A Consumer’s Guide to Navigating the Current Bear Markets — Part 1

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Grizzly Bear by waters edge with fall color background. A game farm in Montana, with animals in natural settings.

When I sat down to write this article, I initially titled it “An Investor’s Guide.” I changed it to “Consumer’s” because valuations have fallen significantly across ALL major asset classes, including cash, thus effecting consumers who may not have much in the way of traditional investment portfolios.  Simply put, 2022 has produced a bear market in everything. The table above is intended to provide a quick cheat sheet to help consumers understand that tools that are available to address the various threats to their financial security.  More detailed insight along with articles to support my perspective are provided below.

In part 1 of this two part series we’ll look at how to best deal with cash and bonds.

CASH

Many consumers perceive cash to be a safe, liquid store of value, and in times of no inflation it is.  However, inflation as measured by the consumer price index (CPI)for the past six months rose by more than 9%, the largest increase since the 1960s.  To make this tangible, if you had $100,000 in a 0% checking account and inflation rises 9% over the next year, your money will only by $91,000 worth of goods and services. 

The easiest way to fight back against inflation without putting your principal at risk and without tying up your money for too long is to put your cash to work in safe, short term interest-bearing instruments such as FDIC insured online banks, short term CDs, and treasury bills.  While interest rates on these instruments have been rising quickly this year, current yields are still far below the inflation rate. If you were fortunate enough to find earn 3% on your over the next 12 months,  your real return will still be 6% loss if inflation remains at 9%.  

One way to fight back more effectively may be to shift money from cash into other asset classes and investment types such as Series I savings bonds, treasury inflation protected securities or even rising dividend stocks, but these alternatives require the consumer to give up some near-term liquidity and/or be comfortable with some price volatility.  For people who have been holding cash waiting for rates to rise, such moves may be timely now.  For regular emergency reserve money and money need for paying the bills, these alternatives may be less suitable.

Bear Market Tips for Retirees: Stay Invested, Buy Dividend Stocks, and Bank Online (Barron’s)

Stop Stretching for Yield. Consider These 2 Investments Now (Barron’s)

8 best short-term investments in June 2022 (Bankrate.com)

Treasury Securities (Bankrate.com)

Best Savings Accounts for Your Emergency Fund (MyBankTracker.com)

BONDS

Bonds are a bit of a sticky wicket as they are generally mispresented to consumers (particularly in 401(k), 403(b) and 457(b) plans.  Specifically, they have historically been presented as the safe portion of consumer portfolios – the part that adds stability to counter the inherent volatility of the stock market.  Shift money from risky stocks to conservative bonds as you approach retirement says much of the retirement planning literature.  This guidance has been sound for much of the last 40 years as interest rates steadily declined from their lofty inflation driven peaks of the late 1970s and early 1980s to historic lows by the end of 2021.

However, when interest rates rise as they have just begun to do in earnest, the value of existing bonds fall.  What this means to investors in who hold bond mutual funds, including balanced funds, “conservative” and “moderate” asset allocation funds, and target-date funds with near term dates, is that they may see much sharper negative returns from the so-called “safe” parts of their retirement account that they may have anticipated. [NOTE: I have been warning about this for years both in my newsletter and to clients directly, and it is now happening.]

Interest rates concept. 3D illustration

While some financial journalists have suggested that consumers who own bond mutual funds just wait it out, I vehemently disagree.  Interest rates have only just begun to rise and interest rate cycles may be decades long.  Unlike stock market volatility, which is both unpredictable and unavoidable, the threat of rising interest rates could be seen a mile away when interest rates on short term bonds hit 0% and thirty-year treasuries dipped below 2% (!!!) in 2020. 

Price volatility when rates rise can be sidestepped by selling bond mutual funds and purchasing individual treasury securities and CDs which, unlike bond mutual funds and ETFs, are guaranteed to return principal and interest if held to maturity.   In today’s interest rate environment, the yield curve is nearly flat, meaning consumers purchasing the shorter maturities captures nearly all of the yield curve with almost none of the price volatility.

With rates just beginning to rise, in my professional opinion, it makes little sense to lock in maturities much longer than 12 months, but the 12-month rates rise to 4-5% it may make sense to begin laddering maturities to 3-5 years and extending the ladder still further if rates continue to creep higher. 

At current interest rate and inflation levels, consumers will still suffer negative real (inflation-adjusted) returns, but laddering may eventually allow investors to make up some of those losses by locking higher long-term rates when inflation begins to abide.  Last week, Federal Reserve Chairman Jerome Powell said it was the Fed’s goal to try to curb inflation to the point where interest rates on treasury securities provide positive real returns.

In the near term, Series I Savings bonds and treasury inflation protected securities provide a near perfect hedge against inflation since the value of these investments is adjusted in 1:1 proportion to the CPI.  For example, consumers who purchase 6-month I-bonds between now and the end of October will earn 4.81% (9.62% annualized) for the first six months that they own them.  The rate for the next 6 months is reset every May 1 and November 1.  The current rate is much higher than comparable bank deposit rates and promises to deliver a whopping 0% real return instead of a negative real return.  With TIPs the interest rate on the bonds is set at the time of issue and the principal on which the interest is paid is adjusted for inflation twice per year when the interest is paid.  

While I-bonds and TIPs represent the most direct way to counter inflation, both have considerable warts that consumers should consider before buying.  For example, I-bonds must be held for a minimum of 12 months and a 3-month interest penalty is applied for redemptions in less than 5 years.  There is also a $10,000 annual purchase limit per person, and the bonds may only be purchased through the TreasuryDirect.gov website, which can be a nightmare to navigate. 

Investors in TIPS should be aware that the principal value may be reduced in deflationary environments and that federal income tax on accrued principal on TIPS held in taxable accounts is due each year even though it is not paid out to the consumer.  Because of tax reporting complexity, I generally only recommend TIPS in retirement accounts.  I also recommend consumers purchase only shorter-term TIPS and avoid TIPS mutual funds. Here again, consumers should be aware that individual TIPS provide principal return guarantees at maturity that are absent in TIPS mutual funds.  To drive this point home, the Bloomberg U.S. Treasury Inflation Protected Securities Index is down more than 8% for the year-to-date through 6/16/2022!

The 9.62% Opportunity in I Bonds (Podcast with Prof. Zvi Bodie)

Why Are Bonds Down?  (Forbes)

How Bad Can This Bond Crash Get? (US News)

TIPS vs. I-Bonds (Morningstar)

Individual TIPS vs. TIPS Funds (Oblivious Investor)

John H. Robinson is the owner/founder of Financial Planning HawaiiFee-Only Planning Hawaii, and Paraplanning Hawaii.  He is also a co-founder of fintech software-maker Nest Egg Guru.

In Part 2 JR will discuss the merits of stocks, real estate and crypto currency. Stay tuned.

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