After nine months of sprinting, the equity markets took a break to catch their breath in the third quarter. The S&P 500 posted a loss of about 3% after three straight quarters of positive returns of over 7%. US Small Cap stocks were down about 5% in the quarter, while international developed market stocks were down 4%. Despite the negative returns this quarter, the 12-month return numbers still look great, with the S&P 500 up 21%, US small caps up 9%, and international developed market stocks leading the way with a 26% return.
The bond market also struggled as rates continued to rise. The Barclay’s US Aggregate Bond Index was down about 3% in the quarter, while short-term bonds were slightly positive and longer-term bonds were down more. REITs fell about 8% in the quarter, and Gold was down about 4%. The one positive area of the market this quarter was in commodities, as higher oil prices drove the Bloomberg Commodity index up about 5%.
We know markets never go up in a straight line, and it’s completely normal to see regular stock drawdowns. This chart above from J.P. Morgan shows the intra-year declines every year since 1980. Despite an average intra-year drop of 14.3%, annual returns were positive in 32 of the 43 years in this chart. Markets never go up in a straight line, but they go up more often than they go down. If you’ve ever tried to run up a long hill, you’ve probably had a similar experience. Sometimes you need to stop to take a breath, but you keep going until you reach the top. The third quarter felt like a breather for equities.
Unfortunately, bonds needed a much longer break after an extended bond bull market. As the chart above shows, we are in the midst of the longest drawdown for the Bloomberg US Aggregate Bond Index in the last 47 years. This decline started in August 2020 when the Federal Funds Rate was effectively zero. That rate has risen sharply and was over 5% at the end of the last quarter.
While higher rates sound great for anyone trying to earn income on their bond portfolio, bond prices decline as interest rates rise. The incredibly steep rise in rates has meant equally steep losses in bonds over the past three years.
The good news for the bond market is that forward-looking returns strongly correlate to the starting yield. With interest rates much closer to what you might consider “normal” long-term rates, bond investors should expect much stronger returns going forward. As always, it’s impossible to say whether we have reached the end of the rate hiking cycle, but those hikes are slowing down, and it appears we are closer to the end than the beginning.
For the second time in two years, we are watching a horrifying scene unfold across the globe. The brutal attacks by the Hamas terrorist organization on Israeli civilians were appalling and heartbreaking. Our thoughts and prayers go out to everyone in Israel.
Just as we saw when Russia invaded Ukraine, this looks like it could be the start of a protracted war as Israel begins its counteroffensive against Hamas. Millions of innocent Palestinians are attempting to evacuate their homes before that happens. Many lives have already been lost, and there will likely be many more lost in the coming weeks. We don’t have any answers for this difficult situation, but we hope they are able to find a way forward that minimizes the loss of life and leads to a peace agreement.
While the impact of this war on the investment markets is of much lesser concern than the impact on human lives, fears over how it will impact your portfolio are understandable. Unfortunately, nobody can predict what will happen in the coming months in this war, and even if we could confidently predict what would happen, we still wouldn’t know how that would impact the investment markets. As we say time and again, there is no way to predict the markets or how certain events will impact the markets. This note from Charlie Biello is just the latest example of why it’s so futile to try to predict the future:
“If I told you 3 years ago that the Money Supply was going to increase 14%, inflation by 18%, and National Debt by 24%, you probably would have guessed that would have been bad for the US Dollar and good for Gold.
What actually happened? A 19% increase in the Dollar Index ETF ($UUP) and a 5% decline for the Gold ETF ($GLD)."
Instead of trying to predict what will happen next, focus on what you can control: diversification, costs, and taxes. Make sure your portfolio is well diversified across all asset classes and your overall asset allocation is still in line with your targets. Keep your investment costs as low as possible. As we head into the end of the year, look for tax planning opportunities to minimize the tax impact of your investments. As always, we are here for you to help with each of these items. We can’t tell you what will happen in the Middle East or where markets will go next, but we can help you plan for any potential outcome.
-Chris Benson, CPA, PFS
The views expressed represent the opinions of L.K. Benson & Company and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person. Please see Additional Disclosures more information.