- The 2022 bear market
- Inflation
- Rising interest rates
Bert Whitehead, author of “Why Smart People Do Stupid Things With Money,” has had a massive influence on how Jackie and I approach helping our clients.
When he’d talk about emergency funds, he’d mention what he called a “triple threat” to a person’s finances, which are three bad things all happening at once. The idea is that most people, at some point in their life, will experience a triple threat. (Imagine a stock market crash threatening the value of your investments, losing your job, and finding out your spouse has cancer all at the same time.)
And with the 2022 bear market, inflation, and rising interest rates, it feels like we’re all going through a collective triple threat.
The 2022 Bear Market
Back in June, news headlines claimed this was the worst start to the year for the S&P 500 since 1970, because the market was down 20.6% in the first six months of 2022. Truthfully, there was some cherry-picking going on with that information, because with headlines like that, you start to think that this year is, in fact, the worst it’s been since 1970. But really, it’s just the first six months.
This is important to realize, because the current decline we’re going through is barely a bear market (which is when the market drops by 20% or more), and it’s nothing compared to the 2008 financial crisis… but that happened during the second half of the year, in the fall of 2008.
So, in terms of other bear markets, what’s happening right now is just a run of the mill bear market—and we’ll dive into more details later.
Plus since writing this in July, there are early indications of June 16 being a possible bottom for this bear market.
Inflation
The inflation that’s happening right now is the worst inflation in 40 years. It’s something most of us have never experienced to this extreme; likewise for most of our clients who tend to be in their 30s and 40s.
And unfortunately, we’re not seeing it slow down: During the pandemic, my family started buying groceries online. Over the last few months, when my wife is making the grocery list, she’ll call out new items that have gone up in price since the week before. It’s usually not that much, but when an item that was $1 last week now costs $1.12; that’s a 12% increase in just a week. When you start spreading that out over your entire grocery list, it adds up.
Rising Interest Rates
In June, we saw the largest interest rate hike of the federal funds rate since 1994. The rate was increased by 0.75%, which was more than the 0.5% the federal reserve initially signaled to us.
They’ve also told us that they’ll probably raise it another 0.75% at their next policy meeting as well.
We see the impact of these hikes in two areas: real estate (mortgages), and bonds.
Mortgage rates have gone up from the lows of last year. For a 30-year mortgage, rates are approaching 6%, which is more than double the rate you could get on the same loans last year.
For those trying to sell their homes, we’re now seeing less competition and price cuts—or delaying home purchases or home improvement projects, simply because the borrowing cost has gone up so much.
Rising interest rates are also affecting bonds. We’re big believers in portfolio diversification, which means owning both stocks and bonds. The portfolios we design tend to start out at 60% stocks and 40% bonds, relying on the bonds to limit volatility. This year, however, the stock market is going down, and the price of bonds are going down as well.
So far, 2022 has been an unusual year with stocks and bonds both going down in value.
5 Things to do NOW
So… what do we do about this triple threat that’s happening to all of us?
It’s definitely a concerning moment in your financial history, and it’s okay to be worried about it.
However, you can be worried and still have a plan—which is key to weathering this storm.
Here are 5 things you can do now to abate this triple threat, set yourself up for a better financial situation, and ease your mind:
1. Keep Enough Cash
Before we talk about why cash is important and all it can do for you, let’s set some simple targets for how much cash to keep on hand. To be clear, this is just simply cash in the bank. We’ll talk about an emergency fund in a minute.
- Keep 10% of your wages as cash in the bank. (To find this, you can look at line one of form 1040 from your 2021 taxes.)
If you made $300,000 in 2021, keep about $30,000 of cash in the bank, not counting your emergency fund.
- For an emergency reserve, keep the greater of 20% of your wages, or 10% of your mortgage balance.
To be clear: the emergency reserve is in addition to the cash you’re keeping in the bank.
Before 2022, I liked my clients to keep their emergency funds in short-term bond funds. But now with the federal reserve continuing to raise rates, it’s perfectly fine to keep both your cash and your emergency reserve in a high-yield savings account.
So… what will all this cash do for you?
- Pay your taxes
The first thing this cash can do for you is cover your tax bill. Just because the stock market is going down doesn’t automatically mean that your tax bill is going down too.
There’s often a bit of a lag between the portions of your compensation that are tied to the stock market (like RSU or stock options) and what gets reported on your tax return.
For example, for most of our clients, 2021 was a great year for their income. The stock market was doing well, and many of them made a lot of money.
The decline, especially for our clients working in tech companies, started in the fall and accelerated through April of 2022. Because of this, we had a lot of clients with large tax bills related to what happened throughout most of 2021, but their stocks and investments had decreased in value by the time that tax bill was due.
Hence the importance of having enough cash on hand to pay taxes: You do not want to have to sell your shares at discount prices just to be able to pay taxes. (Buy low, sell high, remember? Not the opposite.)
But to avoid selling low, keep enough cash on hand.
- “Insurance” against stock volatility
Cash is also a form of insurance, because it’s a buffer. It gives you time to wait to act in the stock market until things start to recover.
When you have cash on hand, you don’t have to sell low to cover your bills. The cash grants you the ability to be patient and make good decisions without feeling rushed.
- Fund your goals
Over the last few years, everyone felt like they were left out for not investing, because the stock market kept going up.
Now, on the other hand, things are changing.
The stock market almost always drops faster than it rises, so don’t risk your short-term goals (things you want to do in the next 1-5 years) by investing those funds into the stock market. It’s okay to keep it in cash, now more than ever.
For example, if you want to buy a house, a higher interest rate may mean you need a larger down payment to make your monthly cash flow work.
2. DON’T Pay Extra on Your Mortgage
If you’ve got a fixed-rate mortgage, don’t pay extra on it.
Why?
The higher interest rates go, the cheaper your fixed-rate mortgage payment becomes… So don’t pay extra on a fixed-rate mortgage below 4%.
For example, in January, my wife and I refinanced our 30-year fixed-rate mortgage to a new 30-year fixed-rate mortgage at 3.125%.
Today, in July 2022, the average rate is 5.83% on a 30-year fixed-rate mortgage.
Let’s assume, for the purpose of this example, the mortgage is worth $750,000, which is the limit for the mortgage interest deduction. (Note: This is not my actual mortgage amount.)
$750,000 borrowed at 3.125% over 30 years is a monthly mortgage payment of $3,213.
$750,000 borrowed at 5.83% over 30 years is a monthly mortgage payment of $4,415.
From January to July (only six months!), that’s an increase of $1,202 per month, or $14,424 per year.
Another way to look at that is that if you have the lower of the two mortgage rates listed above, your mortgage is now saving you $14,424 each year versus a new, replacement mortgage.
Even before inflation started happening, we’ve been telling clients that their fixed-rate mortgage was their best guard against it. Because, for the next 30 years, no matter how high interest rates go, their rate will be fixed.
Plus, if rates drop below their current rate, they’ll be able to refinance.
So just to reiterate: DO NOT pay extra on your fixed-rate mortgage. Got it?
3. Continue Funding Your 401(k)
Better yet: just don’t mess with it at all. Don’t log into it, don’t look at it, and just ignore the fact that the values might be going down for the time-being.
Keep plugging dollars in every single pay period.
Don’t stop.
Remember: the secret to success is to buy low and sell high.
The bear market we’re going through right now gives you the perfect opportunity to buy low, so that in the future, when you’re not working, you can sell high.
The biggest investment advantage our clients have is that they’re still working, which gives them a continuous flow of new cash to invest. Your 401(k) is where you leverage this the most, so don’t stop.
(The only thing you might want to double-check is that those contributions are actually being invested, but once you’re sure that’s happening, leave it alone!)
Target date retirement funds work perfectly well here, so just keep making the contributions and make sure your dollars are invested in a way that lets you take advantage of the cheaper stock market prices.
4. Clean Up Your Portfolio
Once you’ve got your cash funds at the right amounts, you’re not paying extra on your mortgage, and your 401(k) funding is on autopilot, the next thing to do is clean up your portfolio.
When everything’s going up, like it has been in the last few years, portfolios tend to get a little out of whack.
BUT, when things go up, like they were doing before the bear market, those distorted numbers can make not-so-good investment decisions look okay because everything’s going up.
Now, though, that’s not the case. To put it plainly, everything does not look good. ????
And as we all know: diversification is the key to successful investing. A lot of times, though, when new clients tell me they’re diversified, they actually mean that they’ve got an S&P 500 ETF, or a basket of tech stocks.
That is not diversification. (Sorry if I’m bursting any bubbles, but it’s for your good, I promise.)
Diversification, as we define it, means owning most of the global stock and bond market. Think thousands of stocks, not just 500.
Now that the market has declined, it’s a good chance to review your portfolio, to make sure you’re truly diversified, and replace positions that aren’t diversified with a much lower tax cost because of the losses you might have, or the gains that would be a lot less than they were this time last year.
5. Stock Options: Hold Shares at a Lower Price
After taking care of the four items above, it’s time to think about your stock options.
With stock options and equity compensation, think about finding ways to hold shares at now-lower prices.
Here are some ways you can do so with the different types of equity compensation we typically see our clients have:
If you work for a publicly traded company, it’s likely that your stock price is much lower than it was a year ago. This means you can exercise and hold more of your ISO with less alternative minimum tax (AMT).
If you’re at a private, pre-IPO tech company, you might be dealing with down rounds, which is a lower 409a valuation than what you saw at the beginning of the year. This is also a good opportunity to hold shares at a now-lower price by exercising and holding your ISO with less AMT.
Typically, we recommend selling these as soon as possible to convert the discount you get into a small cash bonus. But with some of our clients’ stock prices being down more than 50%, you can take advantage of that decline via your ESPP.
Essentially, you’re getting a discount on a discounted price.
If you’re already holding shares, whether ESPP or from a past exercise, set a target price you’d be happy to start selling at. That way, when the stock reaches that price, you can give yourself permission to start selling without running the risk of continuing to hold, only to suffer from another market crash.
As long as you have time left before those options expire, just sit on them.
Wait for the market to recover to get back over your target price, and then start thinking about exercising a same-day sale.
With NSO, a same-day sale is almost always our plan, but now we’re just delaying it a little bit because we want to sell high, remember?
We almost always push our clients to sell RSU as soon as they vest, but a year like 2022 is the ONE time where I don’t push as hard on this.
If a client doesn’t like that the stock is incredibly undervalued in the market, and fully believes it will recover, that’s fine. They can wait for it to recover and sell then… as long as they have enough cash to cover the taxes.
Handle the 2022 Bear Market, Inflation, & Interest Rate Hike
There you have it!
We’re all facing a triple threat from the economy right now, but there are some solid things you can do to make sure you still come out in a decent financial position.
It’d be unnatural not to be worried about your finances during a time like this, but it’s important to use that worry and put it into action with a solid plan.
This year seems crazy, and it is, but when we look at this year as part of history, nothing happening right now is exceptional or completely unexpected. This is what we plan for.
When we work with new clients around investments, we set the expectation that one out of every five years will bring a bear market that decreases your portfolio by 20% or more. This is that year.
This is just how things work. I’ll say it again: it’s what we plan for. Things like this will happen, but with a solid plan, you’ll be fine.
If you’d like a more-encompassing financial plan beyond the five things I’ve outlined here, schedule a discovery call with me.
