- Global stock markets fell into bear market territory as investors fled risk assets
- Bonds also fell precipitously as interest rates surged
- Simultaneous bear markets in stocks and bonds are very unusual, as slowing growth and recessions typically cause interest rates to fall
- While the probability of a recession in the next 18 months is high, we expect it to be relatively shallow as balance sheets and labor markets remain strong
- The opportunities in stocks are often greatest when consumer confidence is at its lowest
What a difference 6 months makes. Following stock market rallies in 2020 and 2021, the first half of 2022 has been very disappointing for investors. Sharply rising interest rates, roiling inflation, and Russia’s brutal invasion of Ukraine have led to the worst first half of a calendar year for stocks and bonds in decades. This combined with an extremely partisan political environment has driven consumer sentiment down to its lowest level on record. When investors are uncertain and feel pessimistic about the future, their natural tendency is to sell risk assets. And as we will discuss below, the average investor often does the wrong thing at the wrong time.
Heading into 2022, we forecasted below average returns and increased volatility for both stocks and bonds. We also suggested investors were likely to focus on “profits not stories” and that riskier investments (i.e. cryptocurrencies and tech companies) would likely underperform more stable, profitable companies (i.e. dividend/value stocks). Little did we know the extent to which we’d be right.
Bear Market in Stocks & Bonds
At the midyear point the S&P 500 is down 20.6%, with the S&P Growth down 28.0% and S&P Value down 12.4%. U.S. small-caps fell 23.4% and developed and emerging international stocks fell 19.3% and 18.8% respectively. Meanwhile the riskiest assets (which we don’t own) such as cryptocurrencies and NFTs fell over 50% in most cases.
While our strategic overweight to value and overseas stocks along with our allocation to alternative investments helped protect our portfolios slightly on the downside, in the first half there was almost nowhere to hide in equities other than the energy sector.
Meanwhile core bonds fell a whopping 10.3% in the first half thanks to a staggering jump in interest rates. To put that in perspective, the worst year for bonds in the last 40 years was a 3% decline. Thankfully, in early 2021 we eliminated most of our exposure to intermediate & long-term bonds in favor of shorter-term bonds and non-traditional income strategies. As a result, our bond portfolios fell roughly half as much as the index.
The concurrent bear markets in stocks AND bonds are historic. Other than short-term periods of calamity when credit markets have frozen such as 9/11 and the financial crisis, bonds typically buoy portfolios when stocks are falling and vice versa.
Why Did This Happen and What’s Next?
In our opinion, governments and central banks across the globe overstimulated economies by printing too much money in response to COVID. They then missed their opportunity to start raising rates in 2021 as economies and stock markets were emerging from the pandemic. Their dovish approach along with surging demand and constrained supply allowed inflation to soar to 40-year highs. Subsequently we have entered a period of rapidly rising interest rates in hopes of slowing down the economic wildfire. Higher rates increase the cost of borrowing for corporations and consumers, put pressure on asset valuations, and disincentivize spending in general.
Entering the third quarter there are already gathering forces slowing the economic momentum which makes us believe the worst of the surges in inflation and interest rates are behind us. In 2022 the federal budget deficit is likely to fall from 12.4% of GDP to less than 4%, the single biggest decline as a percentage of GDP since the demobilization following World War II. This reflects an end to stimulus checks, enhanced unemployment benefits and a host of other programs that were supporting the spending of lower and middle-income households.
Additionally, the housing sector is being battered by a 2.5% surge in 30-year mortgage rates while U.S. exports are being impeded by a soaring dollar. Consumer confidence is collapsing in the face of spiking food and energy prices and a slumping stock market, all of which threaten to slow the economy in the 2nd half of the year and possibly fall into recession.
What about Stocks Going Forward?
Despite our expectation of continued volatility and the economic challenges above, we remain optimistic about the long-term investing environment for several reasons. First, there are still signs of growth as the global economy recovers from the pandemic. Balance sheets remain healthy for both consumers and corporations. And the labor market remains strong with job openings outnumbering the unemployed by almost two-to-one.
Second, we believe corporate earnings will be the driving force of equity markets going forward as opposed to multiple expansion. The forward P/E of the market has fallen from 21.5x a year ago to 15.9x today (25-year average is 16.8x). This welcome return to fundamentals creates more opportunities for us as investors who focus on profitable companies with sustainable earnings.
Third, it is likely we experience a healthy recession in the next 18 months. For all the concerns about it, a moderate recession may be necessary to clean out the excess of the past decade. You can’t have such sustained growth without an occasional downturn to balance things out. It’s normal and healthy.
Lastly, there are several positive headlines on the horizon. Eventually the conflict in Ukraine will be resolved, inflation will begin to retreat, interest rates will stabilize, and we will emerge from a likely recession. These four issues represent most of the uncertainty investors are feeling, and as they are resolved risk appetites are likely to return.
History suggests there are better days ahead following big bond declines. After periods of rising rates, more yield helps boost returns (remember, over the long-run bond investors want higher rates). Then there’s the recovery: the first and second year after those periods have often been the best years for bonds. So, while rates are likely to continue to increase in the short-term, they are likely to increase at a slower rate and eventually fall as rates stabilize as the economy slows.
Humans are emotional beings and often do the wrong thing at the wrong time. The “average” investor often falls for a variety of behavioral finance pitfalls, which leads them to buy when markets are high and sell when markets are low.
As mentioned above, the University of Michigan Index of Consumer Sentiment is at its lowest point in 50 years. Over that period there have been 8 distinct peaks (confident) and 8 distinct troughs (pessimistic). The average 12-month return of the S&P 500 following a peak was 4.1% vs the average 12-month return following a trough was 24.9%. Notable peaks where investors felt good about taking risk include Jan 2000 before the tech crash, Jan 2007 before the Great Recession and Feb 2020 before the pandemic. Conversely, notable troughs include Oct 1990 before the bull market of the 90s, Nov 2008 before the emergence from the Great Recession, and April 2020 before the recovery from the pandemic crash.
This is not to argue that U.S. stocks will return anything like a 24.9% return in the year ahead. Many other factors will determine that outcome. However, it does suggest that in planning for 2022 and beyond, investors should focus on things they can control rather than trying to time markets based on how we feel about the world. As always, we are here to help ensure you are not “average” investors.