What’s In the Chest

  • Do you have or even know what a ‘war chest’ is?
  • Volatility is a normal part of investing, yet can still be uncomfortable
  • Short term events should not dictate long term goals

This time of the year my family tries to do a little spring cleaning and at the same time, we try to teach our son, Francis, how he is fortunate to have the toys he has as well as how to be tidier.

One item which can get more use in our family is a toy chest. While there are moments when this chest does get filled, more times than not, once it is opened, everything comes out. Long lost toys suddenly reappear which leads to minutes of excitement. If we considered all the toys in the chest, Francis could play for years and not need another toy. I was recently speaking with a client who mentioned a hope chest and the memories she had of collecting items for this chest. Coincidentally, just this morning, I was looking for an old sweatshirt in my cedar chest and recall my fond memories of when I received the sweatshirt years ago as a gift.

Now, I’m sure you are wondering why I have mentioned the various chests. The reason is while we all may have had a type of chest in our past, each one of us still has one and we may not even know it. Some are more easily seen as compared to others. One such chest is within each of our client portfolios and is known as a ‘war chest’. This ‘war chest’, made up of cash and bonds is there to weather a decline or period of volatility in the equity markets. Now the size of ones ‘war chest’ depends on their current cash flow needs. For our clients who have little to no current cash flow needs, their ‘war chest’ may only be a year or two of household expenses. For those individuals who are taking money from their accounts for living expenses, their ‘war chest’ could be closer to nine years.

For example, as we all know, there has been an increase in volatility in the equity markets this year. Having a ‘war chest’ for each portfolio has accomplished two different goals. First, in the event of normal cash flow need requests, there should not be a need to sell any equities. Secondly, historically cash and bonds are less volatile than the equity markets, so there should be less volatility within the portfolios. Thus, even with the volatility of the equity markets, the potential cash flow distributions would be coming from cash and bonds thanks to the ‘war chest’. This is the power of the ‘war chest’ and the reason we think it is so important.

As the calendar turned to 2022, volatility returned to the equity markets. Daily reports of market volatility, while uncomfortable, should not dictate long-term investment strategy or plans. Due to very little volatility in 2021, some investors may have been surprised by the return of such volatility.

I wanted to give you some data points regarding the market volatility.

  • Periodic stock market volatility is entirely normal. Historically, the S&P 500 Index has averaged three pullbacks of 5% or more per year and one correction of more than 10% annually. Investors have grown accustomed to steady, consistent gains over the past couple of years which makes the current bumpy ride feel more uncomfortable. There was only a single 5% pullback in 2021.
  • Potential causes for the recent volatility include high inflation, higher interest rates, and less support from the Federal Reserve.There is still some supply chain disruption and some economic weakness because of Omicron which could also be playing a role.
  • Market history tells us that stock market action in mid-term election years (which we’re in now) is historically quite volatile.
  • The Fed has shifted its priority to controlling inflation.That signal of less support for the economy has made the markets nervous.  The good news is that the Fed is prioritizing inflation because the economy overall is in pretty good shape.  Since that’s usually true when the Fed starts to hike interest rates, the S&P 500 historically has had solid performance (on average) in the year before and after the first-rate hike of an economic expansion.
  • Importantly, we remain confident corporate America has enough earnings power left in the tank to support stock market gains.There are challenges facing corporate America this earnings season, including supply chain disruptions, wage, and other cost pressures, and COVID.  But while it is still early in earnings season, corporate earnings are growing, and companies are mostly optimistic about the future.
  • Even in positive years for the S&P 500, on average the index experiences a maximum peak-to-trough decline of 11%. This year’s max drawdown is now 9.8%.

Over the last week we have started to see some stabilization in the markets.  This is not to say there will not be more volatility as we expect volatility to continue throughout the year.  What we must remember is we have had a strong market for the past two years with very little volatility.

How is your ‘war chest?