3 Valuable Reminders To Be Careful When Investing for 2024

Over the last few weeks, several catalysts are signaling that we may be entering a new bull rally.  The positive June CPI print, improving US-China relations, and the future of AI are all positive momentum drivers supporting market sentiment. However, these factors could change very quickly. As early retirees with most of our wealth in the stock market, my wife and I need to be cautious about how we manage our investments. In this blog post, we share our opinions on how we are approaching our equities portfolio through 2024.

Disclaimer: Please note that the content below are our opinions and should not be viewed as financial advice. You are responsible for your own investment decisions. Please consult your own financial advisor on any potential changes you plan on making to your portfolio.  

Portfolio Context

Before reviewing our approach, we recognize that each person’s financial situation and investment objectives are highly unique.  As early retirees, our approach may differ greatly from other investors who are in the wealth accumulation phase. Whereas, for us, our priority is wealth preservation. Below, we share more details about our situation which may provide greater context into our decision-making approach:

• 39 y/o early retiree couple living in NYC (very high cost of living and terrible taxes!)
• Our primary income sources include: dividends from equity holdings, interest from money market funds, distributions from municipal bond funds and rental income from physical real estate.
• Investment portfolio consists of 70% equities, 30% fixed income municipal bond funds. We are 60% invested with ~40% cash sitting in money market funds earning 5%+ while we look to grow our real estate portfolio.
• Our primary equity holdings are Vanguard’s VOO (S&P 500 Index) and VYM (High Yield Dividend) ETFs
• Our individual equities positions are a mix of growth and high-quality dividend stocks, as well as small positions in call-option ETFs like JEPI for income and managing volatility. Individual equity non-ETF positions represent less than 10% of our equities portfolio and we hold them in our IRA accounts for tax efficiency.

Since we have already achieved our financial independence, we have prioritized our investment objectives as follows: 1) wealth preservation, 2) income, and 3) growth.  Our perspective below builds upon our prior thinking of how we plan on de-risking our portfolio.

Buy Selectively and Cautiously

Unlike other eras, cash is not trash given the Fed’s aggressive rate hikes. Most of you may not understand why we have such a high cash position. In short, the two primary reasons include the S&P 500 being overly expensive and the risk-free return on cash being attractive.

First, when looking at the S&P 500, the current P/E ratio is trading at 25-26X earnings. For context, the average P/E ratio for the S&P 500 during the modern-era post-2008 has been around ~22-23X, suggesting that the index’s current valuation might be overly expensive by ~14%. Compared to the S&P 500’s P/E ratio all-time, this would be a ~53% premium as seen in the chart below:

Most of the S&P 500’s recent gains have been with the “Magnificent Seven”: AAPL, AMZN, GOOGL, META, MSFT, NVDA, and TSLA. Q1 earnings and AI euphoria have been positive catalysts that have boosted the S&P 500 performance, especially as inflation trended downwards. The expensive valuation has driven investors to seek better returns on capital elsewhere (e.g., small-cap funds, international funds, and defensive segments within the S&P).

Second, as the Fed continues to keep the Fed Funds rate high, T-Bills and money market funds pay investors 5%+ to park money on the sidelines. In times of volatility, investors benefit from income without taking any risk with their capital. Short-term, this is better than traditional dividend stocks or ETFs from a pre and post-tax yield basis especially if you choose a tax-efficient money market fund.  The Fed has already signaled that they intend to keep rates high at least through the end of 2023 and likely, the first half of 2024.  This means that investors get paid to be opportunistic with resource deployment. My wife and I are willing to remain patient as we look for the right opportunities over the next 6-12 months and when valuations become more affordable.

Don’t Sell and Stay Invested

Many investors sell positions to take profit or panic sell at times of falling prices during times of market volatility. My wife and I do not plan on following these actions and here is why:

1. Timing the market for buy-sell decisions may result in “buying high and selling low”. Furthermore, the lack of consensus among economists and Wall Street analysts makes it more difficult to plan for the future.
2. Generating income from buying and selling is not needed. My wife and I live comfortably below our means and already have sufficient passive income from our dividends, interest, and rental income.
3. Taxes matter since we live in NY, which has the country’s highest tax rates. We want to optimize our taxes as much as possible, which is why we prefer buying and holding vs. buying and selling.

Bank of America did a recent study that compared the returns of staying invested vs. trying to time the market. Professional traders may like to play the volatility, but as average investors, we are likely to lose more than we win. The study demonstrated that staying invested yielded an average return of 17,715% since 1930 vs. trying to time the market. Missing the 10 best days would only yield 28%.  Excluding the worst 10 days and excluding the best & worst 10 days per decade did yield superior returns, but these scenarios are unlikely.  You would need to be EXTREMELY lucky with timing or have premonitions of when bad things are about to happen.

Additionally, our portfolio decisions do not materially change whether it is a bull or bear market. Building a diverse resilient portfolio, having dry powder and receiving rental income insulates us from the need to “sell” to protect our wealth.

According to the National Bureau of Economic Research (NBER), the average length of recessions since WWII has been approximately ~11 months. On the flip side, bull markets tend to last longer with an average duration of 6.6 years. If we can withstand the short-term volatility by staying invested, then we will win in the long run. If we were to exit our positions and then buy back in, we risk buying in at higher prices.

Don’t Cave to Fear of Missing Out (FOMO)

Yes, the S&P 500 index and the overall market will be more expensive in the future.  We WANT that to happen.  However, let’s not forget that the market is cyclical. We will likely have more economic events which will drive the market down and present new buying opportunities.  Here are our reasons why as a long-term investor, we are less sensitive to short-term price movements of the S&P 500:

• Existing investments in S&P 500 will help us capture upside in a continued bull rally
• Existing portfolio income and dry powder provide us with buying opportunities if a recession occurs
• Our focus is on valuations rather than the S&P 500 price (we should focus on buying at lower valuations)
• Higher Fed Funds rates for longer, likely until the first half of 2024 means cash is an asset and not a liability

If we were to buy-in more aggressively at today’s S&P 500 prices, we would be buying at expensive valuations.  If there is a bear market, we would regret this decision immediately.  The reason is because it is MUCH harder to earn back the principal you invested. In the chart below, we calculate the potential required return in order to break-even for different portfolio loss scenarios.

Therefore, if we bought the S&P 500 high and the index drops 30%, we would need a 43% rebound just to break-even. The numbers get worse if we experienced a 50% loss as we would need a gain of 100%!  We learned this hard lesson in 2021 when we purchased a few positions at the peak (e.g., Block SQ) and then subsequently 2022 humbled us.  We are still recovering from this decision. Fortunately, we have a long-time horizon. We will not let FOMO get the best of us again!

Warren Buffet famously said, “Be fearful when others are greedy and be greedy when others are fearful.” In reviewing the fear and greed index, we are in times of extreme greed. Therefore, we should be cautious.

Final Thoughts on Inflation

This week’s headline CPI was 3% y/y, slightly lower than expected.  The mainstream narrative is that the Fed’s actions are working, which may imply a rate hike pause after July. This will likely create more positive short-term momentum for the bull rally.  However, after taking a look into the components of the CPI, my takeaways were the following:

1. The CPI is largely trending down because of declines in gas & oil prices. The US government can influence pricing via the strategic petroleum reserve (SPR).
2. All the “essentials” (e.g., housing, food, transportation) are still extremely expensive. When compared to 2022, transportation, shelter and food away from home are either exactly the same or even higher in 2023.
3. Low unemployment rates and wage inflation will make getting to 2% extremely difficult

Since this is only one report, it may also be too early to tell whether this is sustainable.  Could we have a subsequent spike in inflation later?  Could traders betting on that the Fed will pause rate hikes in September, but then Jerome Powell disappoints, causing a market sell-off when he raises rates again? Both scenarios may be possible.

Our primary signpost for more capital allocation will be once the Fed decides to fully pause and/or start to pivot toward rate cuts.  Please let us know how you are planning to manage your portfolio in the second half of 2023 and what market events may have an impact on your approach.

If you are interested in the free investment tools that we use to inform our research and analysis, please check out the following:

• Portfolio back-testing: Portfolio Visualizer
• Stock screener research: FinViz.com
• Company fundamentals analysis: Stratosphere.io