Bonds are a fundamental piece of most investment portfolios, and the basics of bonds can confound even seasoned investors. When testing financial literacy through 5 core questions, bonds are frequently the topic that most commonly trips people up (try the quiz here). We want to make it easier for you to grasp the basics of bonds, whether you're new to investing or just want a quick review.

lend money to companies or the government

At its core, a bond is a type of loan. It's usually issued by governments or companies that need to borrow money. When you buy a bond, you're essentially lending money to the issuer. As the bondholder, you receive interest payments from the borrower.

Bonds are generally considered less risky than stocks, because if the borrower faces bankruptcy bondholders get paid before stockholders. However, the return on bonds is typically lower than stocks, and there's a risk that the borrower might not be able to pay back the debt.

key terms related to getting paid back

The principal value is the amount being borrowed by the issuer. Typically bonds trade in $1,000 increments.

The maturity date is the date the bond will return the principal value (aka face value) to bondholders.

You also receive interest when you lend money. The interest received is usually based on the Coupon rate, which is the interest payments paid to bondholders. Typically as a percentage of face value paid annually. For example, if you have $1,000 of a bond with a coupon rate of 5%, you will receive $50 in interest payments every year until the bond matures. Upon maturity, you will get the $1,000 principal back.

Credit rating is like a credit score for a government or company, indicating how likely they are to make payments. A higher credit rating indicates a higher chance of the issuer making payments.

Imagine if Disney needed to raise money via bonds

When a bond is first issued, the issuer sets the terms like the coupon rate and maturity date. The reality is that interest rates and credit risk (how likely the issuer is to payoff the bond) change after the bond is issued, which causes the bond price to fluctuate.

Imagine if Disney issues bonds paying 5% interest, the current market rate.

You purchase a bond for $1,000, and you get a $50 coupon payment from Mickey Mouse every year until the bond matures.

If interest rates go up, this isn’t good for your bondS

If interest rates rise next year to say 8%, and Disney issues new bonds, they will probably issue them at the new interest rate.

Your neighbor Laura decides to buy $1,000 of the new bonds, and she gets an $80 coupon from Mickey Mouse every year.

Because interest rates rose, the value of your bond paying $50/year goes down in value, less than the $1,000 you purchased it for because the $1,000 could buy Laura’s bond paying $80/month.

The reverse if also true. If rates had fallen to 3%, Laura’s bond would only pay her $30, and your $50/month bond would be worth more than $1,000. This is why when interest rates rise, bond prices fall.

Think of a teeter-totter: When one side’s down (interest rates), the other side must go up (bond prices).

When your bond is trading below $1,000, it is trading at a discount, typically with a coupon rate lower than current interest rates. If your bond is trading above $1,000 it is trading at a premium, typically with a coupon rate higher than current interest rates.

Timing bond returns

Remember that the bond market is full of smart people looking to try and make money. As a result, all similar bonds are priced so they provide similar returns. For example, if you see a 2 year bond with a 5% coupon, and a 2 year bond with a 3% coupon, the price of the 3% coupon bond will be so much lower than the 5% coupon bond and you will end up making just as much money either way. This is called the yield, or coupon + price return on a bond. Keep in mind if there are differences in bonds (i.e. higher or lower credit risk, time to maturity, other terms of the loan), that can cause differences in yield too.

When should I own bonds?

Long term equities tend to produce higher returns than bonds. However, these equity returns involve higher risk, and some people can’t afford to wait to make their money back. Bonds are an important ballast to ensure you can sleep at night, keeping a portion of your portfolio safe. Bonds can also provide a reliable source of cash flow that can be more reliable than stock dividends.

Finding the right bond for you

Like stocks, there are different bonds. Sovereign bonds (issued by governments) tend to be less risky, providing lower returns because of the lower credit risk. On the other hand, corporate bonds (issued by companies) provide higher returns, with an increased danger of losses due to companies going bankrupt.

At Human Investing, we provide individual treasury ladders for clients. US Treasuries are broadly considered one of the safest investments in the world. By owning individual bonds, you know you will get your principal returned upon maturity. The liquidity of treasuries also allows for flexibility if funds are needed sooner than anticipated.

Alternatively bond funds can be an excellent solution for clients, particularly those seeking growth. By investing in a bond fund, you gain exposure to a diversified range of bonds, enabling you to take on credit risk more effectively than as an individual investor. Much like owning a stock index fund, owning so many different companies debt means even if a few go bankrupt, they are such a small piece of your portfolio you will be okay.

Still have questions, or want to talk to an advisor? Reach out to us at hi@humaninvesting.com, or 503-905-3100.

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Welcome to 2024

It’s an election year and America will vote in November for a new Congress and President. Regardless of the election outcome, some investors will be pleased, while others will be disappointed. This article will help investors understand how the markets have been influenced when different political parties take control of both Congress and the Presidency. Looking at data from 1926 through 2023, the main conclusion is straightforward:

Over time the markets tend to rise, regardless of which party controls the White House or Congress.[1]

What impact does the President have on the stock market?

Democratic presidents have overseen slightly higher stock returns compared to Republicans. However, this difference is minor and not considered statistically significant. The variance in stock returns under different political parties can be attributed to the random chance of who happened to be in power at a given time. The reality is the US economy is vast and intricate, making it challenging for any individual, even a powerful figure like the President, to completely control its direction.

A recent example is the presidential election of 2016. The general expectation was for Hillary Clinton to win. When Donald Trump unexpectedly secured victory, initial market reactions led to a decline. By the following day’s market close, markets had not only recovered from the dip but ended up positive on the day. It’s hard to know how the market will respond to unexpected information, and it’s equally difficult to predict what impact a President may have on the stock market.

What impact does Congress have on the stock market?

On the other end of the federal government, a Republican-controlled Congress has typically overseen the best stock market returns. The differences are minor enough that there’s no certainty which party controlling congress (or a split) is best for the stock market.

Congress can be the more impactful part of the federal government in the long run. Executive actions are easily overridden day one by a President from the opposing party taking office. Legislation tends to be more enduring due to the requirement for a larger number of people to be involved. It’s important to note that the effects of legislation may take years to become apparent. This time lag makes it extremely challenging to pinpoint and attribute specific policies to their respective impacts on the ever-evolving dynamics of the market.

What about the White House and Congress combined?

When you widen your lens to encompass both the White House and Congress, the narrative remains consistent. Markets tend to go up irrespective of political control.

Regardless of the federal government’s control scenario, markets go up more often than they go down. 

As the 2024 elections unfold, we urge investors to remember that investing is a marathon, not a sprint. Position your portfolio to be successful in the long run, enabling it to weather unexpected changes from any source. Both parties have experienced periods of positive and negative returns while in power. Despite the inevitable changes in government, companies exhibit resilience and innovation, consistently discovering avenues to yield returns for their investors. In the intricate dance of politics and markets, a steadfast and forward-looking investment approach proves to be the key to enduring success.

Sources:

[1] Equity returns are monthly returns for the Ibbotson SBBI US Large-Cap Stocks Total Return for Jan 1926 thru Oct 1989 (data courtesy of the CFA Institute & Morningstar Direct), and the S&P 500 Total return for Nov 1989 thru Dec 2023 (data courtesy of YCharts)

Data for which party controlled both houses of Congress and the presidency is from the history.house.gov website (https://history.house.gov/Institution/Presidents-Coinciding/Party-Government/)

Changes to Congress and the Presidency are assumed to occur Jan 1st of odd years. A split Congress indicates that each party controls either the House or Senate, but neither party controls both.

Appendix: Bonus Chart 📈

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In recent months, I’ve been pondering the US labor force and how it has changed in the last five years. Amid the ongoing conversations surrounding inflation and the Federal Reserve's (aka The Fed) recent decisions to raise interest rates to manage inflation, I don’t want to neglect the other part of The Fed’s dual mandate: the dynamics of unemployment and the labor force. Prior to COVID-19, unemployment was at 3.5%, the lowest rate in the last 50 years. Today unemployment is around 3.8%, and has been 4% or lower since December 2021, significantly below the median unemployment of approximately 5% the US has experienced over the last 25 years. Since March 2021, job openings have consistently surpassed the number of job seekers.

Unemployment is often considered an indicator of an economy’s health. Like inflation, you want some unemployment, but not too much. Too high unemployment indicates a weak economy. If unemployment is too low, high inflation becomes a concern. Businesses seeking to grow may be constrained because of a lack of workers, limiting overall economic growth.

Strong employment is a major reason why 2023 has not experienced the recession that many feared at the beginning of the year. I wanted to delve into the reasons behind the tight labor market, what can be done about it, and what this signifies for the overall economy.

Labor’s impact on the current economy

The fundamental assumption in most economic models is that production is constrained by two primary inputs: labor (i.e. workers) and capital (i.e. technology). While technology has yielded significant advances in productivity, the necessity for a workforce to drive economic growth remains. A shortage of labor would imply slower economic growth, potentially resulting in reduced stock market growth.

Concerns persist regarding automation displacing jobs. Some have even proposed the implementation of a universal basic income due to the scarcity of employment opportunities resulting from automation (as exemplified by former presidential candidate Andrew Yang, who made this a central theme of his campaign). A variation of this concern has been present for over a century.

The latest development in automation centers around AI potentially increasing productivity to the extent that we might encounter a surplus of labor. Numerous case studies illustrate that technological change does not always materialize as successfully or rapidly as initially projected. A decade ago, there was much buzz about how autonomous cars were poised to revolutionize the world. Substantial progress has been made, but the challenge of perfecting driverless cars has proven more intricate than many had anticipated. (An example is Moral Machine, where you weigh in on how a self-driving car should navigate situations where the car must choose who to protect in an unavoidable collision).

Another illustration can be found in the excessive optimism at the peak of the dot-com bubble. While the internet did transform the way we work and introduced new efficiencies, it took significantly longer than what people in 1999 had envisioned. Forecasting the timeline for technological change impacting worker productivity is challenging.

If I had to guess, I would anticipate that in the near term (i.e. the next 5 years), we will continue to experience a tight labor market that will be a headwind to growth, for the economy and the stock market.

Retiring baby boomers present a significant challenge

By 2030, the youngest Baby Boomers will turn 65. The average American retires at 64. These retiring Baby Boomers possess the most expertise and would ideally be succeeded by Gen X workers with slightly less experience. However, Gen X is too small of a generation to fully replace the baby boomers, and Millennials & Gen Z broadly lack the experience necessary to fully replace the skills of retiring baby boomers.

This is backed by recent projections by the Bureau of Labor Statistics (BLS), showing that total employment is expected to grow by only 0.3% annually for the next decade, with a significant constraint being the slower growth of the working age population. Slowing growth in labor likely means slowing growth in GDP and stock prices.

Furthermore, there has been a consistent decline in the labor force participation rate over time. This is a measure of everyone 16 and older who is not in the military or an institution (due to criminal activity, mental health, or aging). Part of this reflects the aging population. As the proportion of the population beyond retirement age increases, a smaller segment of the population remains in the workforce.

How can we increase labor?

Gen Z is entering the workforce, but as a generation, they are too small to completely replace retiring baby boomers. Producing more working-age adults takes at least 16 years and 9 months, and the US birthrate has been below the stable replacement level of 2.1 for most of the last 50 years. If the US wants to sustain long-term population growth, and consequently, workforce expansion, it must either depend on immigration or find ways to boost the birth rate.

Implementing a policy permitting increased immigration could boost the size of the workforce in America. However, this is a politically contentious issue, and the legal framework around immigration is too uncertain to make reliable long-term predictions. Overly restrictive immigration policy could lead to a labor shortage, and too permissive immigration policy could cause a labor surplus. Foreign workers constitute approximately 20% of the US workforce.

A tighter labor market has some benefits for workers

The scarcity of labor translates into more choices when seeking employment and enhances the bargaining power of job seekers. Companies will have to consider their recruitment and retention policies to ensure they have the workers required for optimal performance. US wages and salaries are remaining above inflation, showing workers ability to demand higher compensation.

A tighter labor market plus higher wages could equal higher inflation rates

However, higher wages also entail increased costs for companies, and the allocation of these costs, whether to customers or shareholders, may result in higher inflation or reduced earnings. To counter inflation, the Federal Reserve has been increasing and maintaining higher interest rates. Many are apprehensive that the tight labor market (associated with demand-pull inflation) and ongoing post-COVID supply chain challenges (linked to cost-push inflation) could make achieving the long-term target of 2% inflation more challenging.

In Q3 2023 we observed inflation rates increasing from just below 3% in June to 3.7% in September. Many consider unemployment and inflation to have an inverse relationship. A tighter labor market may necessitate the Federal Reserve to persist with a more extended and aggressive tightening policy to manage inflation. If the Federal Reserve becomes overly aggressive in its tightening efforts, the concerns that led many to anticipate a 2023 recession could materialize.

All of this hinges on the tight labor market persisting. Technological advancements have the potential to enhance productivity to a level where a smaller workforce can achieve more and sustain economic growth. Modifications in immigration policy could either introduce a new source of workers or further reduce the size of the workforce.

In the long run, successful companies will adapt to the new environment and thrive. A diversified portfolio will continue to capture the growth of the companies that excel. We encourage investors to be prepared for a myriad of reasons to be nervous, and understand given time the market will figure things out and continue to grow.

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What recession?

As prognosticators assessed markets and the economy in the beginning of 2023, the expectation for many was a tumultuous year,  with a substantial likelihood of a recession. Now, nearly two-thirds of the way through the year, the S&P (Standard & Poor) 500 has surged by 18.73% through the end of August. Real GDP (Gross domestic product) has maintained steady growth, with quarterly increases of at least 2% since Q3 2022. Inflation, which began the year at a daunting 6.4%, has receded to 3.18%, still above The Fed's 2% long-term target but showing a marked improvement.

What changed given the gloomy expectations for 2023 at the start of the year? The biggest unknown was the impact of The Fed’s decision to continue raising interest rates. The expectation was that The Fed raising interest rates to cool inflation would cause an economic recession. We’ve even seen rising rates play a role in multiple banks failing earlier in 2023, but those events haven’t triggered any distress.

We’ll break down the top themes for why we’re seeing the markets and economy continue to power through.

Theme #1: Strong job market

Inflation has gone down, but GDP growth remains positive, and unemployment remains low. There are still 3 million more job openings than job seekers, and few were expecting The Fed to get this far on inflation without dipping the economy into a recession. Even experts have a difficult time accurately predicting where the markets and the economy are going.

Theme #2: ‘Soft landing’ of interest rate hikes

In contrast to the substantial interest rate hikes witnessed in 2022, the changes in 2023 have been modest. A significant contributor to the slowdown in interest rate hikes was the decline in inflation during the latter part of 2022, which has persisted into 2023. Consequently, The Fed didn’t need to enact as many rate increases, or do so as rapidly as they did in 2022.

Theme #3: Surprising growth from S&P 500 companies

The S&P 500’s rise has a couple of factors going for it. While 2022 saw a decline in earnings per share for S&P 500 companies, 2023 has witnessed earnings growth, with expectations that growth will continue. Analysts are feeling increasingly optimistic that companies will find a way to bolster earnings amidst a higher interest rate environment.

The other piece of the puzzle is the exceptional performance of the largest stocks within the S&P 500 this year. The S&P 500 is a market cap weighted index, meaning that each stock is weighted based on how large the company is. This means AAPL has a bigger weight than Home Depot, and AAPL being up 10% would increase the S&P 500 performance more than HD (Home Depot) being up 10%.

In 2023, returns have been concentrated in a few high-performing stocks. Put differently, only 28% of stocks in the S&P 500 have outperformed the index. This highlights the dominance of a handful of top performers in 2023. It’s worth noting 61% of stocks in the S&P 500 have achieved positive returns for the year, indicating favorable performance across the stock market.

Source: Data for this paragraph is based on using IVV (iShares Core S&P 500 ETF) holdings. Positions were all verified to be held 12/30/2022 and 8/24/2023 to ensure consistency of constituents. Average returns assumes equal weighting of the positions. Top 10 holdings are based on 8/24/2023 weighting: AAPL, MSFT, AMZN, NVDA, GOOGL, GOOG, META, BRK.B, TSLA, UNH. Jan-Aug performance data courtesy of YCharts as of 8/31/2023 market close.

Theme #4: Mid and small sized companies are not far behind

Many talk about the S&P 500 as though it represents the entire stock market. However the S&P 500 represents the largest companies in the US (typically $14.5 billion and greater), leaving out companies considered mid-sized and small.  The mid and small parts of the US markets have been lagging, still positive returns but not as high.

Source: All data courtesy of YCharts. Assumes S&P 500 for US Large, S&P 400 for Mid, S&P 600 for Small, and S&P 1500 for Total Market (blend for all). Uses Value & Growth versions of benchmarks respectively.

Predicting short-term MARKET outcomes continues to be difficult

Short-term value oriented investors may be frustrated to see their performance lagging the broad market. Alternatively, longer-term investors recall seeing a significant benefit in 2022 by experiencing less negative returns than the broad market or growth stocks. You are still positive from the start of 2022 to the end of August 2023. Growth and blend investors are still waiting to recover from the downturn. Trying to time when value or growth will outperform is not recommended. Find an investment style that suits your risk tolerance and financial plan, and be prepared to stick with it for the long haul despite periods of under or over performance.

The year 2023 so far serves as a compelling illustration of how stocks can still generate positive returns even in the face of grim expectations. It is also a great reminder of how difficult accurately predicting the economy or the markets is. The outlook for the equities market is rarely all sunshine and rainbows. Stock market volatility means that short-term corrections are always on the table. There are and always will be valid concerns that could lead to a downturn. If you are choosing a particular tilt in your investments, be prepared to stick with it over time. Long term, equities remain the best way to grow your savings. It is valuable to remember and reflect on the times when you anticipated poor returns but were pleasantly surprised by positive performance.

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Earnings season is coming

With the recent struggles of Nike stock over the past couple of years, many Nike employees are wondering what to do with their stock. Whether it is to diversify into another investment or to fund expenses like vacation, remodels, or tuition for their kids, the current price has made those decisions more difficult. A common question we hear is “Should I sell my NKE now or wait?”

NKE has recently experienced declines. From Sep 2022 to August 2023, NKE fell -4.49% while the S&P 500 has risen 15.58%. Nike had a great run of outperforming the S&P 500 for 10 out of 12 years prior to 2021 but has been on a losing streak since.

Is Nike poised to make a comeback? Predicting the future of any stock, or the market overall, is a difficult task. Nike is the industry leader in athletic apparel, particularly in footwear. If Nike can maintain their brand and industry leadership, they are poised to be successful. Achieving outperformance relative to the S&P 500 is not guaranteed.

Let’s look at a few different ways to approach valuing a stock to get a sense of if NKE appears over or undervalued.

🍰 Price / Earnings (P/E) ratio - how much are you paying for each dollar of earnings:

• Pros: Earnings are the profits of the company, and those profits are ultimately what is available for shareholders as dividends

• Cons: Easily manipulated or adjusted by many line items on the income statement, can vary greatly year to year

• Current P/E: 29.84

• 3 year median P/E: 36.26

• Implied Valuation based on $3.23 Earnings Per Share = $117.12

• Verdict: Undervalued, hold your NKE for now

💰 Price / Sales (P/S) ratio – how much are you paying for each dollar of revenue:

• Pros: Less subject to manipulation or fluctuation

• Cons: Doesn’t consider efficiency (i.e. costs necessary to generate the revenues)

• Current P/S: 2.95

• 3 year median P/S: 4.62

• Implied Valued based on $32.63 revenue per share = $150.70

• Verdict: Undervalued, hold your NKE for now

🔄 Price / Free Cash Flow (P/FCF) ratio - How much are you paying for each dollar of operating cash:

• Pros: Shows cash actually available to investors for dividends or stock buybacks, ignores non-cash expenses (i.e. depreciation)

• Cons: Still subject to manipulation based on accounting practices, can vary greatly year to year

• Currentl P/FCF: 31.06

• 3 year median P/FCF: 43.98

• Implied value based on $3.10 free cash flow per share = $136.50

• Verdict: Undervalued, hold your NKE for now

🥣 Average of all ratios:

• Take the average of the implied values for P/E, P/S, and P/FCF

• Implied Value = $134.77

• Verdict: Undervalued, hold your NKE for now

🚀 Price / Earnings Growth (PEG) ratio = P/E ratio / Earning Growth – measure P/E in context of company’s growth rate

• PEG < 1 implies undervalued, PEG > 1 implies overvalued.

• Currently: 29.89 / -16.46 = -1.81

• Decrease in EPS results in negative value.

• Forward 1 year: 1.775

• Verdict: Overvalued (sell your NKE now).

Based on historical averages, NKE currently appears undervalued

You can also take different time periods for the median of these valuations, to see what Nike’s valuation has been like over a longer period of time.

Note: All data courtesy of YCharts as of:  9/15/2023

While Nike may appear severely undervalued on a 3-year basis, the difference is smaller over 5-year and 10-year medians. If you’re thinking about selling, these valuations may give you some guideline thresholds to re-evaluate at.

Based on historical averages for NKE, the stock currently appears undervalued. The decline in NKE’s price in recent years is a big reason for that. Whether the decline will continue, or NKE will return to its historical valuation norms nobody knows. Looking at the basic fundamentals, NKE appears healthy overall. 

• Earnings & revenue have continued to grow.

• NKE has consistently sold its products above the cost of those goods.

• NKE can cover both its current and longer-term debt needs based on existing cash and future expected earnings.

• NKE has not missed a dividend in the past 10 years.

These metrics are by no means the only way to approach whether now is a good time to sell your NKE stock. Other factors to consider:

• The amount of time you think you will work at Nike.

• How much of your Net Worth is tied to NKE?

• When do your Stock Options expire (if applicable)?

• Your comfort level with the ups and downs over time.

• Do you have any major expenses coming up? i.e. house purchase, funding college, etc.

We’re here to help

Beyond these factors and metrics, it is important to integrate your Nike stock decisions within the context of a comprehensive financial plan. If you have questions or would like to discuss whether to hold or sell your NKE stock, please reach out to us at nike@humaninvesting.com.

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What is the yield curve?

The yield curve refers to the current yields of US treasury bonds based upon time until maturity. It’s frequently depicted as a graph to help summarize the data. Typically, a yield curve is upward sloping. Short-term (ST) rates are lower, and long-term (LT) rates are higher.

Wall Street Journal, Bonds & Rates: Yield Curve, April 25, 2023

Reading the yield curve:

• A “steeper” or “steepening” of the yield curve means short-term (ST) rates are lower, and long-term (LT) rates are higher, resulting in a steeper line when comparing

• A “flatter” or “flattening” of the yield curve is when ST rates and LT rates are equivalent, or are getting closer to parity

• An “inverted” yield curve is when ST rates are higher than LT rates, like the current line in the snapshot above.

What determines the yield curve?

All rates on the yield curve are determined by the market. The Fed only controls the federal funds rate, which is only the rate banks lend to each other overnight. Because the market determines the shape of the yield curve, many look to the yield curve as a summary of overall investor sentiment to draw conclusions about expectations for the future. Some important market factors that influence the yield curve include:

• Liquidity (time horizon): The more time until a bond matures, the longer you have your money tied up. As a result, a longer time to maturity (and lower liquidity) bond tends to have a higher yield. This contributes to an upward sloping yield curve.

• Growth expectations: If there are higher growth expectations, you tend to see a steeper yield curve. This is because higher growth tends to lead to higher inflation, and so rates must be higher to achieve positive real returns.

• Demand: As more investors demand a bond, the price goes up. As bond prices go up, yields go down.

Why is the yield curve inverted, and why does that indicate a recession?

The yield curve is inverted because ST rates are higher than LT rates. This is largely due to The Fed raising interest rates to lower inflation. The Fed appears determined to reign in inflation, and has raised ST interest rates to slow down the economy enough to reduce inflation. This is putting upward pressure on ST rates. Many expect this approach to cause a recession, which would lower growth expectations, reducing LT interest rates. The result is the inverted yield curve we see today.

Why does this inversion indicate a recession?

In theory, the market is pricing treasuries so the returns over a given time period are the same, regardless of what you buy today. Let’s use an example to illustrate this.

Say you want to invest $10,000 in treasuries for 2 years, you can make two choices:

1. Choice #1: Buy a single 2 year treasury

   • Currently a ~4.2% yield, so you earn roughly 4.2% for 2 years.

2. Choice #2: Buy a 1 year treasury today, then a new 1 year treasury in 1 year:

   • Currently a ~4.7% yield, so you earn roughly 4.7% for 1 year.

   • After the first year, your treasury will mature, and you will have to purchase a new treasury at whatever the current rates are. The yield curve today is predicting 1 year rates will be at 3.7% in the following year.

   • Your overall return after averaging those rates for each year is 4.2% — the same as buying a 2 year treasury initially!

A lower rate in the future indicates lower growth expectations at that time. Growth expectations being lower (or negative) does not bode well for the health of the economy. The inverted yield curve also has a solid record of predicting recessions, but that doesn’t mean it’s perfect or guaranteed. The yield curve reflects the average sentiment of the markets, which indicates what expectations are. Sometimes expectations create a self-fulfilling prophecy situation, and sometimes expectations are flat out incorrect because of an unexpected shock, like the COVID-19 pandemic.

What does this mean for me and my portfolio?

Ultimately your portfolio should be allocated for the long term, and that should be positioned accordingly. While the inverted yield curve has been a strong predictor of recessions, the timing of that prediction and how significant it’s going to be are not consistent enough to provide an easy 5 step solution for everyone.

If you are positioned towards the more aggressive end of what you are comfortable with, consider reducing risk with some volatility expected on the horizon. Understand that regardless of the yield curve today, the long run expectation is growth and positive returns for the economy and equity markets.

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It’s a new year, and there are still plenty of old questions about the economy & markets. We thought diving into some questions about today’s economy would be helpful.

2023 Economic Outlook

Many different sources (See Table 1) forecast a recession for 2023. With The Fed combating inflation by raising interest rates, expectations are these moves will force the economy into a downturn. The extent of the recession may depend on The Fed’s actions. If inflation recedes quickly, and The Fed cuts rates or stops raising them, that could minimize a recession or possibly avoid a recession entirely—this is called a “soft landing.” If inflation persists, and The Fed is determined to lower inflation in the face of a declining economy, the recession could be worse. However, market forecasts expect The Fed to cut rates in 2023 in response to a recession. The Fed has yet to forecast those same rate cuts. Based on our observations, the odds are we will experience a mild recession in 2023.

2023 Investment Outlook

Despite the prospects of a recession, investments grow over the long run, and volatility is expected. As we’ve previously covered, it can take years for your portfolio to recover from a downturn. We have always seen markets recover to new all-time highs. With a looming recession, 10-year forecasts for US stocks remain positive.

Downturns present a buying opportunity for investors, particularly workers accumulating for retirement. Continuing to purchase when stocks decline is an excellent investment. Saving more when times are tough is challenging. Ensure you are in good financial shape: have 3-6 months of expenses saved in an emergency fund, pay off any high-interest debt, and consistently spend less than you make. Then consider increasing your savings. Increasing your contribution rate is a wonderful forced savings tool if you have a 401(k) or similar plan.
 
Markets and the Economy
You may have heard the market is forward-looking. We know the market is a flawed prognosticator because prices still adjust daily to reflect new information. Let’s examine how closely market bottoms coincide with recessions.
 
There have been 11 recessions since 1950, according to the National Bureau of Economic Research (NBER). Using the NBER’s trough dates (i.e., the end of a recession), we can compare GDP with the S&P to see when both hit their lowest point. Looking at Table 3, the S&P 500 tends to do one of two things:

1. The market is at its worst about the same time as the economy.

2. The market is at its worst approximately six months before the economy bottoms out.

There are some caveats. Market data is live, and markets are open every business day. GDP data comes out quarterly, advance estimates come out nearly a month after the fact, and aren’t fully revised until around 60 days after initial release. For both the market and economy, knowing when you’ve hit bottom is nearly impossible to determine in the moment. Because it’s difficult to know when the worst is over, we recommend staying invested amidst the potential short-term tumult.

Be prepared for some turbulence this year

Economists and market prognosticators are expecting there will be a recession in 2023. The severity of the recession will vary depending on The Fed. The Unemployment rate remains below historical averages at 3.5%. In November 2022, there were nearly 6 million more job openings than job seekers, suggesting the economy can handle some tightening. Trying to time the market or economy bottom remains a guessing game. Long term, the outlook for returns is still strong. Be prepared for some turbulence this year, knowing you are headed in the right direction long term.

Sources
1. Federal Reserve Bank of New York. The yield curve as a leading indicator. January 2023.
2. The Wall Street Journal. Economists in WSJ survey still see recession this year despite easing inflation. January 2023.
3. Bloomberg. Economists place 70% chance for US recession in 2023. December 2022.
4. Vanguard. Vanguard economic and market outlook for 2023: Beating back inflation. December 2022.
5. BlackRock. 2023 global outlook. January 2023.
6. Charles Schwab. 2023 market outlook: Cross currents. January 2023.
7. Fidelity. Global outlook 2023: New world disorder. January 2023.
8. Charles Schwab. Schwab's 2023 long-term capital market expectations. January 2023.
9. Vanguard. Market perspectives: December 2022. November 2022.
10. BlackRock. Asset return expectations and uncertainty: as of September 2022 November 2022..
11. Data courtesy of YCharts & NBER

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As a Charted Financial Analyst serving as the firm’s Director of Investments and Compliance, I oversee the construction and management of client portfolios. How we go about investing client capital involves evaluating a variety of factors that move the markets. Given the economic backdrop for 2022, I thought it would be helpful to address a few of the components impacting the economy and subsequent stock and bond market volatility.

Historical trends suggest the current high levels of inflation will not persist.

 Inflation is higher than it has been for decades, exceeding 7.5% in the March to October 2022 numbers, represented in the purple line below. The breakeven rate between a 5-year Treasury Inflation Protected Security (TIPS) and a standard Treasury is commonly used as a benchmark for what average inflation over the next five years is expected to be. The graph below shows this in orange below, hovering around 2.34%.

What is causing inflation?

There are broadly two types of inflation:

1. Demand-pull inflation occurs when there is too much demand for a limited supply of items (too much money chasing too few goods).

2. Cost-push inflation occurs when the costs of inputs for producers increase, and those costs are passed along to consumers (too few inputs to produce too many goods).

Both factors are helping push inflation higher. Government stimulus in response to COVID and global supply chains having to adjust in response to the pandemic have both had their part in increasing inflation, along with many other factors.

What brings inflation down?

Macroeconomic theory believes that inflation falls when an economy slows down. A slower economy usually means higher unemployment and less spending and investment. This means there isn’t too much demand-pull inflation occurring because higher unemployment means there are fewer wages chasing the goods produced. Higher unemployment also tends to lead to lower cost-push inflation because the cost of labor typically goes down when unemployment is high.

The Fed is still working on a soft landing.

Higher inflation is not healthy for an economy long term. Banks still want to make money even when inflation is high, so they lend at higher rates to ensure they still make a profit after accounting for inflation. Higher interest rates result in a higher cost of borrowing, making any investment (buying a house, going to college, launching a new business, building a new production facility, etc.) more expensive. Households and companies invest less, which means fewer productive and good investments happen, slowing down the overall economy.

Because high inflation is unhealthy for an economy, the Federal Reserve (aka “The Fed”, the US central bank) is raising interest rates. The Fed’s goal is to raise interest rates high enough to slow down the economy and bring down inflation. The concern is that The Fed will be too aggressive in raising interest rates and cause a sharp economic downturn. The hope is The Fed can execute a soft landing, slowing down the economy enough to reign in inflation but not slowing down so much to trigger a major recession.

The job market is still experiencing labor scarcity.

Currently, there are about 5 million more open jobs than people looking for a job. Unemployment is below 4%, near the historical lows we were experiencing pre-pandemic. Due to labor scarcity, employees are seeing their wages rise.

The overall economy is seeing consistent growth.

Gross Domestic Product (GDP) is the most used measure of the size of an economy. Real GDP (rGDP) accounts for inflation. The orange line is a “trendline” for real GDP, based on the average growth of rGDP from 2012 to 2017. As you can see, GDP is not far off from what would have been expected if the COVID downturn & recovery had never occurred. While the first half of 2022 had two-quarters of negative GDP growth (a common definition of a recession), Q3 2022 saw the economy grow.

Company earnings are still increasing despite downturns.

The following chart illustrates earnings growth compared to the S&P 500. The market tends is forward-looking, setting prices based on what is expected to happen. Current fears about inflation & The Fed triggering a downturn by raising interest rates too much too quickly are pushing the market down. Earnings reflect what companies earned in the previous three months. While there is a lot of anxiety about the state of the economy, companies are continuing to earn money and will continue to do so even in a downturn.

What does this mean for you and your portfolio?

In conclusion, there are contradictory messages. The economy quickly recovered from the global pandemic, and the workers are enjoying a solid labor market with wages rising. The positive economic news is contrasted with poor investor experience in the stock market. Concerns about high inflation and The Fed’s anticipated aggressive rate hikes to combat inflation have the market worrying about a recession. With all this happening, companies have continued to grow their earnings.

While there is conflicting information in the short term, we continue to anticipate long-term growth in the economy and stock market. Having a sound financial plan that accounts for downturns and uncertainties is crucial. Feel free to reach out if you have any questions about your plan or have had any changes in your financial situation.

All data courtesy of YCharts Nov 29, 2022.

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Seeing losses in your portfolio during market volatility may be disheartening. Utilizing those losses through a process called tax loss harvesting affords the opportunity to have your taxes benefit from those losses. Rather than selling stock due to inferior performance and shifting the allocations in your portfolio, you can lock in those losses while keeping your portfolio performance the same.

What is tax loss harvesting? Why should I utilize it?

Tax loss harvesting is when you realize, or “lock in,” the losses of your investments by selling the investment. Say you bought stock A at $150 per share, and that investment is now valued at $120 per share (or a $30 per share unrealized loss). You may lock in the loss of an investment by selling some or all of your shares. This is known as “realizing” your losses.

You can then use these losses to lower your tax bill in three ways:

1. Offsetting your realized gains from other investments sold

2. Offsetting capital gains generated from other activities such as a home sale, business sale, or collectibles

3. Offsetting up to $3,000 of your ordinary income

Tax loss harvesting is typically recommended for clients whose tax liabilities require year-round attention. We implement tax loss when positions we manage to hit a certain loss percentage. Toward the end of the year, we perform "tax-gain harvesting" where we look to sell positions with very high gains to ensure we are not generating a net gain for clients.

The “Wash Sale” Rule that minimizes loopholes

Unfortunately, you are not allowed to sell a stock and immediately repurchase it to recognize the losses. If you decide to sell an investment position at a loss, you may not purchase that same investment or a “substantially identical” investment 30 days before or after the sale at a loss. This is to avoid a “wash sale” rule violation. This rule applies to all investment accounts associated with your household and on your tax returns. If a wash sale rule violation happens, the IRS will not allow you to use the loss to offset your gains. The cost basis of your investment will also change as the disallowed loss is added to the cost basis of the new, "substantially identical" investment you purchased. Click here for more information on the wash sale rule.

Will I miss out on my investment returns by doing this?

While there is no guarantee that the original investment sold to harvest losses will stay valued at or lower than the price you sold it for, you can buy similar positions to maintain the allocation and expected rate of return in your investment portfolio.

For example, you sell your Apple stock (AAPL) and are looking for a replacement, so you decide to use a large-cap growth index fund. Large-cap growth index funds are funds that invest in various stocks/companies that are classified as "large-cap," meaning they are valued at a market capitalization of $10+ billion. The growth piece implies that the fund managers see that the companies offer strong earnings growth and are undervalued in the stock market. Using a large-cap growth index fund gives your portfolio continued exposure to the large-cap growth sector of the market during the time period you are not allowed to buy AAPL stock.

See tax loss harvesting in action.

Say you bought some AAPL stock at $10,000, and the stock is now valued at $7,500. If you were to decide to sell it, you would then realize a loss of $2,500. Then, you have another stock, MSFT, that you bought for $5,000 and is now valued at $9,000. You sell that stock and realize a gain of $4,000. Since you can use the losses generated to offset your gains, you would have a net $1,500 of capital gains to pay taxes on, rather than the original $4,000!

Human Investing is here to help.

Tax loss harvesting is done as part of our portfolio management services. We also offer tax planning as a part of our services, helping to ensure you receive comprehensive financial planning where you need it most. If you are interested, please reach out to us at 503-905-3100 or hi@humaninvesting.com.

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As I write this in May 2022, most major asset classes are down for the year. Stocks, bonds, foreign or domestic, it’s hard to find an investment producing positive returns right now. Since no investor likes to see the balance in their account drop, we have received an uptick in client inquiries about whether it’s worth staying invested. The short answer is yes; we still recommend staying invested. Markets have historically recovered, and grown to new highs. Panicking and selling your investments when they’ve gone down in price is unhelpful for achieving your long-term investment goals. Staying invested when the markets are roiling is easy to say, hard to do.

If you’re interested in a longer, more data driven response about why you should stay invested, keep reading. A lot of client’s concerns boil down to “How long is it going to take for me to make my money back?”. Let’s call this amount of time it takes to hit a new all-time high for a portfolio the “payback period”.

For the returns, I pulled the Ibbotson SBBI US Large-Cap Stocks for equity, and the Ibbotson SBBI US Intermediate-term (5-year) Government Bonds for fixed income. This data compiles the monthly returns from January 1926 to March 2022. I took a 100% equity portfolio (100/0) and added 10% bonds to compare different allocations (i.e. 60/40 is 60% equity 40% fixed income). I assumed monthly rebalancing.

Source: CFA Institute

As the graph shows, the more conservative your allocation, the shorter the time-frame necessary to make your money back. The most aggressive allocations (100/0 and 90/10) can take about 15 years to make your money back. A more balanced investor (40/60 to 80/20) would expect around 7 years as the worst case to make their money back.

I want to emphasize these numbers reflect the absolute worst scenarios over nearly a century of investing. We could always see a new worst case. Typical experiences are usually not as extreme. Even just looking at the 2nd longest time-frame to make your money back, and the longest payback is just over 6 years.

Source: CFA Institute

In most cases, you will make money in a relatively short amount of time if you remain invested. The final graph shows how long your investment horizon needs to be to have made money 95% of the time. As you can see, a majority of the time markets reward investors who stay invested for at least 9 months. That 5% of times where you haven’t made money in 9 months, we have seen some major draw-downs that took years to recover from. Make sure you have positioned yourself in a way where you are comfortable with all possible outcomes.

Source: CFA Institute

So, what do we do with this information? Some perspective for us all:

Understand the Time-frame you’re Investing For

If you’re not accessing funds for 15+ years, you shouldn’t worry about how long it takes to make the money back.

• If you are investing in a retirement account, keep doing that.

• If you move money monthly into a brokerage account, keep doing that.

If you are planning on accessing the funds in 10 years or less, consider incorporating bonds in your allocation to reduce risk, and shorten the time frame to recover a loss in value for your portfolio.

If you’re currently accessing your funds, have a financial plan to understand how you handle downturns in the markets and still achieve your financial goals

• Strategies for this include having a certain amount of cash on hand to cover market downturns, adjusting your budget as needed, etc.

Stay Invested

When you see your account balance down, know that remaining invested is the best way to recover lost value. Most of the time, you won’t have to wait for years to see your balance recover.

Plan in a way that Helps you Sleep at Night

If you can’t handle the thought of waiting seven years to make your money back, a 70/30 allocation may not be right for you. Have a financial plan in place that accounts for the worst-case scenarios, so you know you’ll be able to ride out any volatility in the markets.

Understand History can Only Tell us so Much

The markets could always find a new worst-case scenario. Use history as a guide for setting expectations, not absolute certainty of what is to come.

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There has been a lot of news on high inflation coming and its looming effects on everything from investment portfolios to the price of milk.

As people are searching for ways to combat high inflation and preserve how far their money can go, we’ve been receiving many questions on an investment option called I Bonds. Questions about what they are and why they haven’t heard of them before.

Our hope is to shed some light on Series I Savings Bonds (I Bonds), available here, and outline how the investment works before offering our recommendations.

How risky is an I Bond?

I Bonds are US treasury bonds, meaning they are backed by the full faith and credit of the US government, making them one of the safest, lowest risk investments possible.

What is the interest rate on an I Bond?

There are two parts to the interest rate on an I Bond.

• A nominal (fixed) rate — currently 0% as of November 2, 2021.

• An inflation (floating or adjustable) rate that changes every 6 months — currently 3.56% as of November 1, 2021.

These two rates are added together to determine the interest rate on an I Bond, so the current rate on the I Bonds for 6 months is 0% (nominal) + 3.56% (inflation) = 3.56% total (which is 7.12% annually). This interest rate cannot drop below 0% even if there is ever a negative inflation adjustment. See here for historical I Bond interest rates.

The floating rate on I Bonds will adjust as inflation adjusts. Today, inflation rates are high, but as the historical rates table in the link above shows, inflation rates can be lower.

When can I access my money?

An important factor to consider is that I Bonds only pay interest upon maturity, so you will not receive cash flows from the I Bond as you hold it.

I bonds have no secondary market, so you cannot resell your I Bond, you can only redeem it. I Bonds have no liquidity for the first year after purchase, so it’s important that you will not need to access the funds for at least one year. For years 1-5 after purchase, you may redeem your I Bond early by forfeiting the last 3 months of interest. After 5 years, you may redeem the bond early without penalty. I Bonds will mature 30 years after purchase.

How do the taxes work?

I Bonds only pay interest upon maturity. You can claim (pay) the taxes on the earned interest every year on your I Bonds, or you can pay taxes on all interest upon maturity of the I Bond. I Bond interest is not subject to state or local taxes. See here for more information.

How do I purchase I Bonds?

You have to purchase I Bonds directly through treasurydirect.gov, or with your federal income tax refund. See here for more information.

You are limited to $10,000 of I Bonds through electronic purchase, and $5,000 of I Bonds through paper purchase via your tax refund, for a total limit of $15,000 of I Bonds in a calendar year.

The pros and cons of waiting to get paid out

If you’re still wondering if these bonds are right for you and your financial plan, weigh the pros and cons below against your goals.

Pros:

• The inflation adjustment makes I Bonds a great inflation hedge

Cons:

• Interest is only paid out upon maturity, so don’t utilize I Bonds as a source of cash flows over time

• Funds are locked up for 1 year, so don’t use I Bonds for any funds you might need before then

Other considerations:

• I Bonds must be purchased on your own, so they’re for a more DIY inclined investor

• The inflation adjustment rate will change adjust over time, so the precise amount of interest an I Bond will earn is uncertain

• Consider the potential taxes of having all interest hitting upon maturity of the I Bond, or having to pay taxes each year on interest you have not yet received

• You are limited on how much you can purchase in a year

I Bonds are typically best for medium term (i.e. around 5 year) savings goals.

The inflation adjustment reduces your risk of losing purchasing power due to inflation. The low nominal rates on I Bonds today means your funds will not grow faster than inflation.

For longer term savings goals (i.e. retirement in 10+ years), equities are a great long-term inflation hedge, because companies can adjust their prices (and therefore dividends & earnings) based on inflation. Treasury Inflation Protected Securities (TIPS) are another, lower risk than equities, investment that adjust for inflation.

If you have more questions about I Bonds, or would like to speak to a financial professional about other investments, please reach out to us at hi@humaninvesting.com or 503-905-3100.

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We talk to a lot of different people about investing. A common request is something along the lines of: “I don’t want to lose anything, and I want my money to grow.” This is a challenging, if not impossible mission. The investment world is full of opportunities to grow your money. However, there is an inherent risk when you put your money in any investment.

Finance has a lot of ways of measuring risk. Standard deviation is used to try to show a range of the possible returns. Max drawdown displays your worst-case scenario. Sharpe ratio provides a risk-adjusted measure of performance. However, very few investors ask about standard deviation, max drawdown, and Sharpe ratios. The people we talk to are most likely to ask “What are the odds of losing money” because they don’t want to see their current savings drop in value.

How strong is your purchasing power?

An important consideration when talking about losing money is purchasing power: the ability to buy goods with your money. Inflation has consistently pushed prices up over time, reducing the purchasing power of a single dollar. Wanting to avoid losing money is completely understandable. The danger of keeping your money under your mattress or sitting in cash is that inflation is constantly reducing your purchasing power.

When concerned with losing money, many investors are focused on nominal returns. Nominal returns are the raw return values, unadjusted for inflation, and are simple to calculate and digest. I would argue that most investors should be focused on real returns: returns adjusted for inflation. Real returns are a more accurate measure of your change in purchasing power. Ultimately, very few outside of Scrooge McDuck want a giant pile of money. Most people want to spend that money on goods, like food, travel, or a home, therefore purchasing power is likely what investors really care about.

Real return = (1+Nominal Return) ÷ (1+inflation rate)

Historically, stocks deliver positive returns, and those returns are in your favor. However, stocks are down (i.e. lose money) more frequently than bonds. The safety bonds offer also means they provide lower returns. What blend of stocks and bonds is most likely to protect your purchasing power (i.e. produce a positive real return)?

inflation is dwindling BOND power

To try and answer this question, I looked at the Stocks, Bonds, Bills, and Inflation (SBBI) data from the CFA Institute from 1926-2020. This data included monthly and annual returns; the annual data is for each calendar year. For stocks, I used the Ibbotson SBBI US Large-Cap Stocks total return.

For Bonds, I used the Ibbotson US intermediate-term (5 year) Government Bonds total return. I looked at several different portfolios which include a variety of stocks and bonds. Specifically, I blended the stocks and bonds in 10% increments, from 100% stocks, to 90% stocks 10% bonds, to 80% stocks 20% bonds, and so on to 0% stocks 100% bonds. I also assumed the portfolios were rebalanced at the start of each return period (i.e. the weights were reset at the start of each month for monthly data, and the start of each calendar year for annual data).

I took these different stock/bond portfolio mixes, and I calculated the nominal and real returns from 1926-2020 for both monthly and annual (calendar year) returns. I then calculated what percentage of returns were positive to measure the chance of losing money (nominal returns) or purchasing power (real returns). I’ve graphed the nominal vs real returns for monthly and annual returns below.

You’ll notice the nominal monthly returns paint a clear picture. If you want positive nominal returns more often, you want to own more bonds, hence the steady upward trend to the graph. If you look at the annual nominal returns and want to maximize your chances of a positive nominal return, you actually want a 10/90 portfolio (10% stocks, 90% bonds). As risky as stocks seem, having at least a sliver of stocks actually increases the chances of a positive nominal return

The real returns tell a slightly different story. For the monthly real returns, the stock/bond mix is almost irrelevant for producing a positive return, and hovers right around 60%. There is a drop off after 10/90 (10% stocks, 90% bonds), indicating owning even just 10% stocks in your portfolio helps increase your chances of positive real returns better than owning 100% bonds.

For the annual real returns, you can see that your odds of a positive real return are better with at least some bonds in the portfolio. Interestingly, the 70/30 portfolio and the 20/80 portfolios produce the highest chance of a positive real return. The all bond portfolio, 0/100, has the worst chance of maintaining your purchasing power (i.e. producing a positive real return).

Stocks can seem risky, and the loss of value can make many investors shy away. Even just a small amount of stocks can protect your purchasing power better than owning only bonds. There are still many considerations for how you should invest including your risk tolerance, time horizon, and holistic financial plan. If you’re interested in talking to an advisor, please reach out to us at hi@humaninvesting.com or 503-905-3100.

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