Today, we’re highlighting a number of ETFs that offer built in returns under certain market scenarios. These ETFs can be an ideal investment for clients who want to limit potential downside risk. In exchange, investors also give up some of their upside. We’ll fit these ETFs into three different categories:

• Conservative: lots of protection but small upside
• Moderate: some protection and some upside
• Aggressive: little protection and more upside

How we get the returns

First, the ETFs we are highlighting are known as “buffered ETFs.” We’ve written about these ETFs before, and suggest reviewing this link for a quick educational primer. We have vetted these products and seen that they do what they’re supposed do. They acted as expected during the Covid crash of 2020 and the bear market of 2022. They are somewhat complex, but we use them with confidence.

The buffered ETFs we are focused on will be impacted by the performance of the SPY or QQQ. These are two popular index funds that track the the S&P 500 (SPY) and the NASDAQ 100 (QQQ). So when you see “the SPY” just think “S&P 500.” You can’t invest in indexes directly, which is why people invest in index funds like SPY instead.

Below are real examples that conservative investors may find attractive. The ticker in the left hand side represents the ETF ticker you would buy. The “asset +/-” row at the top signifies how the performance of the SPY impacts said ticker. All of these tickers “reset” at the end of the year, meaning the performance represents the next 8 months worth of performance. We buy them with the intent of selling on or before their next reset date.

For example, ticker JAND will return 5.35% over the next 8 months even if the SPY falls 15%. Notice though, if the SPY goes up 15%, JAND will only return 5.35%. JANH will post a positive return of 4.64% even if the SPY falls 20%.

More aggressive examples

For investors who wish to use the buffered ETFs in a more aggressive manner, there are a number of potential ETF tickers to consider. The ticker XTJA, for instance, will return 10% between now and the end of the year even if the SPY posts a flat return.

However, XTJA offers only little protection against downside. But the idea of earning 10% in a flat market may be appeal to some investors. You’ll notice that QTJA offers an even greater upside scenario, returning 13.57% if the QQQ (Nasdaq 100) rises just 5% between now and the end of the year. But that greater upside is a result of the QQQ being more volatile than the SPY.

For those who want something more moderate, consider BNOV. This ETF is tied to the SPY, and will protect against the first 5% of losses in the SPY. In addition, if SPY is flat, BNOV will still return 6%. BNOV’s return profile is through October 31st. Some may value the shorter outcome period compared to the others.

Use cases for these types of ETFs

The most common way we are using these ETFs is for more conservative investors who want to do something with their cash but don’t want to have outright market exposure. Many investors have 1 or 2 year CDs or Treasury bills that they purchased in 2022-2023 that are now maturing. Additionally, some of the conservative buffered ETFs highlighted above may serve as a fixed-income like allocation.

If you have questions about these types of ETFs and how they might fit in your portfolio, be sure to reach out to us!

Markets are falling so far to start the second quarter after a strong start to the year. The main catalyst has been a renewed spike in bond yields which coincided with the release of the latest inflation figures. The most recent rise in bond yields appears to have caught the market off guard. So what’s going on? Let’s dive in.

Inflation picking back up

Inflation, as measured by CPI, peaked at 9% in 2022 and then started a sustained move back down. This doesn’t mean prices for goods and services went lower. Rather, the pace at which they’ve increased has slowed. By the middle of 2023, inflation had slowed from 9% to near 3%. The problem is that recent inflation reports show one of two potential negatives taking place:

1. Inflation is basing at a higher than expected level of 3%
2. Or worse, inflation is restarting an upward trend

This rate of change in inflation is a negative for stocks because it disrupts a key expectation that we believe is priced in to the market: that the Fed is done raising interest rates. However, for the Fed to be done raising interest rates, inflation needs to be on a path towards 2% (the stated Fed target). If inflation is not on a path to 2% then the Fed may believe the current level of interest rates is not restrictive enough to slow down inflation.

Market expectations are changing

The recent inflation bump has caused a lot of volatility in the bond market, which is a key market for setting interest rates on everything from mortgage rates to business lines of credit. We wrote last month that interest rates weren’t going down, but that they weren’t really rising either. Well, that’s no longer the case. Interest rates are moving higher across the curve. Here’s a snapshot we shared from last month’s article, capturing the interest rate curve as of March 18, 2024:

At the time, the 3-10 year part of the curve was between 4.30-4.60%. Fast forward to today and this part of the curve has moved rapidly higher, to a range of 4.60-4.80%:

Because all of these interest rates are somewhat sensitive to interest rates set by the Fed, the takeaway can be that the market is expecting the Fed to keep interest rates higher than previously expected. Our belief is that the level of interest rates don’t matter so much as the path to getting there. Markets expect volatility from stocks, not interest rates. But, if we look at the MOVE index, the market is again bracing for major volatility in the interest rate market:

The recent reading of 121 is 20% higher than just one month ago. In other words: bond market volatility is up a lot in a very short period of time. Markets don’t like sudden changes.

Real implications

While the inner workings of the interest rate market are rather arcane, they have easy to understand consequences. If interest rates are going higher then that means any business with a floating line of credit is going to see their borrowing costs rise. Consumers who are currently house hunting with an assumption of a 7% mortgage might have to come to grips with different math if mortgages are back at 8%. The same logic applies for anyone carrying credit card debt.

The prospect of higher interest rates can be a negative overhang as consumers wait to see where things settle out. Like the market, consumers like making purchases with known information. Buying a house or a car is not something you do on Amazon from your couch. Most people take months to make such a big decision. So if consumers start to believe higher interest rates are coming, they may shelve those plans all together.

The mortgage rate market is a great example: mortgage rates are higher today than they were one year ago, yet buying activity has actually picked up! That’s because mortgage rates are more stable than they were one year ago (when mortgage rates were in the midst of a perpetual rise).

Markets don’t like unknowns

In summary, the first sell-off of 2024 was sparked by a familiar negative catalyst of the last two years: inflation fears. In turn, this uptick in inflation is raising concerns that interest rates may not be done going up. The market was previously okay with the elevated level of interest rates, but only because it became a known level. As uncertainty arises as to the peak level of interest rates, markets are undoing some of their recent gains.

In effect, a known (interest rate levels) that the market became comfortable with is starting to turn into unknown. Markets do not like unknowns. We suspect things will stabilize once volatility in the bond market subsides, even if that means interest rates stay at a higher level than before.

Interest rates stopped going up last year but that doesn’t mean that they’ve started to go down. The yield on short term Treasuries, those maturing in two years or less, suggests the market expects interest rates to stay high for the foreseeable future. We’ll look at the curve and also expected volatility to see what the market currently expects.

Short term rates remain high

Short term treasury rates are the most sensitive to changes in the Federal Funds Rate (set by the Federal Reserve). In general, the treasury curve will lead changes in the Federal Funds Rate (FFR), i.e. if the market expects the Fed to cut the FFR, short term Treasury yields will move lower. You can see this relationship by looking at the market yield on a 1-year Treasury bill (blue line) with the FFR (red line):

Notice that in early 2022, there was a wide gap between the 1-year yield and the FFR. This was because the market expected the Fed to keep raising rates. So even after the FFR was raised to 0.50-1.0% in early 2022, the market expected that was just the first of many rate increases. As the FFR went over 4%, the spread between the 1-year Treasury yield and FFR narrowed (blue line and red line got closer). This was the markets way of expressing an expectation that the Fed would soon be done raising rates.

General rule: when the 1 year yield is much higher than FFR, the market expects the Fed to raise rates. When the 1 year yield is much lower than FFR, the market expects the Fed to lower rates. When the two yields are similar, the market expects the Fed to leave rates unchanged.

In late 2023/early 2024, the market started to believe the Fed would be lowering rates (so we saw the 1 year yield start moving below the FFR). Today, the spread has narrowed once again. Therefore, at this moment, we would classify the market as generally neutral on Fed policy over the next year; the market largely expects the Fed to keep rates around 5% over the next 12 months. This would imply a current market expectation for one or two interest rate cuts by the Fed between now and March 2025.

Markets seem comfortable with this expectation

The market seems comfortable with its current interest rate outlook. One of the ways we can judge the market’s comfort level is by looking at a volatility index tied to the interest rate market. The MOVE Index aims to reflect the collective expectations of market participants about future volatility.

If the MOVE index is high, then investors expect a lot of volatility in interest rates. This would be construed as the market being uncertain as to the outlook for interest rates. If the MOVE index is low, investors expect low volatility in interest rates. Low volatility is associated with a low surprise interval… i.e. the market doesn’t expect to be “caught of guard.”

Currently, the MOVE Index is near its lowest levels since the Fed began hiking interest rates in 2022:

The two big volatility spikes, when the interest rate market became highly uncertain of the outlook, was last March and October. That was when three large regional banks failed (March 2023), and the 10 year Treasury yield went above 5% for the first time since 2007.

Today’s current level in the MOVE Index is a confirming signal that the market, at least at this moment, doesn’t expect much movement in interest rates over the short-term.

2026-2030 look lower

For those wondering when the market starts to see meaningfully lower interest rates, you have to look out to 2026. The graph below plots the “yield curve” — the current yield of different maturities:

Here you can see the 2, 3, and 5 year Treasuries currently yield 4.80%, 4.50%, and 4.35%, respectively. These current yields are higher than they were at the end of last year when they were 4.25%, 4%, and 3.85%.

The fact these yields have moved higher over the last few months is another confirming factor that the market has adjusted to an expectation that interest rates will be “higher for longer.” You can use this website to see the yield curve at various dates, which is helpful in identifying changing market expectations.

In summary, interest rates appeared to peak last October when the 10 year treasury yield was yielding 5%. However, the top in interest rates has not yet been followed by a meaningful decline in interest rates. In fact, as 2024 has progressed, the market has settled into an expectation that interest rates may stay where they are at. This is important as it suggests rates on key loans, like mortgage rates, may be destined to stay around 7% for the bulk of the year.

For now, the market doesn’t see the start of a decline in interest rates until 2025-2026. The “new normal” of high interest rates looks a lot like the “old normal” of the 1990-2010’s, when interest rates spent most of their time in the 4-5% range. As always, this outlook can change, but for now that is where we stand.

I’m a financial advisor that made a questionable financial decision. My family and I moved last year, becoming one of the few homeowners to willingly swap out of our 3% mortgage for a new, 8%, one. This article will shed some light on how we made the numbers work and what went into our decision to buy in a high interest rate environment.

How the numbers changed

My wife and I bought our first house together in a suburb of Chicago in 2016. We paid $300,000 (with 20% down) and had a 3.75% fixed 30-year mortgage rate. Our monthly/yearly household costs looked like this:

Category	Cost (mo)	Cost (yearly)
Mortgage	$1,101	$13,212
Taxes	$958	$11,496
Insurance	$110	$1,320
Utilities	$275	$3,300
Total	$2,444	$29,328

We sold this house for $415,000 late last year and bought a new house for $610,000 (with 33% down, rolling everything from the sale into the new house). Our new mortgage rate is a 30-year fixed at 8% with monthly/yearly household costs that look like this:

Category	Cost (mo)	Cost (yearly)
Mortgage	$2,950	$35,400
Taxes	$1,250	$15,000
Insurance	$182	$2,184
Utilities	$325	$3,900
Total	$4,707	$56,484

Our household costs went up by about $2,250 per month, or $27,000 for the year. This is obviously no small amount, but we took some steps to help soften the blow.

How we made the numbers work

In order to lower our monthly mortgage payment, we did a rate buy down. Doing this gave us a temporarily lower rate in our first two years of the mortgage. Our mortgage rate is 6% in year 1, and 7% in year 2. Then, the rate will revert back to 8% for the life of the loan beginning in late 2025 (2 years after purchase).

This buy down was attractive for a few reasons:

1. We lowered our monthly payment by $500 in year 1, and $250 in year 2
2. We can refinance anytime within the first 2 years at no charge
3. The seller paid for the buy down, reducing our total cash to close

With the buy down in place, our year 1 and year 2 numbers look like this:

Category	Cost (mo) YR 1	cost (yearly)	Cost (mo) YR 2	Cost (yearly)
Mortgage	$2,450	$29,400	$2,700	$32,400
Taxes	$1,250	$15,000
Insurance	$182	$2,184
Utilities	$325	$3,900
Total	$4,207	$50,484	$4,457	$53,484

So now, in year 1, our total costs are $6,000 less than they would be with our regular 8% loan. This is a nice savings that definitely helps on cash flow. Ideally, we will try to refinance our loan later this year once we get close to the end of year 1, when our rate will move up to 7%. But that will only make sense if rates are below that 7% threshold. Otherwise, we’ll wait until the middle of year 2 and see where rates are at.

As a part of our rate buy down, the lender offered a “no fee” refinance. If you explore a buy down for yourself, make sure you get stuff like that in writing and review the closing documents closely with your attorney.

The rate buy down itself cost us $10,000, but we were able to get our sellers to pay for it by including it in our purchase price. Instead of paying $600,000 for the home (original list price), we paid $610,000 with the sellers contributing $10,000 for our buy down. The seller didn’t mind because the net effect on their sale proceeds was the exact same; they effectively sold for the $600,000 they intended to sell for from the beginning.

This was a good option for us because the buy down cost was rolled into our loan. In other words, we didn’t need to bring an extra $10,000 cash to close in order to pay for the buy down.

Our local market is too strong for us to have asked the seller to pay for the buy down outright. But if you’re a home buyer in a softening market, you may be able to ask the seller to pay for a buy down as leverage against walking away from a deal. In any case, definitely inquire about buy down options in this high interest rate environment.

Dealing with taxes & insurance

Our property taxes and insurance costs also increased by about $365 per month ($4,375 per year) with our new house. We took some steps to better manage these increases as well. First, we shopped our insurance aggressively with an independent insurance agent who was not affiliated with any big-box type insurance firm.

Second, we opted out of escrow with our lender. This meant we didn’t have to pay our property tax bill monthly. Instead, we will pay our property tax bill ourselves when required by the state of Illinois (one half payment in June, one half payment in August).

Opting out of escrow saves us $1,250 per month from September to May each year (until payments are due in June). This is $11,250 in cash that I’m not having to spend for 9 months out of the year. I still have to save that money and be ready to spend it when the first property tax bill is due in June. But, with that $11,250 in my pocket instead of an escrow account, I can invest the money and earn interest on the amount. In my case, at a 5% risk-free rate, I will earn about $420 in interest from this money.

Here’s a secret too: investing your monthly property tax payment is exactly what your bank is doing with your escrow account. Why should the bank be the one who earns the interest? The property tax payments aren’t due until they’re due, so you may as well make money on that money until then. Of course, this strategy requires financial discipline. You cannot confuse the extra cash you have from not paying property taxes each month as discretionary money to spend.

Lastly, on the topic of opting out of escrow, this strategy can be ideal for people who have lumpy or variable income throughout the year (such as bonus, commission, stock grants, etc).

Rates are what they are

In 2022 we were thinking about moving but rates had just gone from 3% to over 5%, so we were tepid. In addition, our local housing market was still rife with bidding wars, so it just didn’t feel like the right time to make a move. Yes, we’d be getting a good price on our house versus what we paid, but we were “trading up” — so the price we were paying was more important than the price we were selling for.

Fast forward a year later and rates were in the 7-8% range, but we noticed our local market had slowed down dramatically. The bidding wars were gone and prices had moderated. We knew our new monthly payment was going to be much higher no matter what, but we felt we were also getting a nicer house at a better deal. Most of the comparable sales for the house we were buying were in the $650,000-$700,000 range, but they had sold in 2021-2022 when the market was much hotter.

When we bought our house we ran all of our numbers based on monthly costs associated with our 8% mortgage. We did not buy with the assumption that we can refinance (though it will be nice if we can!). It is definitely a bit cringe-worthy knowing how much our costs went up. But our household happiness has gone up even more.

Our kids LOVE our new house and it really suits our needs in such a more efficient way than our old house did. So I can quantify that our household costs went up by 93% versus the old house, but I can also say our living situation feels a million times better. You can’t put a price on that.

The S&P 500 has started the year on solid footing, rising 5%. The gains in the index are being led by a familiar cohort of large tech stocks. The obvious stand out is Nvidia (NVDA), which is up nearly 50% so far in 2024. Behind the rise: surging revenue growth for AI related offerings from stocks like Nvidia and Microsoft. While revenue growth can be a fundamental reason for a rising market, there also seems to be an element of over-excitement around AI that is undoubtedly contributing to the rising trend.

The Nvidia moon shot

The main sign of froth that we see developing in the market is the moonshot that is Nvidia’s market value. One year ago, this was a company valued at $510 billion. Today, the valuation has shot up to $1.79 trillion! Nvidia has added more than $1.2 trillion in market value in just the last year.

There is no precedent for a company going from a $500 billion valuation to over $1.5 trillion as quickly as Nvidia did. However, there is some recent precedent in terms of absolute value… Microsoft, was worth $1.7 trillion in January 2023 and is now valued at more than $3 trillion, a rise of $1.3 trillion! The worry is that Microsoft is rising in part due to the same AI fueled excitement that is driving Nvidia higher.

Altman goes for $7 trillion

Perhaps the biggest sign of potential froth in the AI arena is the recent fundraising efforts by Open AI founder, Sam Altman. The Wall Street Journal (WSJ) recently reported that Altman is attempting to raise as much as $7 trillion in capital to spearhead AI missioned projects around the world. So much money flowing into one sector would be reminiscent of the huge fundraising that poured into internet start ups in 1999.

Per Cnet.com: “The information technology industry raised enough venture capital in 1999 to eclipse the total raised in the 11 years from 1988 to 1998.”

To be clear, Altman hasn’t raised the money he’s seeking YET… but if he does, it could be a sign of peak euphoria surrounding AI.

On a related note, and more of an anecdotal tidbit, was this article in the WSJ that ran the following headline:

The headline is enough to be like, “Okay, wait a second…” The article then went on to discuss the growing popularity of custodial accounts for teenagers. We are big advocates for such accounts ourselves, so that’s not what caught our attention. Rather, the different teenagers they profiled espoused a preference for big tech stocks, like the kinds that are benefitting from the AI boom. The idea that investing is so easy a 13 year old can do it, and all you need to do is buy tech stocks, certainly made our antennas go up.

Lessons from the Fiber Optic Boom

The purpose of this article isn’t to suggest that the market is due for a swift fall. Instead, we hope to bring attention to the fact that the market does become risky if it becomes overly reliant on a single tech related theme or stock. Said differently, if stocks like Nvidia and Microsoft are so crucial to the market’s performance, and they are benefitting exponentially from sentiment around AI, any change in that sentiment could harm investors.

This specific focus on AI related tech stocks also represents why diversification can be frustrating even when it works. If you are not overly exposed to tech stocks like Nvidia, which most diversified portfolios are not, you are not reaping as much of the rewards that these stock’s are providing. On the other end of the spectrum, diversified portfolios have held up much better when prior bubbles have popped (see 2000-2002 or 2008).

All in all, if the AI theme continues to dominate the market and the headlines, it will be cause for concern. We’re not there yet, but it’s worth paying attention to. Now is a good time to check up on your general market exposure and see just how exposed you may be to the performance of the S&P 500 and AI related tech stocks.

Lately we’ve been having a lot of conversations with clients related to the housing market. Here are some of the recent talking points:

• why you want to waive escrow in a high interest rate environment
• knowing your rate versus the market
• to prepay or not to prepay?
• how retirees can “beat the rush” in their plans to downsize

We’ll share some of the broader pieces of each of these conversations with hopes that it may benefit our readers or other clients.

The benefit of waiving escrow

When you put 20% or more down on your mortgage loan, you have the option to waive escrow. This can save you money each month and provide better cash flow flexibility. The trade-off is you have to make your property tax and insurance payments yourself. But is that so bad?

When you opt to escrow your property taxes and home insurance, you increase your monthly payment. In a high property tax state like Illinois, your property tax bill adds a significant amount of money to your monthly payment. One of our clients who is going through the home-buying process was slated to have a monthly payment of $3,400 per month. They didn’t realize that $800 of this payment was for property taxes.

By opting out of escrow, the client brought their monthly payment down to $2,600 per month, a monthly savings of 23%. Yes, they still have to pay their $9,600 property tax bill when it is due, but now, instead of the bank sitting on their extra $800 per month, they get to keep it for themselves.

This money can be set aside in a high yield savings account and earn 4% or more each month. Or, if your income is bonus heavy, this extra money can be invested long term (or spent on a nice vacation or home improvements), and then you can use the bonus to cover your property tax bill.

Waiving escrow will increase your monthly savings potential. You just have to be disciplined in preparing for the property tax payment you will now be responsible for on your own.

Know your rate versus the market

We were a part of a somewhat comical experience with a client recently where they were quoted a rate from a lender that seemed a bit high. We expressed to the mortgage lender that their quoted mortgage rate appeared much higher than the normal spreads we’re seeing quoted every day in the market. The lender came back with some BS answer about the rate volatility due to the bond market (which we’re well versed in).

We replied with a simple, “This doesn’t make any sense and we’ll be advising our client not to pursue this loan.”

VOILÀ!

The lender replied that because he values our client so much, he was going to reduce the rate from 7.375% to 6.60%. How nice of him!

The point is, you need to know where the market is at so you don’t get taken advantage of. And if you are being taken advantage of, call them out on it! Your mortgage rate might magically go down.

Another tip is to engage with at least two lenders. These lenders are hurting right now… their loan volume is down 30-50% compared to the 2020-2021 housing boom. They want your business and they want it bad! If they know you will go with someone else, they will sweeten the deal to earn your business. Make sure the lender(s) you’re working with know that they are not the only person you’re talking to.

Lastly, be sure to loop in your financial advisor on any email chain or text conversation. You’ll be amazed at how the numbers change once the lender knows you’re receiving objective advice from someone who understands the interest rate environment.

To prepay or not to prepay?

“I hate having a mortgage so I make extra payments to knock out that debt as soon as possible.”

This is a very common statement we hear from clients, especially those nearing or in retirement. While there’s an emotional component to the statement, it’s important to know the financial ramifications as well.

Here’s the simple rule: if you’re locked in to a mortgage in the 3% range, you should not be making extra payments towards your mortgage. If you are locked in at 6% or higher, you should be making extra payments. In between those ranges and the numbers become less black and white.

Let’s talk about why…

A 3% mortgage represents a debt level that is below the interest rate someone can earn “risk free” in Treasuries or CDs. Therefore, you’re better off financially investing any extra money to earn that higher return.

A 6% mortgage represents a debt level that is below the interest rate you can earn. This means extra money may be better off being applied to your mortgage. If the rate you’re paying on debt is higher than the rate you can reasonably earn on your investments, then choose to pay down the debt.

A note on prepay strategy

One quick mention on something we see a lot of when it comes to prepaying your mortgage… most people tend to make extra payments each month. For example, if their regular payment is $2,000 per month they may decide to pay $2,100 per month (or $1,200 extra per year). But again, in a high interest rate environment, this is not an optimal choice.

If you want to make extra payments on your mortgage, it is better to make one lump-sum payment once per year than it is to make smaller payments each month (assuming these amounts are equal). The payoff benefit will be the same but you’ll do two things that are helpful:

1. You’ll have a little extra money each month which increases financial flexibility
2. You can earn interest on that extra money if you set it aside in a high yield savings account

We encourage clients to think of optionality when it comes to your discretionary budget. Consider the hypothetical where someone makes extra payments from January-June, but then in July decides they need to stop making the extra payments. They can’t get the extra money they spent on their mortgage back. Someone who is setting the extra money aside with plans to make one lump-sum payment in December will have more flexibility if their financial plans change.

Beating the rush on your downsize

We came across an interesting article in the Wall Street Journal that talked about how many Baby Boomers are planning to sell their homes later this decade. The article pointed out that many Boomers live in similar styled homes, in similar settings (metro suburban areas). The premise was that if they all decide to sell at the same time, they may increase inventory in their local markets and get less for their homes than they expect.

We’ve linked an unlocked version of the article here so you can read it for yourself if it applies to you. If you are a baby boomer who has been thinking about selling your home, you may want to accelerate those plans. We know home prices are high today, but we don’t know if they will still be high tomorrow.

So whether you’re actively participating in the housing market this year or planning to in the years ahead, keep these tips in mind and let us know how we can help!

2023 turned out to be a good year for investors, but it wasn’t without its ups and downs. A diversified market index was up 18% through July, last year. However, by the end of October, most of those gains had disappeared and the same index was only up 5%. Then, seemingly out of nowhere, a big rally took hold; stocks went up 15% the last 8 weeks of 2023 to finish the year solidly in the green. The way last year finished was a reminder to investors that staying the course really can work.

Twists and turns on the way to gains

The graphs below illustrate the twists and turns that the stock and bond market saw on their way to gains in 2023. The first graph shows VT, an all-world stock market ETF. There were three rallies of 10% or more and two declines of 9% or more. In the end, this diversified basket of global stocks still managed to rise 22% on the year. 65% of the entire year’s gain took place from November through December:

Next, we have AGG, which is an ETF that tracks the total US bond market. There were multiple fits and starts in the bond market. A prolonged 7% pullback from April-October was followed by an 8.50% rally to end the year. In the end, the bond market returned 5.65% for 2023:

These ups and downs resemble how markets usually move; markets spend time going up and down. But ultimately, markets generally rise over time. 2023 is a good reminder that staying the course can work. If you’re paying close attention to your portfolio, it was probably frustrating to see mid-year gains given back during the fall months. However, you were rewarded in the end. Successful investing involves being able to see the forest for the trees.

So keep this in mind throughout 2024

The first couple of weeks of 2024 have been quiet: stock and bond markets are both flat to start the year. The beginning of the year is a good time to remember that markets will go up and down. But even though markets go down, they’ve been able to go up on a year over year basis about 70% of the time since 1926. Those are good odds.

With that said, here are two graphs we like sharing with clients to start the year. The first shows the average amount of times the S&P 500 pulls back a certain amount each year. Since 1950, the S&P 500 has, on average, pulled back 5% three times per year:

Our next graph plots S&P 500 annual returns (black bars) versus the maximum intra-year decline (red dots) experienced during that year. In 2023, the S&P 500 returned 24% even though the index declined 10% at one point during the year. Despite an average intra-year drop of 14% since 1980, the index has risen in 33 of the last 44 years:

So when stocks inevitably fall at some point this year, remember these two graphs. A decline of 5-10% is well within the normal range of market conditions. Nor would such a fall imply that the market will not post positive returns on the year. If the market does rise this year, much of the gains will likely be attributable to a random period of outsized returns, like the 8 week stretch we saw take place at the end of 2023.

The S&P 500 is on pace to return more than 20% during 2023. We were curious how the S&P 500 has done in the year after rising 20% or more. Since 1926, the S&P 500 has risen 20% or more 36 times (2023 will be the 37th). Of those 36 times, the index has risen the following year 69.50% of the time. The average and median return in the year after a 20% gain occurred is 10.53% and 12.83%, respectively. Let’s look at the numbers a little more closely.

Returns aren’t much different than “average”

The first thing that stands out to us is the average yearly return of 10.53% following a 20% gain is nearly identical to the “average” return of all years. Since 1926, the S&P 500 has risen an average of 10.20% per year. Secondly, the positive return rate of 69.50% is very similar to the positive return rate of 73% for all years. With that said, there are some big returns in the years after a 20% gain. Most recently, the S&P 500 rose 18% in 2020, after rising more than 20% in 2019.

The 1990s also saw a big run for stocks where big gains followed big gains. On the negative side, 2022 saw the S&P 500 decline 18% after it rose more than 20% in 2021. So the very recent past is a mixed bag.

One encouraging anecdote is that there is a lot of time between the worst negative sequences following a 20% rise in the S&P 500. Said differently, because we just had a big down year in 2022, there’s nothing in this statistical data set that would imply another large down year happens again so quickly.

Where things get a little more interesting is if we segment the positive years versus the negative years. The average and median positive return in the data set is 19.50% and 18.67%, respectively. The average and median negative return is 9.82% and 8.07%. One might find comfort in the fact that the numbers are twice as good in positive years as the bad numbers are in negative years.

Expectations into next year

The market entered 2023 on very nervous footing. This was supposed to the be year that the market buckled under pressure from high interest rates. Instead, stocks rose more than 20% for the 37th time since 1926. Such a rally might lead one to wonder if the market will just come crashing back down next year. The data says that’s not the odds on bet.

Historically, the S&P 500 has risen almost 70% of the time in the year after a 20% gain. What’s more, those positive next-year returns have historically been quite large, averaging 19.50% when the market has gone up a second year in a row after a 20% gain in the preceding year. If, however, things develop negatively throughout the year, the historical data suggest a decline of between 8-10% is possible in 2024.

Small cap stock indexes are having their best month in years, with the S&P 600 up more than 8.50% so far in November. You’ve probably never heard of the S&P 600, so let’s touch on that first. 90% of the entire US equity market is represented by the S&P 1500 (another index you’ve probably never heard of). The S&P 500 is the 500 largest companies in the S&P 1500. The S&P 400 is the next 400 biggest companies, #501-900. The S&P 600 is the smallest 600 companies in the S&P 1500, #901-1500.

Add the three indexes together, and you end up with 1500 stocks. For the last few years, the largest 500 stocks (S&P 500) have been beating the smallest 600 (S&P 600). Historically, however, smaller stocks have done better than large. And we’re wondering if that trend may have restarted in the last few weeks.

Looking at historical performance

Small cap stocks have trailed large cap stocks by 2.0-2.5% per year over the last 5-10 years. But if you were to look back over the last 50-80 years, small cap stocks have beaten the S&P 500 by 2.0-2.5% per year:

We have a couple of theories for why performance has shifted in the last 5-10 years. First is the growing popularity of index investing and retail investing. As investors have poured more money into broad market index funds, those funds have, by rule, been forced to buy the largest companies in the index. Think about it like this: if you’re an index fund and your goal is to “track an index,” every time investors buy more of your index fund, you must buy more of the companies that make up the index you’re tracking.

The most popular index funds are those that track the S&P 500. Thus, there’s been a circular cycle of S&P 500 stock buying in effect over the last decade. Look at the overall rising trend of inflows since 2008, and then the massive inflow that took place from 2020-2022:

Secondly, the rise of the retail investor has been another positive catalyst for S&P 500. Research has shown the retail investor greatly favors the largest and most well known stocks in the market, like Apple, Amazon,  Tesla, Microsoft, and Google. These five companies make up the largest holdings in the S&P 500. So as their share prices have risen, they’ve helped power the S&P 500 higher. In effect, S&P 500 outperformance has been a simple case of follow the money.

So why not just buy the S&P 500 and call it a day?

A common question we’re hearing is if the S&P 500 is performing better than small cap stocks, why own any small cap indexes at all? If we have logical reasons for why the S&P 500 will keep attracting investor money, won’t it continue to outperform the other indexes? The short answer is no. Why not? Because we believe markets weed out inefficiencies over time.  If everyone is piling into a certain area of other market, that area of the market will have to correct.

Bubbles are great examples of the inefficiency/efficiency rhythm that markets experience. In the late 90’s, tech stocks went up 100%… they looked overvalued… then they went up another 100% in 1999! But, by 2002, tech stocks had fallen nearly 80% from their peak. Yes, you could have made money buying tech stocks in 1998 after they had already went up huge, but navigating those seas proved treacherous.

Look at the valuations

While the S&P 500 is not in a bubble from a valuation perspective, we can measure its fundamental value, along with small cap stocks, by looking at price-to-earnings ratios (P/E). This ratio measures how much investors are willing to pay for $1 of earnings a company generates. For example, a P/E of 10 means that you are paying $10 per share for every $1 in corporate earnings that a company generates.

Investors are currently paying 19 times earnings per share for the S&P 500 compared to just 13 times earnings per share for smaller companies in the S&P 600:

The price to earnings ratio investors are paying for the 8 most popular and largest tech stocks in the S&P 500, referred to as the “Mega-Cap 8” is at a more extreme level of 28:

The valuation premium of the MegaCap-8 illustrates how fund flows and the popularity of the crowd can overwhelm fundamentals. However, this is a classic example of a market inefficiency that we expect will be corrected over time.

What could that correction look like?

Much of our thesis that small cap stocks could start outperforming large stocks relies on two premises:

1. In general, you want to avoid the most popular areas of the market. There’s no bet more popular in the market right now than the one being placed on the S&P 500, and especially tech stocks inside of the index itself.
2. When the popularity contest of the market is over, investors usually turn back to fundamentals. By that reasoning, with valuations near 20 year lows, small cap stocks offer upside.

Looking back at the last few times small cap stocks traded with a P/E ratio of 13 or lower, like they do now, forward returns were very strong:

Small cap stocks averaged 1, 3, and 5 year returns of 8%, 15.54%, and 16.10% since 2000 during the other instances that the index traded with a P/E of 13 or less (like it does now).

Let’s compare versus the S&P 500

To really decide if small cap stocks were the place to be during these low valuation periods, let’s compare those returns to the S&P 500 during the same periods:

Overall, the performance of small cap stocks versus the S&P 500 was much better across all time frames whenever the small cap index P/E ratio was below 13. Not just by a small amount either, the annualized outperformance of small cap stocks versus the S&P 500 was greater than 6%, on average, across all time frames:

This outperformance is equal to an extra $6,000 worth of returns per $100,000 invested in small cap stocks over the S&P 500. So while an oversized allocation to small cap stocks in the last few years has resulted in lagged performance vs the S&P 500, we wouldn’t be surprised if that trend reverses course over the next 1-3 years.

Keep in mind, small cap stocks have historically outperformed large ones over the last 50-80 years. And today, valuations are in your favor. If you’re looking to get index exposure to small cap stocks, consider ETF tickers like SPSM, IJR, or DFAS. These are three low-cost index funds that will do very well if the November rally in small cap stocks continues.