomberg, February 6, 2018
4-5) The Wall Street Journal, February 2, 2018
6) CNBC, January 11, 2018
7) CNNMoney, February 2, 2018
8) MarketWatch, February 12, 2018
9) Bloomberg, January 31, 2018
10) Bloomberg, February 7, 2018
11) MarketWatch, February 14, 2018
