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Can you trust this stock market rally?

Peter Switzer
17 August 2022

It’s been another good trading session for shares in the US and this should again help our stock market, though not all indexes rose. That said, there has been a screaming comeback for stocks since the middle of June, but can it last? And can you trust stocks will have a better year ahead?

If you look at last year, our stock market lost 5.4% and over three years, the gain was 12.4% plus say 4% a year for dividends. So that’s 16.4%, or let’s round it up to 5.5% a year.

For you to get that, you’d have to be 100% invested in stocks, which financial planners say is for the younger investor who’s happy to take risks for big returns and can sleep at night if the market drops 40%.

Most older people want a safer portfolio of stocks and bonds, which reduces their overall returns.

This kind of person would’ve brought their three-year returns down to about 3% by dropping a lot of their potential stock market holdings for the safety of bonds. Well, that’s what they and others, like financial planners, might have thought, but we’ve lived through the worst time for bonds.

This is the way The New York Times described it in March this year: “Hammered by high inflation and the start of interest rate increases by the Federal Reserve and other central banks, the bond market is having a horrendous year — producing painful losses on a scale last seen in the 1980s”.

Expert bond traders have been shocked by the losses coming out for bond funds and in simple terms, it’s the fallout from being rescued from the Coronavirus and its lockdowns that threatened a Great Depression.

To fight this threat, central banks cut the cash rate to unbelievable levels. Our rate was cut to 0.1% and governments spent like there was no tomorrow to save jobs, businesses and governments!

So for the first time since the 1980s, both stock prices and bond prices fell and investors who played it safe by reducing their exposure to the stock market actually had negative returns.

Yep, even our industry funds had negative returns over the financial year. Not all their investments are valued by the stock market. They hold property and other assets such as airports, and we have to rely on a valuer who the industry funds employ to tell us what has happened to the value of these assets. These valuers could be fair or wrong but I bet they were more friendly than the vicious stock market in 2022.

The famous index that tracks the performance of bonds (i.e. the Bloomberg Aggregate Bond Index) was down over 6% in the year to March and has lost even more since.

And one bad year for stocks and bonds can ruin your portfolio’s return as this little example shows. Imagine you had three great years of 10% returns. To work out your 3-year return, you’d add 10% to 10% to 10% and divide it by 3, and the average is 10%.

Now, what if in the fourth year the return is minus 4%? The average is found this way: 10% + 10% - 4% = 16%. And now divide 16 by 3 and your average 3-year return is down to 5.3%. A really bad year for stocks and bonds can significantly bring down your returns.

Over the past three years, stock markets have faced:

1. Donald Trump fighting China.

2. China slapping big tariffs on Aussie goods such as our wine, coal and agricultural goods.

3. The Coronavirus, lockdowns, a related recession and a stock market crash.

4. Supply chain shortages, made worse by China going into long lockdowns to beat the Omicron virus.

5. The loss of about 500,000 foreign workers entering Australia, which isn’t helping us beat down inflation.

6. The Ukraine war, which has subsequently hurt European growth and sent petrol and power prices through the roof. This all created really high inflation. And now central banks are raising interest rates aggressively.

7. Throw in floods, fires and worries about China invading Taiwan and you can see heaps of reasons why stock markets have had a poor three years.

The past 10 years have been good, with a rise of 6.6% a year. If we add in 4% for dividends, then that’s a return of over 10% a year. And that’s what a lot of textbooks tell you the stock market makes per year but over a decade!

You get bad periods like the past few years, but then the market screams back and brings the overall returns up. History says those who are fully invested in say a group of stocks that do as well as the overall index then pocket returns of 8-10% a year.

That’s why being scared now and playing it safe could mean you lose twice: you lose with this terrible period for stocks and bonds and you go into a 3% term deposit, and then you see the stock market rebound 10% or more!

History shows after a bad year like 2022 (when the US Nasdaq market index was down over 33% and the overall market was off 24%+) that stock markets roar back in the following years.

Also, years three and four of a US Presidency are usually good for stocks. And you have to think that the Ukraine war will eventually end and stocks should like that too.

There’s even talk that in 2023 the US will be cutting interest rates, and stocks like that as well.

The current rally in stocks is a sign of things to come but there could easily be another sell-off, if US inflation doesn’t fall next month as expected, or if Putin or Beijing do something crazy. But history tells me that being invested in good stocks over time works. It’s about time stocks delivered. I think we’ll see that over 2023 and 2024.

Want proof? Look at this chart below of the All Ordinaries and see how it has kept rising, despite a huge number of curve balls. Even adjusted for inflation, the numbers on the returns are really good. Since 1980, the real return (i.e. adding dividends and deducting the impact of inflation) has been 7.1%.

If you were in a 4% term deposit over that time, after deducting 3% for inflation, your real return would have been 1%!

The stock market can be a pain at times but over time it delivers, and given bond experts think bond funds will have a good year, sticking to exposure to stocks and bonds should prove an OK strategy.

I’m trusting this rally is a sneak preview of what lies ahead. I wouldn’t be surprised to see another sell-off but by Christmas, I reckon I’ll be popping champers because I’m invested in stocks.

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