Bear Market Doldrums - Signs of Hope?
Bear Market Doldrums
We are in the depths of a painful bear market. Almost every asset class is impacted. Year to date, the US stock market is down 24%. The international stock market is down 27%. The US bond market is down 14%.
Rarely are both the stock and bond markets down this severely at the same time. Bonds have never lost so much value so quickly, which is particularly painful as many conservative investors rely on bonds for stability and income during periods of market turbulence.
Of course, much of the pain is a result of the Federal Reserve raising interest rates to combat inflation. When the Fed raises short-term interest rates, borrowing costs for consumers and businesses go up, and this hurts corporate earnings and economic activity. Higher interest rates also decrease the value of existing bonds with lower coupon rates.
We are also experiencing increased volatility. There was a relief rally in July and August, and we had some significant daily moves recently. Geopolitical risks are also heightened. The war in Ukraine is exacerbating energy supply issues, especially in Europe. Midterm elections are approaching.
We Tend to Have Short Bear Market Memories
It is human nature to block out painful memories. We have all recently experienced bear markets, even though we may not remember them very well. The last one was only two and a half years ago in 2020 during the initial phase of the pandemic. Before that was the 2018 taper tantrum. Before that was the 2011 debt default. Before that was the financial crisis in 2007-09. Before that was the tech bubble burst in 2000. And so on.
Sometimes we tend to forget how frequently we experience bear markets. There have been 16 of them since the end of WWII. This is the 17th.
The average bear market downturn is 29% and the average duration is about 12 months. So far this year, the stock market is down about 25% and we have been in a bear market for about 10 months. In other words, we are approaching the depths of an average bear market. Please see list of “Bear Markets Since WWII” attached to my October 17 newsletter posted here.
Inflation Remains a Stubborn Problem
At the start of the year, the Fed believed that inflation would be a “transitory” problem caused by supply and demand imbalances created by the pandemic. It turns out the problem is more stubborn and serious than the Fed first realized.
When the pandemic hit, demand for many goods and services collapsed overnight. After the initial phase passed, demand surged while supplies were constrained. As we all learned in basic macroeconomics, when demand exceeds supply, prices rise and inflation results. Fiscal policy has also contributed to the problem. The COVID-19 relief packages passed to help families get through the pandemic pumped a lot of extra cash into the economy, which was also inflationary.
Of course, this won’t last forever. Markets adjust and adapt. Demand is slowly dropping off. Supply chains are catching up. There are no more relief packages in the legislative pipeline. But last week’s Consumer Price Index (CPI) report was disappointing. Inflation is still rising in some areas.
There are signs of hope. Commodity prices are generally down. Oil prices were down, at least until OPEC+ announced production cuts last week. And according to a recent New York Federal Reserve survey, inflation expectations are way down. But food prices remain elevated and the costs of services and housing remain stubbornly high.
The current trend is difficult to see. Inflation measures, like the CPI report, are lagging indicators. The report we received last week was for September. Also, we should remember that producers and suppliers are quick to raise prices and slow to lower them.
The Fed has stated that it wants to see “clear and convincing” evidence that inflation is coming down before it will stop raising rates. That has been interpreted to mean three consecutive months of lower inflation reports. It may be difficult for the market to sustain a recovery until we know the full extent of future Fed interest rate increases. We will have to remain patient.
The Federal Reserve Is Attacking Inflation – at the Expense of the Economy and the Markets
The Fed is attacking inflation by raising short-term interest rates. Since March, the Fed has raised short-term interest rates five times (one of the largest and fastest rate hike cycles in history). We are expecting at least three more increases between now and January.
Many hope the Fed will pause rate increases after January, but this is “data dependent” (as the Fed says). According to the Fed, it takes 12-18 months for Fed policy to have an economic impact. If that is true, the full impact of Fed policy will start to take effect at the beginning of 2023.[1]
The market is very volatile right now. Short-term investors and hedge funds are frantically trying to time the market to show some gains this year. Some traders are betting that the market bottom has already been reached and are buying in, while others are making the opposite bet and selling. Both sides are gambling to make gains but exposing themselves to additional losses.
Timing the market is risky and difficult. As a long-term investor, all you need is discipline and patience to work through this market. More on that in a moment.
Recession Is Almost a Certainty
There have been 13 different rate cycle increases in modern Fed history. This has resulted in ten recessions and three “soft landings.” While the Fed hopes to engineer a soft landing here, I think we should expect a mild recession, at least.
We are already seeing signs of economic weakness. Consumer demand is cooling off. Inventory levels are building and supply chains have improved. The housing market has cooled significantly as mortgage rates are approaching 7%. Sentiment indicators have weakened considerably. Of course, this is exactly what the Fed wants to see to try to get inflation under control.
But other areas of the economy still seem to be relatively strong. The labor market is still somewhat tight, although job openings are starting to shrink. The housing supply remains tight, but sales volume is declining. Rent is still increasing, but vacancies are starting to creep up.
Eventually, the economy will turn over and inflation will start to come down. The danger is that something might break in the meantime (like the pension funds in Britain). Fortunately, US banks are in a relatively strong capital position and markets have been orderly so far.
Geopolitical instability is another risk. The war in Ukraine rages on and seems to be escalating. Midterm elections are fast approaching. The US dollar is very strong, which is hurting US multinational companies as our goods cost more in foreign markets.
How Long It Will Last and What to Expect from Here
When inflation eventually peaks and starts coming down, the Fed will stop raising interest rates. We are not there yet.
For the remainder of 2022, I think we should expect further rate increases from the Fed, as discussed. We will continue to watch the mid-month CPI report to see if any trend can be discerned. If inflation continues to rise, expect markets to struggle. If inflation peaks or starts to come down, the market could sustain a rally. For what it’s worth, many economists and analysts are predicting inflation will start coming down by the end of the year – although their predictions on this topic have been wrong from the start.
We should probably expect the economy to be in recession in 2023. But remember that markets are forward-looking and typically begin their recovery in the middle of a recession, not when it is over. By the time any recession is over, the market recovery will likely have already taken place.
Between now and the recovery (whenever that may occur), it is helpful to remember that bad news is good news. That is, bad economic news (recession, higher unemployment, lower corporate earnings, etc.) is a sign that inflation may start to cool off, which means the Fed will stop raising rates. That is why the market is rallying on bad news right now. Good news has the opposite effect. Good news means inflation may remain hot and the Fed will have to keep raising rates. Confusing, I know.
I do believe we will get through this in good time. We have recovered from every other bear market. This one should be no exception.
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Recommendations
Even though we are in the middle of a bear market, there are opportunities and other strategies to better position your portfolio, save on taxes, and potentially improve returns.
Opportunities in the Bond Market
After many years, bond market yields are finally approaching more attractive levels. This is good news for investors who desire income. Some bond analysts feel that we are nearing the peak of an interest rate cycle.
As I write, conservative bond funds are yielding about 5%-6%. The one-year Treasury bond is currently yielding about 4.5%.
Some investors are thinking about purchasing individual bonds. I have attached an article from Kathy Jones at Charles Schwab that discusses the advantages and disadvantages of individual bonds versus bond funds.
Of course, for those investors who have held bonds this year, the prices of those bonds are down a whopping 14% because when the Fed raises interest rates, it makes the price of existing bonds (with lower coupon rates) go down. This has investors interested in individual bonds. Some of those same investors believe that if you buy an individual bond (as opposed to a bond fund), you are insulated from bond price fluctuations – that all you must do is collect your coupon payment. Not so fast.
When you buy and hold an individual bond, the price of your bond still fluctuates daily in the marketplace. You are still subject to price volatility. Of course, if you hold the bond to maturity, you will be repaid the par value (so long as the bond does not default) – and that is great. But if you are the type of investor who checks your portfolio value frequently, do not be surprised or disappointed to see the price of your individual bond fluctuate (both up and down).
My point here is that there is no special magic to buying individual bonds versus owning bond funds. Regardless of how you hold your bonds, you will receive the coupon payments, the price of your bonds will continue to fluctuate, and you should be repaid the par value of the bonds at maturity (barring default) – regardless of whether you hold them individually or in a fund.
One final thought here. Make sure your bond allocation is well diversified and of high quality. Don’t be tempted to reach for yield right now. With a recession likely, if the economy hits an iceberg or there is some other market shock, there may be a flight to safety. In that scenario, if you are holding lower-quality, high-interest bonds, the value of those bonds may decline precipitously in a market panic and you may be tempted to sell them at a loss.
Opportunities in the Stock Market
The stock market is down significantly. Good companies are looking more and more attractive at these valuations, especially if you are a long-term investor. Historically, the money that is put to work in the stock market during the depths of a bear market has earned an excellent rate of return over the long term.?
Look for companies with strong balance sheets and good earnings records. High-flying growth stocks have been absolutely hammered, and the good ones will recover eventually, but during a recession they may continue to struggle for a while.
In my view, it makes sense to continue to be invested in the stock market, but be defensive in your selections. If you invest in funds, pay attention to the balance between value and growth stocks as well as large versus small cap stocks. If you are feeling defensive, large cap value has outperformed growth and small cap stocks by a large margin this year. How long that will continue is difficult to say.
Harvest Your Losses
Between now and the end of the year, consider harvesting some of the losses you may have in your taxable accounts. You can utilize these losses later to offset future gains for tax purposes.
When harvesting losses, promptly reinvest the proceeds from your sales. For example, if you sell a large cap growth stock mutual fund at a loss (and you want to continue to have some exposure to this sector), reinvest the proceeds from this sale into another similar (but not identical) large cap growth fund. This way you can realize the loss for tax purposes but stay invested and prepared for any recovery.
Rebalance
Check your overall asset allocation to see how close you are to your intended targets. You may have drifted away from your targets with these recent market moves. Rebalance if necessary so you are prepared for further volatility.
Avoid Market Timing
With all the wild swings of late, there are short-term investors and hedge funds trying to time the market. Some of these investors are desperately trying to make some gains for themselves or their clients before the end of the year, but they are also exposing themselves to even deeper losses. It’s a very risky strategy. Avoid playing these games and keep your focus on the long term.
Invest Wisely
This has been a brutal year for investors. Predictably, alternative investment managers have unleashed their sales and marketing legions to extoll the virtues of private investment strategies that have “guaranteed income,” are not subject to market “gyrations,” or are usually only available to “ultra-high net worth or connected” investors. Be very careful here. There are unique risks to these strategies. They are usually complicated, expensive, and not fully transparent and lack liquidity. If they were really such a good deal, these companies would not need to pay commissions to hired sales personnel or buy commercial airtime.
Believe me, nothing is more frustrating than to be locked into a poorly managed or broken private investment strategy. You are forced to watch your money evaporate, sometimes completely. As Warren Buffet says, return of capital is just as important as return on capital.
Be Patient – As Tough As That Is Sometimes
Sometimes, we must remember that we have survived bear markets before and then gone on to new heights. So far, we have recovered from each and every one of the 16 earlier bear markets since WWII.
Avoid catastrophic thinking. The catastrophist casts the weight of all this history aside. They believe this time is different. It must be worse. It must be intractable. It is the end of the capital markets and Western civilization as we know them.?
The media does not help. Rather than put today’s challenges into the proper perspective, the media presents them in such a way as to make things appear worse than they really are because fear sells. Don’t buy into it. ?
For what it’s worth, I believe we will recover from this bear market – just like we have from all the others. Time will tell.
If you have questions about your portfolio or your long-term financial plan, give us a call at 855-353-3800.
Thank you.
D. Austin Lewis
This is an educational newsletter expressing opinions only. This newsletter should not be relied upon until your individual situation is taken into consideration by an experienced advisor. This newsletter is not designed or intended to give you individual investment, tax, or legal advice. We strongly recommend that you consult with your own financial/tax advisor and/or legal counsel for information and advice concerning your particular situation. If you are a client, please give us a call. Past performance does not indicate or guarantee future results. Investing involves substantial risks, including loss of principal.
[1] Not discussed is the impact of the Fed’s quantitative tightening program where it sells bonds on its balance sheet into the market. This also puts upward pressure on rates and sucks liquidity out of the economy.