Last week’s surprisingly high inflation reading of 8.6% prompted a bout of selling in both stocks and bonds.
The total U.S. stock market officially entered bear market territory, currently down just over 20% for the year.
Meanwhile, the growth and meme stock bubble has popped. For many, it has been quite painful.
The average stock in the NASDAQ is down around 50% from peak levels and many pandemic era favorites are lower by significantly more.
Managing Bear Markets
Bear markets are uncomfortable and difficult, but steep drawdowns are part of every market cycle. They are required for higher gains to be possible.
At Personal Capital, our focus is discipline and efficiency in all market conditions – finding opportunities and avoiding big mistakes. We remain confident our approach provides clients the best chances for long-term success.
Less than a year ago, greed was rampant. Now fear is dominant. Both can be dangerous times to be emotional or without a strategy.
While attempting to predict the future can be counterproductive, we’d like to share some of our perspective on the current state of capital markets and what may come.
Inflation and Interest Rates
The recent inflation report was indeed bearish. It showed that we have not already passed peak inflation, as many had believed. This forces the Fed to be more aggressive in attacking inflation, as evidenced by this week’s 75 basis point rate hike – the first of this magnitude since 1994. The median projection of Fed FOMC members is now for fed-funds rate to end the year at around 3.375%, implying further increases of 175 basis points.
Rising interest rates pressure stock valuations for two main reasons:
Valuations tend to compress because the earnings “yield” in stocks becomes less attractive relative to more stable bonds.
Higher rates suppress economic activity and increase the odds of recession.
Rising rates create a headwind, but it is worth noting that high absolute rates do not preclude strong stock returns. Ten-year yields spent most of the ’90s in the 5-7% range, a period where stocks did extremely well.
Interestingly, stocks initially reacted positively to the Fed’s 75 basis point hike this week, thought we don’t believe this is particularly informative.
Valuations and Big Picture
From a valuation perspective, equities are considerably cheaper than they were at the beginning of the year. Prices are down and aggregate earnings are up. We view current overall price levels as reasonable.
At the end of May, the trailing PE of the MSCI World index was 18.5, implying an earnings yield of 5.4%. With earnings still expected to grow, the forward PE estimate is 16. These levels are relatively attractive given U.S. bond yields in the 3% to 3.5% range, and most other developed country yields are lower. International stocks, which have held up somewhat better so far this year, remain more attractive in this regard.
The following chart shows the “Fed Model” for comparing stock and bond yields.
We see that for much of the last 30 years, 10 Year Treasury yields were higher than the S&P 500 earnings yield (the trailing PE ratio flipped on its head). That meant you could get a higher immediate yield with lower risk bonds.
Currently, stocks provide a higher yield, even more so if you were to use forward-looking earnings. This is bullish, especially because earnings should continue to grow over time while bond yields, once purchased, will not change if held to maturity.
Valuations should provide some comfort to those with a long-term view, but they tell us little about where markets will go next. Just as investors can become irrationally exuberant around bull market peaks, extreme pessimism can push valuations to irrational lows.
We believe the odds of recession in 2022 or 2023 are high. History may show we are already in one. But we also believe stock prices already reflect at least a mild recession in 2022-2023. Economic slowdown need not bring further market declines. A steeper recession remains a risk, and there is upside if a slowdown can be avoided altogether. Markets usually move in advance of economic data, with market recoveries often materializing ahead of the depths of an economic slowdown.
Historical Look at Bear Markets
We see many comparisons to the 2000-2002 and 2008-2009 bear markets. These can be useful, but perspective is important. Those were two of the worst bear markets of the last hundred years, with stock prices cut roughly in half.
Most bears are significantly less painful, and we think it remains unlikely the current one turns out to be as deep. Since 1950, the average bear market has experienced roughly a 35% decline from peak to trough, with a duration of just over one year. Bear markets tend to finish with extremes and rebound sharply from the bottom. The trough is the most difficult emotionally, but it tends to be short lived and isn’t necessarily the best way to think about entire experience.
Between the 2000 and 2007 bear markets, the dotcom bust is the more relevant comparison. However, in that case, valuations had reached much more extreme levels, especially in the largest technology companies. There should be less room to fall this time around.
Most bear markets don’t end until there is widespread panic and a handful of gut-wrenching down days. Last week may qualify. Only time will tell.
It is hard to find anyone who is bullish on the remainder of 2022, but things don’t feel nearly as dour as they did at the depths of most bear markets.
The Bottom Line
Whenever markets are falling, a scary narrative emerges.
Now, the combination of high inflation and the end of easy money makes it easy to craft a frightful outlook. We are not downplaying the situation but also note that free economies tend to be incredibly resilient. The natural path is growth, and it is a powerful force.
As an example, COVID quarantine and economic shutdowns were extremely concerning, but the COVID crash turned out to be one of the shortest bear markets on record and yet another example where emotional selling proved costly for many.
As always, sticking with a strategy doesn’t mean doing nothing. Financial tools like our Retirement Planner often bring clarity and can highlight if you should consider changes in your approach to investing, saving or spending.
On behalf of our clients, we continue to rebalance in a disciplined manner. We have been tax-loss harvesting throughout the year and expect to accelerate it.
Especially with higher inflation, excess cash that you’re putting toward retirement should typically be invested in a diversified strategy meant for growth. If there is a need to hold significant cash, yields are no longer zero, but that is what many bank accounts continue to pay. It is once again worthwhile to be thoughtful about where cash is invested.
Personal Capital’s financial advisors are available to connect with you on markets or any part of your financial life – it’s what we like to do.