Retirement Savers Stay the Course: May. 9, 2023

Retirement investors who stayed the course during volatile market conditions this year have had some relief from equity losses of 2022, but as risks such as the U.S. debt ceiling, monetary policy tightening, corporate earnings uncertainty, regional bank instability and geopolitical turmoil mount, individuals’ grit is being tested. In the coming months we will see if recent market gains are part of a longer trend or just a bump during a prolonged market decline while updated data from retirement services providers will reveal if investors are riding out the challenging landscape.

Regardless of the market direction in the foreseeable future, from a long-term perspective, equities have delivered attractive returns for patient investors. Even though past performance is no guarantee of future results, a historical look at equities provides perspective on market declines and recoveries that can help investors avoid selling at market bottoms and then missing out on subsequent market gains.

Winter and Spring Bring Equity Gains

After dropping 18.11% in 2022, the broad equity market as measured by the S&P 500 Index has reversed course and is up approximately 7.5% year-to-date as of early May. Investors still have a considerable way to go to make up for last year, but with a long-term perspective, the challenge appears less daunting. Consider a $100 investment that loses 18.11%, bringing the balance to $81.19. For the account to grow back to $100, the $81.19 balance must experience a 22% return, which at first blush makes the year-to-date 7.5% return seem paltry, but equity markets have previously recouped their losses, and consecutive years of market declines, while often significant in their scope, are rare.

Back-to-Back Declines

Since 1928, the S&P 500 has generated consecutive years of negative returns only four times with each one resulting from one of the following events:

• The Great Depression
• World War II
• The 1970s oil crisis
• The dot-com bubble during the 2000s

Of those declines, the only one that lasted for four years was after the Great Depression. Periods of three-consecutive-year declines occurred twice and a two-consecutive year decline occurred once. Broadly speaking, the second year of declines, when they do occur, have been more dramatic than the first-year decline, with the decade of 2000-2010 being an example. It is often referred to as the lost decade because it would have taken the entire 10 years to break even.

That period is often viewed as an unusually extreme and rare example; nevertheless, it illustrates why investors should maintain a risk/return profile based on their investment time horizon. Many advisors recommend equity time horizons of 3 to even 10 years depending on the types of equities being invested in. Of course, diversifying with other asset classes such as bonds can also be important for managing the potential impacts of market declines, and a portfolio’s final blend of assets should reflect an investor’s time horizon.  

In many instances, some of the best market returns have occurred after a negative year. Prior to 2022, the last downturn was 2018, when the S&P 500 dropped 4.38%. The following year, it gained 31.5% and in 2020 and 2021 it returned 18.4% and 28.7%, respectively. From a long-term view, the S&P 500, which was originally a 90-stock benchmark, has generated an average annual return of approximately 9.82%. In 1957, the index became a 500-stock benchmark and since that point, it generated an annualized return of 10.15%.

Retirement Savers Ride Out Downturn

Earlier this year, Fidelity reported that the average contribution rate among participants in plans it serves was 13.7% in the final quarter of 2022, down only slightly from 13.8% in the third quarter and 13.9% in the second quarter. The rates include both employee and employer contributions. The average fourth-quarter 401(k) account balance increased from $97,200 to $103,900 quarter-over-quarter. Additionally, 401(k) loans have declined with 16.7% of participants having outstanding loans in the fourth quarter of 2022 compared to 17% in the fourth quarter of 2021.

Challenges Ahead

Investors have placed an 88% probability that the Federal Reserve will pause its rate hiking during its June meeting and only a 12% probability of a 25-basis point hike. Following the last fed meeting, however, new data showed the Fed’s aggressive rate hikes haven’t cooled down the job market sufficiently, with employers recruiting 253,000 workers in April, up substantially from 165,000 in March. Consumers appear to be tapped out with buying goods but are still splurging on non-housing services, such as traveling and entertainment, which is a major concern for the Fed. Recently, the services sector S&P Global PMI reached a 12-month high of 53.6 while manufacturing climbed out of the contraction territory, which is indicated by a score of 50 or below, and hit 50.2.

The S&P 500 Index, meanwhile, is trading at a forward price-to-earnings ratio of 17.7, which makes it pricy relative to the 10-year average of 17.3 and potentially vulnerable to increased volatility if the economy weakens further and if the outlook for already weakening earnings worsens. Against that backdrop, the following risks exist.

• Elected officials in Washington appear far from reaching a decision that would allow for an increase in the debt ceiling and Treasury Secretary Janet Yellen recently estimated that the federal government could run out of money by June 1.
• The Russia invasion of Ukraine and OPEC + production cuts have created volatility in energy prices while growing tensions between China and Taiwan are another geopolitical concern.
• The stability of regional banks is also an issue. As more banks have revealed losses with held-to-maturity securities and have been hit by strong redemptions, many have cut back on financing commercial real estate.
• Recession fears have continued to grow as the Fed has raised interest rates. The majority of economists including myself now forecast that the U.S. will enter a recession this year.

On a more encouraging note, equities represent tangible value in corporations and despite periods of volatility they can reflect corporations’ ability to adapt to changing economic conditions, thereby helping create wealth for their investors. While investment gains are likely to trail the results of the past decade, investors can potentially generate additional returns through the proper use of options. In particular, low-risk strategies such as covered calls can help generate additional income and partially insulate portfolios from investment losses. 

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