As 2022 progressed, investors and consumers were treated to a steady stream of bad news, and the markets reacted in-kind, with most stock and bond indexes losing ground through the third quarter. A familiar adage says that the most dangerous words for an investor are “this time is different.” It can be easy to fall prey to pessimism and the thought that the current situation will persist indefinitely. Even if we know that this too shall pass, it requires discipline and patience to ride out the storm. Many of the headwinds we’ve encountered in 2022 are ones we’ve been in before. But it’s been some time since we’ve had to navigate inflation, rising rates, conflict overseas, and lingering supply chain issues. What lessons from years past can we lean on to help us navigate our current predicament?
Don’t Fight the Fed
The phrase “Don’t Fight the Fed” was coined by finance professor Martin Zweig in 1970 to highlight how the market reacts to how the Federal Reserve alters interest rates. We can look no further than the last decade to see the theory in action. For much of the 2010s, interest rates were near historic lows, mortgages and loans were cheap, and the stock market thrived. In 2018, the Fed began to raise rates at a slow but steady pace, and we saw two significant market declines of 19%. These declines, while all but forgotten just four years later, were similar in magnitude to the 20% drop we’ve seen this year.
Then the pandemic hit, and the Fed dropped rates back to near 0%, and we saw the market move higher in 2020 and 2021, even in the face of COVID-related disruptions. Now, in 2022, with the Fed raising rates, we have seen a prolonged market decline.
While the Federal Reserve doesn’t control the stock market, and there are plenty of exceptions to Zweig’s rule, we can see a clear correlation. For the long-term investor, however, these gyrations should be the sideshow rather than the main event. If we look at the last five cycles, a typical Fed “tightening cycle” (period of rising rates) lasts 21 months on average. Meanwhile, going back to World War II, the average bear market lasted 14 months.
So, while these periods can be painful, and seem like they’ll never end when we’re in the middle of them, history tells us otherwise. A one-to-two-year period of volatility is uncomfortable, but a relative blip in the context of a 30-year retirement or a 60-year investing career. One way to look at these periods is that they’re the price of admission we have to pay in order to enjoy long periods of steady gains like we saw from 1982 to 2000, or again from 2009 to 2022.
Inflation Is Unpredictable
For the first time in decades, investors and consumers have had to contend with significant inflation. For investors, this has often prodded discussions about the best investments you can make to hedge against inflation. Unfortunately, there’s no foolproof answer. Gold and precious metals were long thought to be a dependable hedge, thanks to good performance during the 1970s.
However, gold declined more than 20% from March to September 2022, providing no protection for investors looking for a safe haven. Others touted cryptocurrencies as a solution, but they fared even worse this year, with Bitcoin down 71% through September. Stocks and real estate have more dependable records, generally doing well over the long-term when inflation is elevated. But, here again, the major stock indices are down 20% – 30% through three quarters of 2022. Bonds typically suffer in periods of high inflation, and this year has been no different.
In short, there has been nowhere to hide, and the areas that have been safe havens in the past have not provided protection in 2022. We’ve learned, once again, that there are no foolproof investments, and bear markets can inflict pain indiscriminately.
With inflation and the Fed forming a two-headed dragon in 2022, has anything worked? For investors with a long-term focus, several tried and true tactics have helped weather the storm.
Plan Ahead with an Emergency Fund
Of course, while the markets are the amalgam of millions of investors (and computer programs) trading daily, each individual is affected uniquely by the markets. Younger investors in the prime of their working careers should view a market dip as a sign to put 401(k) contributions to work at more attractive prices.
For those in retirement, the declines can feel more worrisome, particularly for those without pensions and who lean heavily on their retirement portfolio for living expenses.
For those with ongoing cash needs, an emergency cash reserve is a powerful resource when markets are wobbling. Generally, if you have expenses coming up in the next six to twelve months, it’s good to have cash on hand now to cover those expenses, whether they’re monthly living expenses or larger one-time purchases. This allows us to view panic with a measure of detachment. If your obligations are already covered for the year, you can rest with the assurance that you don’t need to sell at the wrong time.
There’s no magic to the six-to-twelve-month time frame, however, most of us can reasonably anticipate our needs for those upcoming months. Forecasting further out can be uncertain. And, again, with an average bear market lasting around 14 months, a cash reserve allows you to be patient when others are fearful.
Diversification Works, But It’s Not Perfect
The decline in bonds, as interest rates rise, has introduced a painful note to what was the more conservative portion of most investors’ portfolios. As a result, the average 60/40 portfolio has posted one of its worst results in nearly 80 years. While diversification has blunted some of the effect of the large declines in growth-oriented tech stocks and long-term bonds, even conservative investors have seen their portfolios suffer a noticeable decline.
This is a good time to take a fresh look at your assets and confirm that they are still appropriate long-term holdings. While its best to avoid wholesale changes during a market swoon, there may be some positions you own where things have changed materially, and they no longer fit in your long-term plan. In some cases, moving on from these positions can provide a silver lining when it comes to taxes.
Seize on the Silver Linings
One consequence of the long bull market that began in 2009 for many was an ever-increasing tax bill, thanks to larger and larger investment gains. These can come in the form of capital gain distributions, realized gains on sales of profitable investments, or larger required minimum distributions from rapidly growing IRA accounts. A bear market decline in markets may mean some portfolio positions are now showing a loss from the initial investment.
Investors can extract some (usually) modest benefit out of a bear market by capturing these losses and lowering their tax bill in this and future years. Taxable losses are first offset against gains. If you’ve offset all your gains, then up to $3,000 can be deducted against your ordinary income. Any remainder can then be carried forward for use in future years.
For example, let’s say you sell a position at a $15,000 loss. Elsewhere in the portfolio you had gains of $4,000. That gain would offset by the loss, leaving you with $0 in capital gain income. Of the remaining $11,000 in losses, you would then deduct $3,000 against your ordinary income, and the remaining $8,000 would be carried forward to 2023 and beyond.
In order to capture a loss, you have to sell the position and remain out of the position for 31 days. Some will simply hold the sale proceeds in cash, and then reinvest once they are outside the 31-day window. However, if you are worried that the market may recover while you’re waiting, you can use the proceeds to buy a similar investment, and then sell that one and buy your original investment back after 31 days. This allows you to both capture the loss for tax purposes and remain fully invested.
It takes discipline and a little bit of courage, but, historically, bear markets have offered tremendous opportunity for those willing to invest. Most recently, we saw a quick snapback rally following the March 2020 stock market swoon. Looking back a bit, the S&P 500 returned 25.3% per year for the five years following the low in March 2009. The bear markets of 1973-1974 and 2000-2002 both saw five-year annualized gains of over 17% per year following the lows. If you have cash available for long-term investment, and it fits within your risk tolerance, an investment during bear market declines could lead to significant gains in future years.
Patience is a Virtue
Above all, history tells us that patience is a virtue when it comes to markets. Market cycles ebb and flow, and while the proximate causes of a market drop can be scary, over the long-term, these concerns tend to recede as we recover and move on. As noted above, the average bear market has historically lasted around 14 months. Investors who have been able to stay patient and avoid making moves in a panic have been rewarded handsomely, as the average bull market has lasted 4.4 years, and has seen a cumulative return of 152%. We don’t know how much lower the markets will go, or how strong the recovery will be, but with discipline we can ride out this storm and take advantage of tax savings and investing opportunities in the meantime.