This is one of those sections where you might want to avoid delving into your investments.
Now come the performance reports for the three months that ended in September, and they’re ugly. The vast majority of mutual funds and exchange-traded funds — the vehicles most Americans use to invest — fell. Losses occurred in most markets and in almost all asset classes.
If you’ve lost money, take a deep breath, practice yoga, watch a ball game, enjoy time with family and friends – whatever works. However, do not make abrupt changes in your investments. A good plan is better than an emotional reaction when the markets fall.
I say all this assuming that you already have a solid investment portfolio – ideally a simple one that contains low-cost funds, preferably index funds, that reflect the overall market.
If you don’t already have a solid plan, a downturn is a good time to start. In principle, stock and bond prices will be lower than they were shortly before.
But invest for the long term. Hold diversified stock funds for higher returns and bond funds for income and stability (although bonds haven’t exactly been the epitome of stability lately), and stick with them. Store the money you need to pay your bills in money market funds, short-term savings accounts and Treasury bills.
Keep your costs low and hold broadly diversified investments for the long term. Numerous studies show that for most people this is a far better choice than stock picking and frequent trading.
However, this approach requires the ability to withstand losses and this ability is currently being tested.
Bad numbers
The average domestic equity fund in the Morningstar database lost 3.5 percent in the quarter. The average taxable bond fell 1.1 percent. The average municipal bond fund fell 3.3 percent. Internationally oriented equity funds performed even worse as a group. They fell by 4.7 percent.
In addition, major stock and bond indices, which serve as benchmarks — and in some cases basis — for many mutual funds and ETFs, fell during the quarter.
Including dividends, the S&P 500 stock index lost 3.3 percent in the three months to September.
These numbers are not shocking in themselves. What makes them painful, however, is that they only come just as markets had begun to recover from last year’s sharp declines.
It shouldn’t be too surprising if the stock market falls. Such declines have made headlines for decades. But bonds are different. They have a reputation for consistent, even sluggish performance. Recent returns contradict these assumptions.
Last quarter, the Bloomberg Aggregate Bond Index (formerly the Lehman Brothers Aggregate Index) lost 3.2 percent including dividends, almost as much as the S&P 500. What’s worse, over three years, this core bond index lost almost 15 percent, including those in dividends interest paid out, while the S&P 500 gained around 34 percent.
These yields underestimate the carnage in the bond market. The Bloomberg US Treasury 20+ Year Index, which tracks long-term government bonds, lost 13 percent in the quarter – and around 42 percent in the three years through September, including dividends.
You don’t have to worry about high quality individual bonds if you hold them until maturity. However, if you trade them when market interest rates are rising, you could incur significant losses.
What causes the losses?
A major interest rate turnaround caused problems in the bond market and also hurt stocks.
Recall that in the first phase of the pandemic, the Federal Reserve cut the short-term key interest rate to almost zero to support the struggling economy. Then, as inflation got red hot, it began raising short-term interest rates early last year to put out the inflationary fire. It’s not finished yet.
Longer-term interest rates in the bond market initially did not rise as much or as quickly – perhaps signaling an eventual recession – but longer-term bond rates have risen sharply recently.
Increases in interest rates have automatically led to a fall in bond prices. This is a function of bond math. Yields and prices move in opposite directions, so rising interest rates have led to falling bond prices, particularly for longer-dated securities.
For stocks, the impact of rising interest rates is more complicated. On the one hand, utilities and high-dividend paying stocks have been hit hard because their core virtue – their ability to generate income – doesn’t seem nearly as attractive, with high-quality bonds offering reliable payouts of more than 5 percent per year. In addition, corporate costs have increased with higher interest rates, which slightly affected corporate profits in the third quarter.
The S&P 500’s gains earlier this year were largely based on investor optimism about future earnings growth. AI fever swept the market, sending stocks like Nvidia, which supplies computer chips that enable artificial intelligence programs to run, soaring. Nvidia was the S&P 500’s biggest gainer in the calendar year through September, with a total return of nearly 198 percent.
But market sentiment has turned gloomy as the Fed has signaled it wants to keep interest rates higher “for longer.”
However, Nvidia shares weakened in September with a monthly decline of 11.9 percent.
The stock market is top-heavy and disproportionately dependent on a handful of large companies. According to data from Bespoke Investment Group, the 10 largest stocks in the S&P 500 accounted for nearly 70 percent of the index’s price increase in the calendar year ending in September. These are Apple, Microsoft, Alphabet (Google), Amazon, Nvidia, Meta (Facebook), Tesla, Berkshire Hathaway, Eli Lilly and Visa.
When some of these stocks faltered in the third quarter, they dragged the market with them. Apple lost 11.7 percent during the quarter. Because it is so heavily weighted in the S&P 500, it accounted for a quarter of the overall index’s decline, according to calculations by Birinyi Associates.
Hurt and help
Energy prices rose this quarter, causing various problems. Gasoline is becoming more expensive again, and higher energy costs are ripple through the economy, complicating the Fed’s fight against inflation while weighing on the profits of companies that are net energy consumers.
However, there was a positive side for some investors. Higher energy prices are a boon for stocks and funds focused on fossil fuels.
Compare these stock returns for the quarter:
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Solar Edge, which describes itself as “a visionary leader in smart energy technology committed to harnessing the power of the sun to create a sustainable future,” fell 51.9 percent, the worst quarterly performance in the S&P 500.
If you’re worried about climate change, profiting from higher fossil fuel prices isn’t ideal. However, the economy still relies on fossil fuels. And even as alternative energy dominates the future, oil and gas are creating wealth now.
Energy stock funds that focus primarily on fossil fuels rose 10.4 percent in the three months through September, according to Morningstar, and funds such as Vanguard Energy Index Fund and Fidelity Advisor Energy Fund gained more than 13 percent. Exxon was the largest holding in these funds.
Energy – fossil fuels or alternative energy sources – has once again gained popularity, with prices falling in October. Where they go next remains unclear.
Further
In general, the question of where interest rates and inflation are heading – and whether the economy will slip into recession – are crucial questions to which there are no reliable answers. I would be skeptical of anyone who claims to know.
Predicting commodity, stock or bond prices is dangerous at best. If you bet right, you can win big but take big risks.
If that’s not what you do for a living, I wouldn’t go there. Instead, for most people, when it comes to long-term investing, it makes far more sense to aim for an absolutely average return without trying to pick favorites or time the movements of the markets.
Just being average was a solid strategy. Since November 2000, a basic investment of 60 percent stocks and 40 percent bonds in index funds with a broad US market has achieved a return of almost 300 percent despite numerous crises and downturns.
To achieve this return, you had to keep fees to a minimum, have diversified index funds, and ignore market declines like this.
There will be more storms, and big ones. Try to prepare for them and succeed.