Market Fall Further in June – Enter Bear Market Territory
The S&P 500 Index closed June 2022 at 3,785.38, or 21.08% below its all-time closing high of 4,796.56 on 1/3/22, according to Bloomberg. By definition, this indicates that the index has entered into a “bear market,” which is defined as a price decline of 20% or more from the most recent peak price of a security or index. The price declines are due to a combination of factors, including higher oil and gas prices, persistent global supply chain problems, and massive government spending programs that have contributed to high inflation levels and the dramatic rise in interest rates.
Many economic indicators have reached near historic levels where market declines have bottomed in the past. That being said, there is no guarantee that we have seen the market’s lows. Still, for long-term investors, we think it is prudent to opportunistically add to high-quality companies at lower valuation levels.
Below is a chart of how the markets have performed after a 20% decline in the S&P 500 Index. Generally, one year later, markets have recovered.
Inflation and the Federal Reserve
In June, the Federal Reserve increased the Federal Funds Rate (FFR) 0.75%, which was the largest percentage increase in the FFR since 1994. On June 15th, Chairman Powell said “From the perspective of today, either a 50 basis point or a 75 basis point increase seems most likely at our next meeting…we anticipate that ongoing rate increases will be appropriate.”
The FFR remains the Feds primary policy tool to combat inflation and it remains too low given the current inflation levels (see chart on the next page). However, there are limitations to the impact of Fed policy. Higher interest rates dampen consumer spending and reduce demand, but they can’t help fix insufficient supply can’t help fix insufficient supply problems. Chairman Powell admitted, “there’s really not anything that we can do about oil prices…they’re set at the global level.”
As of this writing, the consumer price index (CPI) increased 9.1% (from a year ago) in June, above market expectations. In addition, gasoline prices increased 11.2%, while food prices have risen at least 1% for six consecutive months. Core-CPI, which excludes energy and food, came in at 5.9% year-on-year as housing rental costs accelerated in June.
We think that the high inflation rate will moderate this summer, which will take pressure off the consumer and the Federal Reserve. If inflation data cools, this may allow the Fed to slow its pace of interest rate hikes. The Federal Reserve is in a very challenging position and will have a difficulty engineering a “soft-landing” for the markets. We do not believe the Fed will be able to bring inflation down to its stated target level of 2.0% without causing a recession. Policymakers must curb demand from government spending, consider reversing prohibitive oil and gas policies, and markets must see a resolution to the persistent global supply chain problems that have continued to put upward pressure on prices.
Earn Interest on Cash Balances and Savings
During the last few years, interest rates were collapsed by the Federal Reserve, and the economy was flooded with cash to help offset the economic shutdown due to the COVID-19 pandemic. So, unfortunately, your savings accounts and money market funds at your banks and credit unions went to zero yields. However, now that the Federal Reserve is again raising interest rates, we have been buying Treasury bills, notes, and short-term municipal bonds to replace the lost income.
What has become very obvious is that even though interest rates are rising banks and brokers are not passing on these higher yields to customers. For example, we purchased 4-month T-bills and currently receive 1.95% on those funds, while most banks and money market funds are still returning only 0.20%! So if you have a large amount of capital just for savings and want it kept safe and earn some interest on it, please get in touch with us. We will invest it in the T-bills and other short-term government bonds with income and preservation of capital as the primary objectives. The cost for our cash management service is very low and that is why the principal amount must be large. We would establish a separate brokerage account for you, and the account would be custom designed to your requirements. The funding for the account must be new money to Pacific Coast Investment Advisors, LLC.
If you have other large savings or money market accounts that you want to be kept safe and receive some income, please contact us. Sitting in cash at the banks and money market funds, especially now that yields are rising, is missing an opportunity to increase your income and safety.
Bonds Swaps and Tax-Losses
As interest rates rise, bond prices decline. The good news is that bond prices will recover to $100.00 or “par value” at maturity. The farther out the maturity date of the bond, the greater the prices fluctuate in the interim. We will look for opportunities to complete bond swaps, which is the process of selling one bond and subsequently purchasing another with the proceeds to take advantage of the current market environment. This process gives the investors a tax-loss to offset other capital gains, thereby reducing taxes and roughly maintaining their current position.
The process of tax-loss harvesting also applies to stocks. If you own shares in a company you want to have for the long-term, sell the shares which were purchased at higher prices and realize the loss, then repurchase the shares after 31 days. You can carry any unused tax losses forward indefinitely until used to offset gains.
This recent decline in stocks and bonds is an opportunity to realize what may be temporary losses and use them to offset future capital gains and reduce income taxes.
Premium Bonds
Premium bonds are not bonds of higher quality but rather bonds that trade at higher prices than their value at maturity. For example, let’s assume you purchased $100,000 (at par value) of a bond when interest rates were higher, and it pays a coupon of 5%. Now, fast forward to today and that same company could issue another bond at 2% at the same $100,000 par value. Well, no one would want a 2% bond when they could have a 5% bond, so the price of the 5% coupon bond rises until it now yields about 2%.
In our example, let’s assume that both bonds have the same credit quality, and they each mature after a period of 10 years. The 2% coupon bond sells for $100,000 or 100% of par value, and the 5% now sells for $127,000 or 27% over par value. Both bonds are priced to yield 2% to maturity. The difference in income between the two bonds is $30,000.
So, which bond is the better investment? The 5% bond selling at a premium of $27,000 would net the owner $3,000 more in income ($30,000 – $27,000 = $3,000).
The 2% bond will produce $20,000 income until maturity
2% X $100,000 = $2,000/year
$2,000 X 10 years = $20,000 income until maturity
The 5% bond produces $50,000 income
5% x $100,000 = $5,000/year
$5,000 x 10 years = $50,000 income until maturity
In practice, a 10-yr premium bond may yield about 2.2% while the newly issued bond yields 2%. This would add $2,000 for a total advantage of $5,000 over the 2% bond at par value. The higher yield of 0.20% reflects compensation for putting up additional capital. For taxable bonds, the premium, $27,000 in our example, is amortized over 10 years, or $2,700 per year. This is deducted for income tax purposes against the $5,000 income the bond generates, leaving $2,300 subject to income taxes. Higher cash flow from premium bonds is one of the main advantages to investors who want to maximize current income.
There are advantages to owning premium bonds in one’s portfolio, and we would be happy to answer any questions you may have about including premium bonds in your accounts.