"The Enigma"

“The Enigma” has made headlines as the rare black diamond gets ready to hit the auction block. Experts predict the stone could fetch as much as $6 MM with auction house Southeby’s accepting bids from February 3-9th. The 55 sided 555.55-carat diamond is said to originate from a diamond-bearing asteroid colliding with Earth. But before you grab a shovel and start searching for a similar stone in your backyard, the only known locations for black diamonds are Brazil and Central Africa.

As last year came to a close, the US markets finished with new all-time highs after marking 70 all-time highs in 2021, second only to 1995. This performance happened despite the resurgence of Covid with the variants, supply chain issues, growing levels of price inflation, job market aberrations, and the threat of rate hikes by the Federal Reserve. There were plenty of arguments favoring why the markets couldn’t fall significantly, and the most prominent one spoke to a concept known as TINA, or “There Is No Alternative”. The argument is that with bond rates near all-time lows, real estate prices near all-time highs, and commodities too volatile for ordinary investors, the stock market was the only game left in town and thus would continue to benefit from money flowing from investors. This, along with the continued pace of corporate buybacks, would help keep stock prices elevated, even during a potential pick-up in inflationary pressures.

The start of 2022 has seen the markets begin to come under pressure, particularly with the technology sector. As of the writing this morning, the NASDAQ is down over 11% for the year, firmly placing it into correction territory. In addition, darling stocks that benefited greatly from the pandemic like Peloton and Netflix have issued poor earnings reports showing net subscribers down significantly compared to the boom times when everyone was couped up in their house during large parts of 2020. Interest rates have also played a contributory factor. Rates continue to move higher as the bond markets price in the eventual ending of the pandemic fueled stimulus from the Federal Reserve. Unlike “The Enigma” above, it appears that we are starting to see the first cracks, but it remains to be seen how this will all play out in the coming weeks and months.

If this is true and we are seeing the beginning of a more significant move lower for US Stocks, what will we do for client portfolios?

Well, this answer is straightforward and may seem counterintuitive, but we have already planned for times of market stress, and it is a crucial tenant of how we build long-term allocations that help fuel client success. A few key ideas are at work together. The first revolves around diversification. While the US stocks are struggling to start the year, International stocks and Emerging Markets remain positive for the year. Secondly, and most importantly, we build return assumptions for unique plans that take into account periods where returns are up, down, sideways, and every other way. We model these returns into our planning software and run 1000 simulations of what the potential future could be like. In recent years, we have adjusted lower expectations for returns, particularly for US stocks, as they have continued to perform well above their long-term expectations. The same assumptions are made for all the components of our portfolios to ensure that we use realistic and conservative measures to determine the potential for long-term plan success.

In the short run, we will continue to monitor markets in the same way we always do by running allocation reports that will identify any opportunities for rebalancing into any weakness in the coming weeks or months. For example, while US stocks enamored many at the end of last year, we took that opportunity to add to our allocations of International and Emerging markets positions. We did this not because we thought they would perform better but because they were the most underweight relative to the other components of our model portfolios.

The above was taken from the RK 2021 Trade Activity Summary. It highlights the purchases of Emerging Stocks while they performed poorly in 2021. The bars denote the net number of accounts where the trading activity occurred.

While the market will remain a random, sometimes scary enigma, investors who have built a well-diversified portfolio and follow a systematic approach to rebalancing will be much better served than investors who follow the headlines and react to events emotionally.

Nathan Smith is a Portfolio Manager with Rather & Kittrell.