As expected, neither stocks nor bonds reacted very well in the first half of the year to a rise in inflation which hit an annual rate of over 8% in June, the highest level in 40 years. To combat this first serious case of inflation since the 1970s, the Federal Reserve has been raising interest rates in hopes of reining in inflation closer to its target of 2%. But of course, the steady escalation interest rates now has investors worried that the Federal Reserve could actually choke the economy and thrust the economy into a recession.
How do investors react when faced with the prospects of high inflation coupled with the threat of recession? The table below offers a pretty good answer:
Most stocks were down 20% or more, including smaller companies and foreign stocks. Surprisingly (and we’ve been highlighting this theme all year), bonds have been no place to hide this year. They’re down 10% or more, which ranks as the worst half for high quality bonds in at least 40 years—even worse than in 1994 or 2008.
A drop of 20% or more is the common measure of a “bear market,” and most stock indices have met that mark. Typically, before the bear market has run its course, every area of the market comes under pressure. For the first five months of this year, commodity and natural resource stocks actually performed well, gaining over 10%, while the broader market fell over 10%. In June, however, this sector turned down, falling over 15%. At this point, it seems that there has been no area of the market that has been spared the wrath of this bear market. For those curious about the performance of crypto currencies, like Bitcoin, those assets are down 60% this year.
Outlook for the Second Half of the Year
As most of you probably know by now, the FSA portfolios were essentially out of the stock and bond markets for much of the second quarter. As a result, our portfolios were down only a fraction of the decline in the broad stock and bond indexes. It’s nice to have a heavy money market position during those weeks when stocks are down sharply. As stocks start to rebound, however, it’s natural to wonder if a rally could be the beginning of a new bullish cycle. Cash is king for the moment, but we want to use that cash to take advantage of opportunities that might be looming down the road.
Overall, we want to see signs of some bullish momentum before moving into stocks again. With most stock indexes trading below their long-term trend lines, we will be looking to move cautiously back into the market. Nevertheless, in our more aggressive strategies, we may add small allocations to areas of the market that are able to exhibit strength. For example, we added a small health care position in some Core Equity and Tactical Growth portfolios in late June.
Historically speaking, during a mid-term election year, there is often a rally in stocks in the second half of the year after weakness in the first half. We don’t invest according to historical tendencies, but it’s helpful to be aware of them. Now that we have some “dry powder”—large money market allocation—we are in a good position to take advantage if market conditions improve in the second half of the year.
Portfolio Update
Keep in mind that because we manage clients’ portfolios individually, the holdings in your particular accounts may differ somewhat from the averages.
Strategies That Employ the FSA Safety Net®
Income (Strategy 1)
Bonds continued to lose money in the second quarter, with the broad bond index falling almost 5%. Thus, in the current environment, having elevated money market levels has been advantageous. Currently, we hold two shorter term bond funds that have held up pretty well. Currently, the Income portfolios hold 20% in bond funds and 80% in money markets.
Income & Growth (Strategy 2)
As stocks and bonds continued to lose ground in the second quarter, we shifted the Income & Growth portfolios 100% to money markets. At the end of the month we added a floating rate fund to the portfolios in an effort to eke out a better return than what is available from money markets. As we move into July, the portfolios hold 10% in bonds and 90% in money markets.
Conservative Growth (Strategy 3)
During the second quarter, we reduced the equity allocation from 35% to 10%, with our only holdings being a market neutral fund and a managed futures fund. The market neutral fund fell about one-third the loss of the S&P 500 Index, while the managed futures fund is actually up for the year. Currently, these portfolios hold 10% in equities and 90% in money markets.
Core Equity (Strategy 4)
Core Equity portfolios held 60% in money markets at the beginning of the second quarter, so were very defensive as stocks suffered a loss of over 15%. As we moved through May, we lowered the equity allocation to 15% and added an inverse position, which effectively brought our net exposure to stocks to essentially zero. Overall, the Core Equity portfolios hold 15% equities and 10% in an inverse S&P 500 fund with 75% in money markets.
Tactical Growth (Strategy 5)
Approaching the second quarter, Tactical Growth portfolios held a balance of stocks, commodities, and cash. As stocks continued to sell off, that allocation was reduced to just 10%, with commodities reduced to just 5%. In June we added a health care fund to the portfolios and also made 5% allocation to a China fund in some accounts. Currently, these portfolios hold 10-15% in equities, 5% in commodities, and 75-85% in money markets.
Strategies WITHOUT the FSA Safety Net®
Sector Rotation
This all-equity strategy has performed relatively well in 2022. Currently, the portfolio is at its most defensive allocation with 64% in equities, 16% in an inverse S&P 500 fund, and 20% in money markets. For the July sector rotation, these portfolios hold energy, consumer staples, utilities, and biotechnology.
Global Rotation
This aggressive strategy became more defensive as the year progressed. Though Global Rotation was fully invested in January, the allocation to money markets was increased such that as of the end of the second quarter these portfolios held 32% in value stock funds and 68% in money markets.
Strategies That Remain Fully Invested Through ALL Market Cycles
Global Moderate
This strategy holds a constant 70% allocation to equities, with 30% allocated to bonds. Bonds offered some cushion relative to equities, but both asset classes were down sharply in the quarter.
Global Growth
This strategy holds a constant 90% allocation to equities, with a modest 10% allocated to bonds. Investors in an aggressive strategy such as this must expect sharp losses in down markets, but they will also capture most of the gains when stocks ultimately rebound.
Please remember to inform your advisor of any changes in your life that might affect your investment objectives and how we manage your money.
Ronald Rough, CFA
Chief Investment Officer
Disclosures are available at https://fsainvest.com/disclosures/market-update/.
FSA’s current written Disclosure Brochure and Privacy Notice discussing our current advisory services and fees is also available at https://fsainvest.com/disclosures/ or by calling 301-949-7300.
