Abacus Investment Committee Insights: The Equity Premium and Staying the Course

The first quarter of 2022 reminded investors that volatility, inflation, and geopolitical risk come with the territory when investing in global markets:

• On Thursday, February 24th, Russia invaded Ukraine, triggering Europe’s largest refugee crisis since World War II and causing more than 4.6 million Ukrainians to flee the country with an estimated 7.1 million displaced as of April
• U.S. inflation accelerated to 8.5% in March, marking a four-decade high and hitting levels not seen since 1981
• The S&P 500 has fallen 7.4% since the start of 2022
• The Federal Reserve approved its first interest rate hike in more than three years at 0.25 percentage points, and indicated an aggressive path ahead to try and control rising prices

This time period brings with it a humbling perspective and we pause to acknowledge the true human cost of the events unfolding in Eastern Europe. The headlines and stories are heart-wrenching, and the number of lives lost will undoubtedly climb. It is normal to feel anxious or nervous during a time like this. It’s also natural to question what will happen to the markets, and to wonder how our own lives will be impacted. And yet, we stay the course. 

Volatility

The S&P 500 stock index started the year at 4,796.56, dropping to 4,326.51 on January 27th, bumping back up to 4,589.38 on February 2nd, and fluctuating between -2.82% to -12.5% in the two months since [1]. This is volatility. 

Volatility is the measure of the up and down movements of the market. The lower the volatility, the smoother the ride. The higher the volatility, the more it feels like a roller coaster you’d like to exit. This random, roller coaster behavior of the stock market over a period of days, weeks, or months, is largely driven by uncertainty in the economic and business outlook. In this particular case much of the uncertainty and volatility we’re seeing this year is a result of the invasion of Ukraine, sanctions on Russia, increased energy prices, inflationary pressure, and anticipation of the Fed ratcheting up interest rates. 

Inflation

Inflation accelerated to 8.5% in the twelve months ending in March, the highest rate in 40 years, with a 48% skyrocketing of gasoline prices accounting for half of the increase [2]. Over those 40 years, inflation averaged 2.81% and has been trending lower each decade, averaging 2.44% over the last 30 years, 2.37% over the last 20 years, and 2.25% over the last 10 years [3]. ‘Core CPI (Consumer Price Index),’ which removes volatile food and energy prices from the equation, ticked up just 0.3% for the month versus the 0.5% expected [4]. However, the overall 8.5% increase, as we’ve noted previously, is a significant spike.

Inflation is effectively a flat tax on everyone equally, no matter how much money or income you have. It’s a rise in the overall price of goods and services (think of the recent increase you’ve seen at the gas pump, on your grocery bill, and for many other day-to-day items) coupled with a decrease in the purchasing power of the underlying currency. Inflation can arise from higher demand for these goods and services – which drives up prices – or it can also result from an increase in the amount of money in circulation. The more dollar bills there are in the economy, the less “special” each dollar is (and the more of them it takes to buy your groceries). 

The Equity Premium and Staying the Course

At Abacus, every client portfolio is allocated between stocks, real estate, bonds, and cash in a way that aligns with their goals. Our experience tells us that over time, investing in equities is generally a good way to outrun inflation. From 1928 to 2021, the stock market has increased by an average of 10% per year. While this wasn’t a straight shot upwards, and there were normal periods of up and down fluctuations, this is still outpacing current inflation rates. 

At Abacus, our investment advice is goal-focused and planning-driven versus market-focused and current-events-driven. In over 20 years of helping individuals and families reach their goals, we’ve found that successful investors continuously act on a plan in lieu of reacting to the market. You’ll find we prefer planning over prognosticating and once your plan is in place and funded, we rarely recommend a change in portfolio so long as your long-term goals haven’t changed. 

Abacus client portfolios and plans are based in large part on stocks earning a premium over “safe-haven” investments like cash and bonds. The long-term historical annualized return in excess of inflation has been a little over 7% for the S&P 500 stock index and 3% for bonds. The 4% “premium” provided by equities can create a significant impact. 

Imagine you buy $100 of groceries per week. If you invest your money for 20 years in bonds earning 3% over inflation, you’ll be able to buy $180 of groceries per week in today’s dollars. An investment in the S&P 500, however, would allow you to buy $390 of groceries per week, giving you twice the purchasing power. By accepting a higher level of uncertainty in the short run, a stock investor captures a significant increase in purchasing power relative to bonds over longer periods of time. 

While market headlines will continue to amplify bold declarations about the future, the four most dangerous words in investing are “this time is different.” Staying the course and remaining invested through uncertainty is the reason why you earn that valuable stock market premium over time. 

References

[1] MarketWatch

[2] U.S. Bureau of Labor Statistics – Consumer Price Index Summary March 2022

[3] U.S. Bureau of Labor Statistics – Inflation Calculator

[4] U.S. Bureau of Labor Statistics – Consumer Price Index Summary March 2022

Disclosure

Abacus Wealth Partners, LLC (Abacus) is an investment adviser registered with the U.S. Securities and Exchange Commission (“SEC”), with its principal place of business in the State of California. Registration as an investment adviser does not constitute an endorsement of the firm by the SEC, nor does it indicate a particular level of skill, training, or ability.

The article is for educational purposes only and nothing herein should be construed as a solicitation, recommendation, or an offer to buy, sell, or hold any securities, investments or to adopt any investment strategy or strategies.  The Information and opinions presented in this article have been obtained or derived from sources believed by Abacus to be reliable and Abacus has reasonable grounds to believe that all factual information herein is true as at the date of this material.

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