It’s tough out there, no doubt about it. The headlines are coming in fast and furious, and only a fool would scoff at it all and profess not to be worried. But amid the bad news we have to remind ourselves that investing is a long-term proposition requiring us to go against the grain. Not all the time, that would be exhausting. Just when it matters. And this, of course, is what makes it so hard. Others will be reacting, hollering, “Sell!”, and somehow we have to ignore them, hold firm, and perhaps even offer a measured response of, “Buy.” Not easy.

Through yesterday, the S&P 500 is down just shy of 12% so far this year. We’ve dug into gains of the past 12 months, but most diversified investors should be doing better than the broad market. And recency bias is starting to kick in, worsening an already sour mood. But we don’t have to go back far to see the positive returns that now seem like a distant memory to some. The same stock index is up about 59% in the past three years and has nearly doubled in the past five years. Ten years… 270%.

It was easy to be bullish back then, or at least it was in hindsight. Just think of all the events investors had to contend with during those years. Would anyone blithely report being bullish 100% of the time? Of course not. But what did you do about it? Many sold during the numerous lows and were never able to buy back in. Let’s the rest of us hope that with enough time, and enough hindsight, that we’ll be proven right for holding on now just as we have been many times before. Again, that sort of all-weather patience and persistence isn’t easy, nor is it for everyone, but it’s required to be a successful long-term investor.

And there’s good news out there too. One example: We’re all aware that oil prices shot up dramatically on Russia’s invasion of Ukraine. But they've since come back sharply. Bespoke Investment Group reports that the price of West Texas Intermediate (the US oil benchmark) rose over 30% in just over a week earlier this month but has since fallen about 22%, potentially setting up the largest decline from a WTI highpoint over a week ever. Among other things, this illustrates how investor sentiment and market prices can change rapidly, and it goes both ways. Assuming oil stays at these levels, prices at the pump should eventually come down as well. And that would be welcome indeed.

As a helpful reminder of how hard investing can be, and perhaps license to cut ourselves some slack, here’s an excellent article by Jason Zweig of The Wall Street Journal from a few days ago. He packs a lot of truisms into a short piece that’s worth reading a few times. I’m reproducing it here minus the variety of embedded hyperlinks, but a link is below if you’d like to read in full.

In the fall of 1939, just after Adolf Hitler’s forces blasted into Poland and plunged the world into war, a young man from a small town in Tennessee instructed his broker to buy $100 worth of every stock trading on a major U.S. exchange for less than $1 per share.

His broker reported back that he’d bought a sliver of every company trading under $1 that wasn’t bankrupt. “No, no,” exclaimed the client, “I want them all. Every last one, bankrupt or not.” He ended up with 104 companies, 34 of them in bankruptcy.

The customer was named John Templeton. At the tender age of 26, he had to borrow $10,000—more than $200,000 today—to finance his courage.

Mr. Templeton died in 2008, but in December 1989, I interviewed him at his home in the Caribbean. I asked how he had felt when he bought those stocks in 1939.

“I regarded my own fear as a signal of how dire things were,” said Mr. Templeton, a deeply religious man. “I wasn’t sure they wouldn’t get worse, and in fact they did. But I was quite sure we were close to the point of maximum pessimism. And if things got much worse, then civilization itself would not survive—which I didn’t think the Lord would allow to happen.”

The next year, France fell; in 1941 came Pearl Harbor; in 1942, the Nazis were rolling across Russia. Mr. Templeton held on. He finally sold in 1944, after five of the most frightening years in modern history. He made a profit on 100 out of the 104 stocks, more than quadrupling his money.

Mr. Templeton went on to become one of the most successful money managers of all time. The way he positioned his portfolio for a world at war is a reminder that great investors possess seven cardinal virtues: curiosity, skepticism, discipline, independence, humility, patience and—above all—courage.

It would be absurd and offensive to suggest that investing ever requires the kind of courage Ukrainians are displaying as they fight to the death to defend their homeland. But, for most of the past decade or more, investing has required almost no courage at all, and that may well be changing.

Inflation rose to a 7.9% annual rate last month, the highest since 1982, and some analysts think oil prices could hit $200 a barrel.

In early March, Peter Berezin, chief global strategist at BCA Research in Montreal, put the odds of a “civilization-ending global nuclear war” in the next year at an “uncomfortably high 10%.”

In another sign of the times, a 22-year-old visitor to the Bogleheads investing forum on Reddit asked plaintively this week: “I can’t get over the thought that by the age of 60 will earth still be livable? Should I be using [my savings for retirement] somewhere else and live in the ‘now’?”

Yet the S&P 500 has lost less than 1% since Feb. 24, the day Russia launched its onslaught. Over the same period, according to FactSet, more than $770 million in new money has flowed into ARK Innovation, the exchange-traded fund run by aggressive-growth investor Cathie Wood.

That’s a familiar pattern. On Oct. 26, 1962, near the peak of the Cuban missile crisis, The Wall Street Journal reported that “If it doesn’t end in nuclear war, the Cuban crisis could give the U.S. economy an unexpected lift and maybe even postpone a recession.”

From their high in mid-October 1962, U.S. stocks fell only 7% even as the world teetered on the brink of nuclear war.

Nevertheless, a grim era for investing was not far off, in which stocks went nowhere and inflation raged. Had you invested $1,000 in large U.S. stocks at the beginning of 1966, by September 1974 it would have been worth less than $580 after inflation, according to Morningstar. You wouldn’t have stayed in the black, after inflation, until the end of 1982.

That shows two things.

First, glaringly obvious big fears, like the risk of nuclear war, can blind investors to insidious but more likely dangers, like the ravages of inflation.

Second, investors need not only the courage to act, but the courage not to act—the courage to resist. By the early 1980s, countless investors had given up on stocks, while many others had been hoodwinked by brokers into buying limited partnerships and other “alternative” investments that wiped out their wealth.

If it feels brave to you to rush out and buy energy stocks, you’re kidding yourself; that would have been courageous in April 2020, when oil prices hit their all-time low. Now, it’s a consensus trade. Courage isn’t doing the easy thing; it’s doing the hard thing.

Making a courageous investment “gives you that awful feeling you get in the pit of the stomach when you’re afraid you’re throwing good money after bad,” says investor and financial historian William Bernstein of Efficient Frontier Advisors in Eastford, Conn.

You can be pretty sure you’re manifesting courage as an investor when you listen to what your gut tells you—and then do the opposite.

Here’s a link to the article. The Journal has a soft paywall, so let me know if you can’t access the site and I can send it to you from my account.

https://www.wsj.com/articles/the-secret-to-braving-a-wild-market-11647015689?mod=wsjhp_columnists_pos2

Have questions? Ask me. I can help.

Russia’s invasion of Ukraine is taking a real human toll. The stories and pictures we’ve seen have mostly been horrific, but there are also those of heroism and enduring humanity. While the ins and outs of geopolitics are well beyond my area of expertise, these events continue to impact markets and sentiment more broadly, so of course we need to pay close attention to the details.

In another break from our recent look at bond alternatives, I want to share portions of analysis from my research partners at Bespoke Investment Group and some of a weekly update from JPMorgan. I know you’re getting information from a variety of sources, but these are two that I trust. Bespoke’s is on the longer side but provides a good summary of the situation. [Bracketed notes are mine.]

First, from JPMorgan looking at last week…

Following Russia’s invasion into Ukraine, markets saw a sharp sell-off in risk assets, while safe-haven assets (i.e. Treasuries, USD and gold) outperformed. Russia-linked commodities popped with European natural gas +60% and Brent prices crossing $100/barrel. However, by the end of Thursday, markets largely reversed their course with only minimal moves to the 10Y (-1bps) and WTI (+$1).

Looking ahead, markets will be sensitive to sanctions and Russia’s counter response to them. This is a balancing act as the West wants to punish Russia, but not at the expense of other economies. It is further complicated by the fact that Russia is the 2nd largest producer of oil and natural gas and a major commodities supplier (i.e. fertilizer, wheat, aluminum). As of Friday, sanctions have involved Russian oligarchs, new Russian sovereign debt, Russian banks and Nord Stream 2. But, they have not yet involved Russian oil and gas.

For U.S. consumers, this crisis is likely to dampen sentiment and has the potential to delay peak inflation. Despite these headwinds, Americans are coming into this at a fundamentally healthy position – consumer demand has been robust (i.e. January retail sales surprised to the upside despite Omicron concerns) and consumer balance sheets have been strong. While we might see price pressure on energy and food in the near term, they do not have the same capacity to shock as they once did. [Energy] and food spending now represents much less of Americans’ overall wallet share – 12% of total spending vs. an average of 23% throughout the 60s/70s. Furthermore, America has a greater degree of energy independence and the luxury of natural resources that Europe does not, which should also soften the blow.

In terms of investment implications, remember that staying invested in a diversified, goals-aligned portfolio has paid off through countless geopolitical crises and should continue to do so. Ultimately, portfolios should benefit from quality stocks with durable profits and fixed income for portfolio ballast. We are not advocating for broad rebalancing at this time, but rather are seeking balance between value vs. growth and U.S. vs. international. Diversification will remain key as we ride out volatility. [Your portfolio likely has limited direct exposure to Russian stocks since the country occupies only a few percentage points of the main emerging market indexes.]

And now from Bespoke as of yesterday and again this morning…

[Yesterday] morning in Ukraine, fighting is intensifying around major cities. A residential neighborhood of Kharkiv was hit with a barrage of rocket artillery, while the Russian army is still trying to encircle the capital of Kyiv in the north. Over the weekend, Russian forces mostly laid off heavy urban areas after probing attacks were broadly smashed last week. That may be changing, and Russian doctrine may be getting less concerned with minimizing civilian casualties. For now, the Russian advance remains bogged down, and while Russia has claimed air superiority, Ukraine’s air force has continued to fly sorties. That air force may last much longer than anticipated given the shocking decision by the EU to directly supply fighter aircraft from military reserves of several countries. A broader torrent of small arms including anti-tank weapons and hand-held surface-to-air missiles is flowing into the country via EU borders even as a torrent of refugees flow west.

On the Russian side, losses have mounted. Estimates are difficult to nail down, with conflicting reports between Russian sources, Ukrainian sources, third country intelligence agencies, and open-source intelligence, but at this point the Russian casualty count is in the thousands and hundreds of fighting vehicles (including large formations of tanks in some cases) have been lost to the fight. Russian forces have moved roughly at the same pace as US forces did during the 2003 invasion of Iraq, but in doing so they’ve been hit far harder than the US coalition was at the time, and have been able to secure their supply lines and rear areas to a far lesser degree. While the situation in military terms is still at best dire for Ukraine, the Russian military has underperformed all estimates of its ability to establish air superiority, overwhelm the Ukrainian military, seize cities, and perform basic logistical operations all while taking far larger-than-expected losses.

One possible explanation for this phenomenon is that Russian units are intentionally fighting poorly or even abandoning the field when they are confronted with the reality of stiff Ukrainian resistance. Simply put, convincing Russian units to fight a group of people they broadly view as cousins and friends may be much harder than war planners assumed, on top of Ukrainian resistance being much more effective than anticipated and the poor strategy and doctrine Russian generals selected for the invasion. Hopefully, the peace talks underway in Belarus between Russia and Ukraine as we type this note will yield at least a temporary cease-fire, but given the relatively weak Ukrainian position and the incentives for Russia domestically, we are skeptical anything will come of them permanently.

Western sanctions over the weekend were of the “shock-and-awe” variety, with a broad coalition of countries (including the US, EU, UK, Canada, and others) limiting Russian access to the SWIFT payments messaging system for Russian entities, blocking access to a wide range of Russian reserve assets, and starting the process of evicting Russians linked to the most powerful elites from their respective countries. The Central Bank of Russia [the CBR] has responded by banning sales of foreign equities in the Russian market, hiking interest rates from 9.5% to 20.0%, establishing a trading band for the ruble, and requiring sales of hard currency by corporates.

At the lows overnight, [Russia’s currency, the Ruble] traded down 30%. It has since rallied to a 20% decline versus Friday’s close (still one of the largest drops from any emerging markets currency on record), as the CBR has apparently been able to defend its ruble trading band for now, but it’s not clear how long it can do so given that its access to reserves held outside Russia and held in a range of developed market currencies has now been sharply curtailed. For US investors, [Russia-specific] ETFs like ERUS or RSX are down ~24% pre-market, and their underlying holdings cannot be liquidated under the CBR regulation change, even if markets were open in Russia to sell those holdings […]

An incredibly important side effect of Russia’s aggression in Ukraine is to pull European countries together for common defense and policy. This week, the Finnish parliament will consider a popular initiative to join NATO while even the Swiss are signaling that they will mimic EU/US/UK sanctions on Russia. EU-level policymaking has been unified despite some wobbles initially and has been expanded to include arms transfers. The biggest shift, though, has been Germany, where a huge swath of key policy approaches ranging from low military spending to bans on arms transfers to tight fiscal policy to closures of nuclear power plants have been effectively reversed over the course of a single speech from Chancellor Olaf Scholz on Sunday. Russia’s invasion of Ukraine has given every European country on its borders a huge imperative to join the alliance while driving Europe together to sanction Russia, unwind reliance on Russian energy supplies, and expand fiscal and military capacity on a joint basis. The policy specifics are quite lengthy, but at the end of the day, this weekend was the largest step forward for EU integration since at least Mario Draghi’s “whatever it takes” response to the Eurozone crisis in 2012, and possibly since the adoption of the euro. This unity has implications both for the response to the current conflict and far beyond it, with the unlocking of more fiscal capacity, more EU wide investment in resilience, and a more cohesive EU-wide grand strategy for dealing with geopolitical challenges.

China has so far tried as hard as it can to avoid explicitly backing or condemning Russia over Ukraine, and it remains to be seen how much the [People’s Bank of China] works to accommodate the CBR as a source of liquidity (for instance, sales of gold reserves) given sanctions on other Russian reserve assets.

[And this morning…] A re-evaluation of Russia’s doctrine and tactics appears to have temporarily at least slowed the pace of ground fighting in Ukraine. After leaning heavily on deep strikes and relatively light columns earlier in the war, Russian units now appear to be massing to use overwhelming combined assaults to gain ground. This has the unfortunate side effect of larger potential for loss of civilian life, especially around cities. Large bombardments are much harder to control, and the Russian military could be running low on the sorts of precision guided munitions which limit (though do not eliminate) civilian collateral damage when hitting targets. In concrete terms, the UK released a public assessment this morning describing the Russian advance as stalled, reporting more shelling in civilian areas, and still citing a lack of Russian air superiority. Ukraine is receiving reinforcements of MiG-29 fighter jets from Poland as well as shipments of TB2 drones from Turkey, so the air war may not end any time soon.

With respect to civilians, we’re seeing increasing numbers of videos showing non-violent resistance across the country, with groups of civilians blocking convoys and shaming invading troops. In practice, this is not a dramatic hindrance to the Russian ground assault, but it illustrates how much opposition there is on the ground to invaders...fertile ground for a bloody insurgency even if Russian troops are able to capture Kyiv, kill President Zelensky, and declare a puppet government. We also note that calls from aggressive commentators in US and Europe for a “no fly zone” in Ukraine enforced by NATO are thankfully falling on deaf ears. That policy would lead to direct NATO-Russia airborne combat, and dramatically increase the odds of a full-blown war between those belligerents with a substantial risk of nuclear exchanges. While a “no fly zone” may sound like an attractive way to protect innocent civilians, the potential costs that it would include are extreme to say the least and no serious, informed international relations commentator we are aware of is calling for one. A different step that the UK is reportedly exploring this morning: removing Russia from the UN Security Council.

[…] On sanctions, this morning shipping giant Maersk reported it would stop accepting bookings to Russia except for food, medical supplies, and humanitarian supplies. [This is on the heels of other major western companies making similar moves in recent days. Essentially, these companies are independently setting aside their profit motive in favor of making a strong statement against Russia’s actions.]

Finally, an update on Russian markets: equities remain shuttered, but Russian equity tracker funds in Europe continue to plunge this morning with a London-traded MSCI Russia fund down 23% (80% in total since the invasion).

Here’s a link to Bespoke if you’d like to check them out.

https://www.bespokepremium.com/interactive/research

And here’s a link to JPMorgan’s Weekly Market Recap.

https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/market-insights/weekly-market-recap-us.pdf

Have questions? Ask me. I can help.

Before we begin this week’s post I wanted to share this quote that arrived in my inbox this morning from my research partners at Bespoke Investment Group. It just seems fitting with everything going on out there in the world, and in our own households, these days.

“What we know is a drop, what we don't know is an ocean.” - Isaac Newton

We’ve been discussing alternatives to bonds in recent weeks for obvious reasons. Inflation is surging and some of it seems sticky, interest rates are rising, consumer confidence is flagging a bit, and sabers are rattling in the East, although there’s a glimmer of positive news this morning. During times like these it’s natural to wonder about other ways of doing things, if for no other reason than getting some validation that you were doing the right thing all along.

There are lots of potential stand-ins for bonds. I thought of including some, such as commodities or even crypto, but they all touch more on longer-term speculation than a reasonable medium-term store of value. TIPS have been in the news lately, but they’re also a longer-term bet. Solid fixed income investments play a large role in the capital structure of our lives and appreciating that structure is important. Mix too much risky or illiquid stuff with the wrong time horizon and you’re asking for trouble.

In that vein, let’s extend our list of bond alternatives by looking at annuities.

Annuities –

In general there are three types of annuities: variable, fixed, and immediate. I’ll go out on a limb and suggest that you throw out the first type, variable annuities. If you already have one with large, imbedded gains or perhaps fancy add-ons from a bygone era, great, you’ll probably want to keep it going. Otherwise, just toss them out as an investment option, and certainly as a replacement for bonds. The reasons why could easily end up in a rant that’s beyond the scope of this post, but the bottom line is variable annuities are convoluted and expensive, a hybrid claiming the best of everything while usually coming up short. (There’s another variation on this theme, an equity-indexed annuity. Throw those out too.)

The other two types of annuities are different and can be good alternatives for replacing some of your bonds under the right circumstances. Both are insurance contracts based on the interest rate environment but neither has a secondary market, so you won’t see their values fluctuating all over the place. The difference between them is fundamentally about time, how long you can park your money and when you want to spend it.

The mechanics of a fixed annuity are similar to a bank CD. You put cash down for a set period at a guaranteed interest rate. If you break it early there’s a penalty. The important difference is in who’s making the guarantee. With a CD it’s the bank backed by the federal government (up to at least $250,000). With a fixed annuity it’s just the insurance company. In practice, there’s a state fund that could help you recoup some losses if the insurance company goes bust, but that’s only vaguely similar to government insurance and shouldn’t be counted on in the same way. But assuming you’re sticking with a high-quality insurance company (as rated by AM Best, for example – Google makes this information easily available) it’s unlikely you’ll have to deal with bankruptcy in a shorter timeframe, say five years or less.

Looking at this shorter timeframe on annuity.org, you could get 2.65% on over $100K if you were willing to let the money sit for five years. Rates drop to just over 2% for a couple years and periods in between have rates in the middle of that range.

By way of comparison, as of this morning the yield on the 10yr Treasury, a key bond benchmark, is hovering a hair over 2%. The 30-day SEC yield (a standardized way to assess bond fund cash flow) for the Vanguard Total Bond Market Fund is about 2%. Vanguard’s shorter-term bond option has a 30-day SEC Yield of 1.4%. And 1yr CDs on bankrate.com top out at 0.9%. There’s also a 5yr CD at 1.2%.

Say you’re thinking five years. You’d pick the annuity because the yield is higher, right? Maybe. The correct answer depends on your personal liquidity structure and willingness to take risk. The annuity return is fixed, and the bond fund’s isn’t, so that’s one up for the annuity. The annuity also offers tax deferral on the interest if you leave it in the contract, so that’s another bonus. The bond fund has the potential to outperform the annuity, and I would expect it to over five years. But the bond fund can be too volatile for some investors. So maybe bonds are tied with fixed annuities? Let’s add a layer of risk to the annuity and see how it stacks up.

At the end of five years the contract “matures”. You can either take the money and run or reinvest in another annuity. But let’s say you want some access to your cash in the meantime. Typically there’s a percentage maximum the company will let you withdraw early without paying a penalty. Beyond that the penalty could be hefty.

Annuity companies invest your cash, usually in high-quality bonds and work off the spread between what they make on their portfolio and what they’re forced to pay you in interest. Since, at least in our simple example, the company has to sell bonds to generate the cash you’re asking for, they’ll assess a Market Value Adjustment (a penalty) for taking out too much money too soon. The MVA is based on the bond market and bond prices tend to fall as interest rates rise. This potentially makes the MVA painful in a rising rate environment, such as we’re in now.

If you structure things right, however, you shouldn’t have to worry about an MVA. You’d still have ample cash in the bank (as we’ve discussed in prior posts), and you’ll still want to keep some bonds. My suggestion is that a fixed annuity shouldn’t account for more than half of your fixed income allocation and no more than a third of your liquid net worth. Beyond that, the MVA and any other penalties lurking in the contract’s fine print can become larger issues. But again, I would expect the bond fund to outperform the annuity over this five-year timeframe. This makes the annuity a good option for someone who’s super skittish about investing and is willing to risk underperforming for more certainty.

Now let’s look at immediate annuities.

These contracts bake in a small investment return and include a guarantee to pay recurring income for the rest of your life. Although people typically begin taking income immediately, hence the name, you could decide up front to defer income for several months, even years.

What’s interesting about these annuities is that the company is essentially sending you back your own money until you outlive their life expectancy for you. If you die earlier they keep what’s left but you can buy a time guarantee, such as for ten years, to protect your heirs. And the cost can really add up over time. For example, immediateannuities.com shows that a 65-yr-old woman in California could receive about $460 per month for life on a $100,000 purchase, but $420 per month with a “ten-year certain” guarantee.

Some fuzzy math shows us that $460 per month equals $5,520 of annual income, or a 5.52% annual return. Sounds great, right? But recall that this is overwhelmingly the buyer’s own money coming back to her until she lives another 18+ years and breaks even on her original purchase. Then she’s on the company’s dime but still lagging behind having invested in bonds and spending down the principal on her own.

In short, immediate annuities are an appropriate replacement for bonds if someone; 1) has no heirs; 2) needs to stretch their savings to meet their monthly needs; 3) has a recurring bill to pay that isn’t tied to inflation, such as the principal and interest on a fixed mortgage; 4) doesn’t want bond market risk; 5) could check all five of these off their list.

And the same rule applies that no more than half of your bond allocation should go into an immediate annuity because it’s fundamentally illiquid.

Have questions? Ask me. I can help.

Inflation, Fed policy, the stock market, the bond market, how Russia’s invasion of Ukraine will continue to impact each one, and the human cost of war. All are on the mind of investors again this week. Oh, and lest we forget our hopeful emergence from the pandemic as well; there’s no rest for the weary.

With all this going on it’s natural for investors to feel nervous, anxious, maybe even panicky. I mean, the word “nuclear” has popped up in different contexts in recent days. The price of oil briefly spiked to $130 per barrel (currently down to $122) and local gas prices are getting ridiculous. And this has been reported in the news with lead-ins like, “Not since 2008 has oil…”. Now, the reporters were likely only referencing the roughly $180 per barrel oil price that year and how it coincided with the Great Financial Crisis, but the connection is enough to make all but the most hardened investors wince.

The GFC was mostly about the structure and incentives of our financial system. Systemic problems and largely unchecked risk-taking allowed millions of consumers to become woefully overburdened by housing debt and led to enormous numbers of defaults. Borrowers were allowed, and even incentivized, to use excessive leverage by big financial companies that were themselves gambling extensively. Then the music stopped and the risk of these too-big-to-fail companies reneging on their agreements to each other caused the system to grind to a halt before almost imploding. Those were white-knuckle times indeed and a reminder of how fragile our modern financial system was and perhaps still is in some ways.

But is the current environment 2008-esque? Russia’s invasion of Ukraine certainly could spiral out of control, directly involve NATO, and lead to more and wider bloodshed. But unless that happens it’s not a structural issue for our economy like the GFC was. Instead, its economic impact seems to be indirect, linked to rising prices for commodities, such as oil and wheat, and how that impacts global demand. Bad timing, of course, because our main issue right now is inflation. But ours was caused in large part by massive amounts of government spending during the pandemic, and Russian aggression/commodity-induced inflation is relatively small when compared to that.

I don’t pretend to know what the future holds, but we can at least check some things off the list of what the current situation isn’t. That said, stock prices could certainly keep grinding lower. (It’s tough to be optimistic with my screens full of red as I write this.) So is it time to throw up our hands, cry uncle, and start looking for advantageous spots in the yard to bury our savings?

Of course my answer is no. I think the best investment strategy is to remain disciplined and focus on rebalancing as our portfolios suggest it’s time to do so, such as buying stocks in modest amounts when they’ve fallen past predetermined thresholds. This has worked throughout all kinds of inclement market weather, and I expect it will continue to do so.

I wanted to share some additional information from JPMorgan and Bespoke again this week (emphasis mine). The former provides us with a look at rising energy prices and the potential impact on American consumers. And the latter provides some updates on the situation in Ukraine.

From JPMorgan…

When it comes to economic growth in the United States, the consumer is key, accounting for nearly 70% of gross domestic product (GDP). Following the initial pandemic shock in early 2020, the consumer came back with a vengeance, as stimulus checks and enhanced unemployment benefits stabilized balance sheets across the U.S. and spending on goods accelerated meaningfully. However, with food and energy prices rising, there is a risk that the composition of consumer spending will begin to shift. Looking at energy spending as a percentage of total spending, we are able to model a scenario in which crude oil prices rise to $120 per barrel. In aggregate, however, the model forecasts energy spending would increase to 5.0%, which is only slightly above the 2021 average of 4.8%.

That said, the devil is in the details. To an extent, economic growth has been solid and inflation has been elevated due to stimulus that lined the pockets of lower-income individuals. This group has a much higher marginal propensity to consume – put differently, if they have extra money in their pocket they are more likely to spend than save. As we show in the chart of the week, this cuts both ways. If oil prices spike to $120, energy spending may rise to 13.9% of total spending compared to an average of 10.1% in 2021 for the lowest earning individuals, limiting their ability to consume other items. This could in turn lead to slower economic growth than expected, but also a more rapid decline in core inflation. While we still expect the Federal Reserve (Fed) will hike interest rates at its March meeting, this dynamic may allow the Fed to tighten more gradually than markets currently expect.

From Bespoke Investment Group yesterday morning…

No substantive forward progress has been made by Russian forces in Ukraine since Friday with the exception of a push west towards the Kyiv suburbs on the east side of the Dnieper. It’s not clear whether that lack of progress is due to preparations being made for a new push or if the combination of Ukrainian resistance and Russian logistical ineptitude is driving the slowdown. One significant fact about the fighting over the weekend is that the Russian air force has taken significant losses from Ukrainian surface-to-air missiles and remaining aircraft. The New York Times reported on Sunday that the US alone has already delivered more than 17,000 anti-tank weapons to Ukraine, and that’s only a small slice of the overall military support the country is getting. US intelligence has also reported that Russia has now committed roughly 95% of the forces amassed prior to the invasion, roughly 15% of total military personnel. Outright conquest of Kyiv and most of the country’s landmass is impossible at this point unless something changes significantly. The Russian Ministry of Finance has signaled that it will pay foreign investors in rubles which would ultimately trigger a wave of defaults.

From this morning…

Russian advances remain very slow and deliberate over the last 24 hours. Russian forces are largely consolidating in the south of the country having been pushed out of Mykolaiv (between Crimea an and Odessa) and having made no progress to fully takeover encircled Mariupol. In the northeast, major cities Chernihiv, Surny, and Kharkiv are being bombarded but are not encircled as the advance has stalled out. Slow progress has been made in the west of Kyiv, and Russian forces have advanced from the east in a salient that bypassed Surny. Kyiv is not encircled, and ground lost to Russian forces has been bitterly contested with significant losses imposed by defenders in terms of both material and lives. The Russian military is clearly trying to encircle Kyiv for a siege but has not been able to do so despite progress. Ukrainian units are lighter, more mobile, and are able to avoid large-scale engagements outside of cities, meaning that while Russia has been able to advance, their rear areas are not secure and the supply situation in terms of equipment and consumables is tenuous.

That supply situation is further threatened by the fact that they have not been able to establish air superiority and are vulnerable to strikes from both Turkish-supplied TB2 drones and Ukrainian air force jets. The current situation is therefore a race between the two countries to sap Russian logistics enough that front line troops can no longer hold ground they’ve taken. Despite triumphant social media posts trumpeting Ukrainian success, Russian gains are very real. That said, their logistical situation is dire, morale is unsteady (especially given the loss of at least three generals since the war began, something that almost never happens on modern battlefields), and Ukraine is resisting to a degree that will make outright conquest of the entire country impossible if it continues. We should also note that the US intelligence community now believes Russia has committed all pre-positioned troops and equipment to the fight, meaning that military is getting close to its limits on available manpower.

And some historical perspective, also from Bespoke this morning…

With the entire world focused on the Russia-Ukraine war and possible scenarios under which President Putin can either ratchet up or dial back the tensions, it’s ironic that today marks the 105th anniversary of the start of the ‘February Revolution’ which essentially ended the reign of czarist rule in Russia when Nicholas II abdicated his throne. Historians cite a number of factors for the February Revolution including frustration with government corruption, a poor economy, and autocratic rule, but the Russian military’s poor performance in World War I was the primary catalyst for the Revolution. Russians came out in droves to protest the conditions and despite an attempted crackdown Russian police and ultimately the military, the protestors refused to back down. Within less than a week, Nicholas II abdicated the throne ending the era of czarist rule in the country.

Not long after Nicholas abdicated, Vladamir Lenin returned from exile in Switzerland to lead the Russian Revolution, and as he is often credited with saying, “There are decades where nothing happens, and there are weeks where decades happen.” During the February Revolution, it took less than a week for protests to lead to the abdication of the throne by Nicholas II and usher in the communist era. The current Russia-Ukraine war hasn’t even been two weeks yet, and several years from now, with the benefit of hindsight will we be looking back on this period as another one of those moments where ‘decades’ occurred within a matter of weeks?

Here are links to JPMorgan and Bespoke…

https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/market-insights/weekly-market-recap-us.pdf

https://www.bespokepremium.com/interactive/

Have questions? Ask me. I can help.

I wanted to take a few minutes this morning to discuss recent market volatility and what, if anything, to do about it. We’ll get back to our list of bond alternatives next week.

For sure these continue to be unsettling times and the list of issues to be concerned about seems only to grow longer. Maybe that’s a little pessimistic, but that’s where my head is at on this Twosday morning.

Anyway, let’s jump right in by reviewing recent performance through last Friday of four popular index funds from Vanguard: Total US Stock Market (VTI), FTSE Developed Markets (VEA), FTSE Emerging Markets (VWO), and Total Bond Market (BND). Together these funds allow for a quick look at how global stocks and US bonds are doing.

First, year-to-date…

US stocks are down the most, followed by developed foreign stocks (primarily the UK, Europe, and Japan). Perhaps surprisingly, emerging markets (mostly Chinese, Taiwanese, and Indian stocks) have performed well so far this year. These latter two asset classes, and especially emerging markets, have been getting beat up for a while. We have to go back to 2017 to find a time when developed and emerging markets performed better than the US, so there was certainly room for some short-term improvement. And bonds, as we’ve discussed several times in recent weeks, are offering scant comfort lately.

Next let’s stretch out the timeline a bit and look at the last 12 months, again through last Friday…

As 2022 began US stocks, developed foreign, and US bonds all seemed to hit snags at about the same time, and for the same proximate reasons: inflation concerns, how the Fed would/could deal with it, and growing consternation about war in Europe.

Unfortunately, none of those issues are primed for a resolution anytime soon. As we’re all aware, inflation was tracking at 7.5% in January. That’s an average, of course, and the prices of many things we buy regularly are up more than that. The government’s inflation numbers are subject to multiple revisions and may show signs of slowing in the coming months. That’s what the Fed hopes. The markets, however, are assuming inflation will persist and the bond market is currently “pricing in” 4-5 quarter-point rate increases this year. The Fed could raise faster than that, and speculation has been growing for a half-point or even full-point increase at its rate-setting meeting next month. Much will depend on the inflation number for February and any meaningful revisions to prior months.

While inflation and the Fed’s policy response are active and open questions, gauging the outcome of another Russian foreign policy adventure is beyond my ability, and seems to be beyond our government’s ability too. Right or wrong, that adds to the uncertainty of the situation and unsettles investors in what would otherwise be, frankly, a non-event for most of the US economy and our financial markets.

Now let’s broaden our view to the last three years…

These standard asset classes move around a great deal throughout the year and over time. This is totally normal and occurs for a variety of reasons. Even bonds jump around every so often, and we see that in the little blue “W” during the worst of the financial market’s response to the pandemic in March of 2020.

These are arbitrary timeframes but they’re helpful in getting some perspective. To illustrate this point, let’s expand even further and look at performance from January 1^st, 2008, a date that captures all four funds (one was created late in 2007). Take a look at the blue bond “W” in 2020 again in this longer-term context. It’s small enough to be a piece of lint on your computer or phone screen. Now add that to the myriad other market (and even cultural) shocks that took place since the Great Financial Crisis. Amid all this volatility, if given enough time the direction remains positive for stocks and bonds as they grow with the economy, each in their own way.

I don’t mention all of this to make light of our current predicament. We have much to be uncertain and concerned about. I hope that inflation moderates over the coming months. While a growing economy needs some inflation, too much too soon is harmful and destabilizes the financial system, even if only for a short while. I also hope that cooler heads prevail in the geopolitical realm. The world has been through much these past two years and a period of relative calm would be welcome by all, or at least by most of us. Fingers crossed.

In any case, as long-term investors we need to be able to weather bouts of uncertainty in hopes of eventually being compensated for our patience. And we will be compensated. If you’re still 10+ years from retirement, stay aggressive if possible. Time is on your side and your regular investments at lower prices will ultimately pay off. If you’re closer to retirement, re-confirm the details of your plan, keep your focus, and adjust as needed. And if you’re one of those who’ve left fulltime work behind, you’ll also want to double check your plan. You’re likely in better shape than you thought.

Beyond that, recent market volatility isn’t that bad. We’ve seen worse but it’s tough to swallow given the emotional roller coaster we’ve been on for almost two years now. To stay on track it’s best to focus on controlling what we can control, like the structure and maintenance of our investment portfolios, while trying (and sometimes failing) not to dwell on the rest.

Have questions? Ask me. I can help.

In recent weeks we’ve been looking at bond alternatives given the asset class’s poor performance of late. As I’ve said before numerous times and in different ways, I’m not suggesting that you sell your bonds tomorrow and buy shares of an apartment building, a bunch of gold, or bitcoin. There’s no easy answer to the bond alternative question. Instead, I’m advocating for a balanced approach where you make sure your financial bases are covered before branching out into more exciting fixed income options.

It's important to remember a key benefit of bonds these days: ease of use. Since we typically access bonds via an exchange-traded index fund that usually trades for “free” within seconds, buying and selling good quality bonds is just a few clicks away. This helps make bonds a good store of cash beyond what you need to keep in the bank and what you don’t want to risk in the stock market. In other words, mostly we’re talking about bonds for the medium-term, perhaps three to ten years out. Beyond that, your savings really should be put to more productive use in the stock market, buying real estate, or perhaps even starting your own business.

Also recall that volatility risk is something to appreciate when thinking about bond alternatives. Too many investors have confused their time horizons and mismatched longer-term investments to shorter-term goals. Doing so is easy in a strong market because the rising tide effect offers lots of validation. But market mood can quickly change and that Warren Buffett quote about seeing who’s been swimming naked only after the tide has gone out can become a truism. Don’t let that be you.

(Look back at the last couple posts for a rough guide to determine how much, if any, of your bond allocation you can explore with.)

Here’s the next installment of our list of bond alternatives. I was going to include more categories this week, but this post was getting way too long. Instead, I added some extra detail regarding one category, convertible bonds. Next week we’ll look at floating rate bonds and fixed annuities.

As I mentioned previously, this list of bond alternatives isn’t meant to be exhaustive. I’m looking at investments that are relatively easy to find and buy. Also, this list should be taken as a jumping off point for your own research and not as specific investment recommendations.

Convertible Bonds –

Like preferred stocks, convertibles are a hybrid of bonds and stocks built to facilitate borrowing by companies with lower credit ratings. These companies can choose to pay higher interest rates on traditional bonds or allow bondholders the right to convert the company’s bonds into shares of company stock if the stock appreciates. This “equity kicker” allows investors to stomach buying lower quality bonds at lower interest rates. Companies of all sizes issue convertibles but smaller growth-oriented companies like this setup because money is cheaper to borrow and, assuming they grow a lot, debt can be shifted to equity over time and make room for more borrowing.

Convertibles can make sense if you’re on the fence, so to speak. After all, if you’re bullish on the company you’d just buy the stock, right? But say you like the company but also like the relative safety that comes from owning the company’s bond. If the stock appreciates you convert the bond to stock and then, presumably, sell the stock and reinvest in another convertible, sort of like flipping a house. But if the stock doesn’t appreciate, you’d hopefully earn a small amount of interest along the way to getting your principle back when the bond matures. The company could still go bust in the meantime and default on the bond, but it’s a great company with lots of potential. Seems like a win-win, right? What has ever gone wrong with circular logic?

Besides the issuer risk fundamental to bonds, this is where volatility risk comes in. Convertibles lure investors with higher average returns but the catch is they’re riskier than core bonds and act more like stocks, especially during periods of uncertainty. You’ll see this playing out over two timeframes in the charts below.

The first chart is performance for all of 2021 for bonds (the green line), stocks (blue), and two popular convertible funds. The iShares Convertible Bond Fund, ticker symbol ICVT, is the orange line and the Calamos Convertible Fund, ticker symbol CCVIX, is the lavender/purple (I’m bad with colors). The second chart is the same set of investments over the past 30 days.

We see that convertibles did fine for most of last year as stocks rose. But then investors turned skittish nearing year-end and into last month. ICVT is over half invested in tech-oriented convertibles, so it really took a hit as tech faltered. The decline was nearly as swift for CCVIX, mostly for the same reason. And then in the second chart we see that both convertible funds have tracked with the stock market in the last month as volatility rose. We also see core bonds, the green line, losing ground, but to a lesser extent.

The Calamos fund performed better last year but has slightly underperformed ICVT during the past five years. This underperformance could be blamed on Calamos owning convertibles in riskier sectors of the US economy and holding less in tech, a sector that has done extremely well during the last five years. The fund has a longer track record than ICVT (which was created in 2015), so we have to infer quite a bit about how ICVT would have performed during 2008, for example. The Calamos fund was down about 26% compared to the S&P 500’s 37% decline that year. Also, the Calamos fund is actively managed, which makes it more expensive to own than ICVT (1.14% per year vs 0.2%). That extra cost is a drag on performance. ICVT is an index fund and comparing the cost of actively managed funds to index funds is a bit unfair but, just as with the bonds versus stocks comparison, we do it anyway.

Given the complexity of convertibles, I would consider a solid manager with a long-term track record like Calamos, but it’s hard to ignore the relative simplicity and cost savings of index funds like ICVT. Either way, hybrids like convertibles can play a role in the fixed income side of your portfolio if you have room for them. Just be prepared for periods of heightened volatility along the way.

Have questions? Ask me. I can help.