We are excited to be issuing our first client reports under our new banner – as SoundPath Investment Advisors. Rest assured, this is only a name change. We remain local, independent, and 100% owned by current management, who remain committed to the investment approach and dedication to client service you have come to expect.
We are pleased to report solidly positive returns across client portfolios. Stocks, particularly those of large U.S. companies, enjoyed remarkable returns for 2021. The three most widely followed U.S. indices – the S&P 500, Dow Jones Industrial Average and NASDAQ Composite – all had gains in excess of 20%, with the S&P 500 leading the way with a 28.7% total return, including dividends. Small stocks and developed country international stocks, while not as robust as their large U.S. counterparts, also enjoyed double-digit gains, with the small-cap Russell 2000 up 14.8% and the EAFE international stock index up 11.8%. Among the stock categories we follow, only emerging market equities were negative for the year, down 2.2%.
Bonds, which are a considerable weighting in our most conservatively balanced portfolios, were a drag on performance. As interest rates started to tick up, prices declined, with the Barclays aggregate bond index down 1.5% for the year. More about bonds later.
A closer look at the sources of returns for stocks reveals some considerable shifts over the last year. Some of which signal a healthy market, others of which might give cause for concern. On the positive front, after years of the largest tech stocks almost single-handedly propelling markets higher, there was a considerable broadening out of performance contribution in 2021. Value stocks did well, small stocks did well, and the top three performing sectors in the S&P 500, for instance, were energy, real estate and financials. In spite of this sector rotation, its importance can be a little misleading. For instance, the entire energy sector only accounts for 2.7% of the index. By comparison, Apple alone counts for 6.9%. In other words, the performance of the entire energy sector has less than half the impact on the index than does the performance of Apple stock alone. The top five companies account for 23% of the index, while the 200 or so companies that make up the bottom five sectors account for only 16%. We mention this just to illustrate the potential for distortions resulting from extreme weighting discrepancies between stocks in the index.
Further, as you’ve no doubt noticed, we might typically highlight the difference between value vs. growth, and small versus large stocks. This year, however, the distinction was a little more nuanced. Interestingly, while large did better than value overall, the real leadership, if you break it down further, was small-cap value. Followed by large-cap growth, then large-cap value, and finally small-cap growth. So, perhaps counterintuitively, even in an environment where large beat small and growth beat value, small value did best of all.
Of greater concern to us, as we parse the index, is what S&P defines as the single greatest contributing “factor” to return. Without getting too deep into the weeds, S&P looks at things like growth, value, dividends, volatility, and momentum, among others, to determine which of several quantifiable “factors” contribute most to returns. In 2021, it was “High Beta.” By a pretty wide margin. In other words, the most volatile and risky stocks in the index contributed most to its outstanding return.
In such an environment, we take our role as fiduciaries quite seriously. When market gains, at the margin, are driven by risk and speculation, that is not an environment that lends itself to performance chasing. We concern ourselves with matters of prudence and suitability when it comes to your investments and taking speculative risk to maximize returns is neither suitable nor prudent for most of our clients.
Which brings us back to bonds. The primary role of bonds in a portfolio is to reduce volatility. In most environments, a portfolio with a balance of stocks and bonds will go up less than a good stock market and down less than a bad stock market. Over very long periods of time, an all-stock portfolio offers the highest expected return. But a balanced portfolio offers a better “risk-adjusted” return. If your goals and needs are strictly long-term, you should care more about absolute expected return. If your goals and needs are short-, intermediate and long-term in nature, you need to care about risk-adjusted return. And if you are retired and dependent on your investments for your living expenses, you are definitely in the latter category. And if you have any doubts about whether your current portfolio allocation is appropriate for your circumstances, please speak to your advisor.
As we look forward, the concerns that most investors share are rising interest rates, inflation, and the potential impact on asset prices. We think it’s highly likely that the Federal Reserve continues to taper its bond purchases, as signaled, thereby reducing liquidity in the system. We further believe that the Fed will follow through with interest rate hikes through 2022 and perhaps beyond.
Interest rate increases, all else being equal, reduces asset prices. Inflation reduces the real value of nominal dollars. If either proves to be disruptive to the economy, it could be disruptive to markets as well.
So here’s the conundrum as we see it: If you are worried about a stock market correction, cash and bonds can be a good place to park some money. But if you are worried about inflation, cash and bonds are not the best bet. So how do we reconcile this? Put simply, corrections are a near-term issue, and inflation is a long-term issue. Stock corrections are more severe in the short-term, but are usually short-lived, and full recoveries usually occur fairly quickly. Inflation, on the other hand, is a little more insidious. It’s unlikely to be severe in the short-run, but can be utterly destructive to your purchasing power over decades. Which brings us back to a prudent, diversified portfolio. You want enough in cash and bonds to cover your short- and intermediate-term needs during a market correction, but enough in stocks to combat the long-term ravages of inflation.
While we have long felt that we should prepare ourselves for a lower-return world, and have been somewhat surprised by the nearly uninterrupted upward trajectory of the market, we are pleased to have largely participated in its gains. We tend to stay invested, even when our expectations are muted, heartened by these words from famed investor Peter Lynch: “Far more money has been lost by investors trying to anticipate corrections, than lost in corrections themselves.”
As a final matter of housekeeping, you may notice elevated cash levels in your account at year-end. Several mutual funds paid large distributions in December, and we did some year-end tax-loss selling. Rest assured, we will be putting this back to work in due course. And if the first week in January has been any indication, we may get to do so at better prices.
Thanks, as always, for your continued confidence.
SoundPath Investment Advisors
Julius Ridgway Eddie Carlisle Doug Muenzenmay