Navigating Market Challenges: Diversification and Sustainable Investing

Sometimes, when it comes to investing, it’s two steps forward and one step back. This past quarter felt like a big step back as both the bond and stock markets declined in tandem. The Barclays Aggregate Bond Index retreated by 3.3% for the quarter, erasing all its yearly gains while the S&P 500 dropped 3% over the quarter and experienced a sharp 5% decline in September alone. Small and mid-cap stocks, the international markets, and alternatives like real estate and gold performed even worse.

Diversification = De-Worsification?

Source: CNBC and Factset

The S&P 500 is typically used as a proxy for the entire market. However, it’s important to keep in mind that the S&P 500 is just one component of the global market. The index is market cap weighted meaning that the larger companies take up a bigger percentage of the total index.

If you look at the ten biggest companies in the index, they represent 31% of the total value. The bottom 250 companies only represent 14%. In certain periods, like the present, the S&P 500 doesn’t always accurately reflect the broader market and economic trends.

If you equally weighted each of the 500 companies in the index then the performance would be flat this year while the market cap weighted index is up over 12%.

The only area of the market performing well this year is the mega large cap stocks, such as Tesla, Alphabet (Google), Meta (Facebook), and Nvidia. In fact, if you take out the top performing 7 mega caps from the S&P 500 then the index is actually negative for the year.

All-In on the S&P

It may be tempting to ditch diversification and just buy the sustainably challenged S&P 500. However, this can be a major misstep. History shows that we’ve had prolonged periods where the popular index has been flat to negative. For instance, if you decided to buy the iShares S&P 500 index fund (SPY) in 2000 then you would wake up a decade later with a paltry 3% return and a loss of purchasing power due to inflation. However, if you used an asset allocation strategy with different size companies, international exposure and some bonds, you would have fared much better.

The following Callan Chart shows the highest performing asset class each year at the top, down to the worst. There are some important takeaways. One is that there isn’t a distinct pattern when it comes to the top performing asset class each year. Also, you’ll notice that U.S Large Caps, represented by the S&P 500, aren’t always at the top of the chart.

U.S Large Caps have performed extremely well over the past ten years, but the past isn’t prologue. Market leadership is constantly changing which is why it’s important to diversify across all different areas of the market.

Poor Performance

The past two years have been frustrating for investors as well as financial advisors like myself. It should come as no surprise that being a financial advisor is much more enjoyable when the markets are trending higher!

The S&P 500 topped out at 4600 at the end of 2021 and subsequently declined almost 20% the following year while the bond market was down 15%. This is all with the backdrop of high inflation which further eroded real returns. If you add up all the inflation over the past 2 years then we would actually need the market to be closer to 5000 in order to get back to even, when including the 10% of inflation we’ve experienced since the beginning of 2022.

Given this backdrop, I have had many clients question the wisdom of staying invested in these markets after a lackluster couple of years. Why not just pivot to a high yield money market account with a risk-free 4.4% yield? The reason is that stocks historically have averaged over 9% a year while bonds have provided around 5% so you would likely be leaving a lot of money on the table over the long-term while imperiling your financial plan.

Furthermore, there is a good chance that the Fed is done raising rates as the market is currently pricing in a 1% rate cut next year. This means the yield on money market accounts will likely start to drop.

What’s up with the Fed?

Picture a tightly stretched rubber band, poised to snap back any moment. This is analogous to the Federal Reserve's recent swift and aggressive actions on interest rates. Their rapid rate hikes have created tension, much like that in the stretched rubber band. Once inflation eases and the Fed hints at rate reductions, the bond and stock markets could swiftly rebound, just as a rubber band would snap back.

In the short term, the market's movement will be influenced by the 10-year treasury. The ten-year treasury bond influences rates for mortgages, credit cards, and even student loans. In August, the ten year was at 3.3% and the sharply moved up to 4.7%. This may not seem like a big increase but on a percentage basis it represents over a 42% jump.

This makes borrowing and new debt issuance much more expensive. In fact, if you are trying to take out a mortgage, you are lucky to get under 8% on a 30 year loan. Financing a $1 million loan today would cost $80,000 a year versus $28,000 just two years ago. This is a 185% increase in interest payments in just the past two years! This is why raising rates slows down inflation and makes everyone reluctant to borrow and spend.

Broken Record Time

So what should you be doing right now? The best action right now is to stay the course and stick to the asset allocation strategy. Even better, this is a great time to invest cash on the sidelines. Investing in today's market is like going for a morning jog. It might be tough to get started and may feel uncomfortable in the moment, but the long-term benefits for your health and well-being are undeniable.

At the same time, it’s not a bad idea to evaluate your own risk tolerance. There is nothing wrong with lowering risk if you aren’t comfortable with the volatility in the portfolio. This is something that should be continually evaluated with the backdrop of still being able to reach your financial goals. You may think you’re comfortable with the roller coaster ride but then realize halfway through that your stomach doesn’t agree.

Clean Energy and High Interest Rates

Are high interest rates bad for the environment? According to the IEA, the 5% increase in interest rates we’ve experienced actually increased the cost of clean energy by 30%. This has been a similar drop that the clean energy index funds have experienced year-to-date.

Even with the higher costs, installing solar and wind are still less expensive than coal and natural gas.

The problem is that clean energy projects are very capital intensive so when the Fed raises rates it makes these projects much more expensive to finance. If capital is cheap, then investing in solar and wind projects becomes even more cost effective compared to the fossil fuel counterparts.

Regardless of the recent performance, the future is still green. Over time, the markets will adjust especially as the inherent cost of solar, wind and battery storage continue to drop exponentially. The Inflation Reduction Act passed last year, is estimated to inject $1 trillion into clean energy projects and should provide a major boost to the clean tech industry while helping to leave fossil fuels where they belong, in the ground.

Investing in a Peaceful World

Last Saturday, I was deeply saddened by the news of the awful terrorist attack in Israel. Opponents of freedom and democracy often share a common funding source: oil revenues. This money fuels their disruptive and anti-democratic actions globally. By swiftly transitioning to clean energy, we can diminish the financial power of nations like Russia and Iran, thereby reducing their capacity to create global unrest.

At Impact Fiduciary, we avoid investing in fossil fuel energy and instead focus on clean energy technology that is disrupting the incumbents. It may not work out perfectly in the short run but investing retirement money and long-term dollars in the world that you want to shape, not the status quo can help make a difference and speed up the transition to a more peaceful world.

Thanks for reading!

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Patrick Dinan, and all rights are reserved.