Talk about a yo-yo. We reached bear market (top-to-bottom drawdown of 20% or greater) status twice this year. The S & P 500 (total return) index was down 22% on June 13, 2022. Then recovered to be down only 9% on August 16. But ended the third quarter down 24% for the year.
Since I began personally investing at the start of my working years, there have been five bear markets. And some of them have been doozies. Most notably the one from 2007 – 2009 in which the market was down 57%.
Prospects for the economy remain uncertain: Will there be a hard landing, stagflation or soft landing?
Dividend paying stocks have fared relatively better, down 16% YTD. And Large Cap Value stock are down 17% YTD
International stock were down 27% YTD, hurt by the strengthening US Dollar, which magnifies losses for US investors.
Commodities lost 4% in the quarter, but still show gains for the year of 14%
The Bond Market
Bonds 101 tells us that when interest rates rise, bond prices fall. At the end of September, the Fed raised interest rates by .075% for the third straight meeting; setting the federal funds rate at 3.25%. The Fed is not just raising rates, but also beginning to diminish its balance sheet of the unprecedented number of bonds it purchased during the pandemic. This also has the effect of increasing interest rates in the bond market across all maturities. Consequently, the Bloomberg US Aggregate Bond Index fell 4.75% in the quarter and is down 14.61% YTD.
The upshot is that bonds have been no savior in 2022. Balanced portfolios, containing generous helpings of both stocks and bonds, have lost value. Normally bonds provide protection. But it is not unusual for both of these asset classes to show losses on a short-term basis. However, over longer time horizons, say over a three-year period, it is hardly ever the case that both stocks and bonds are down.
Bonds with shorter maturities haven’t been hit as hard. The 1-year Treasury Index was down .50% in the quarter and 1.77% YTD. And the 1 -5 year Government Bond Index was down 1.79% in the quarter and 5.03% YTD
Two-year Treasuries are now yielding around 4%; a yield not seen since 2007.
The good news is that bonds have a built-in stabilizer. Once rates stop rising, the higher coupons will begin to restore value to your bond portfolio with much more certainty than with equities.
As usual all the data is captured by our friends at Dimensional Funds in their Quarterly Market Review.
Rate Shock
Higher interest rates put pressure on stocks for two reasons: 1) bonds become relatively more attractive, diminishing the TINA (There is No Alternative) trade; and 2) a higher discount rate reduces the present value of future earnings; a key fundamental for valuing stocks.
Rising interest rates have also shocked the housing industry. Mortgage rates have more than doubled from around 3% to over 6%. Consequently, real estate values have been softening sector-wide across wide areas after years of extraordinary gains.
How Do You Solve a Problem Like Inflation?
Back in May, I wrote about the emerging problem of inflation. Current inflation is running at around 6 – 8%. Historically, inflation has averaged around 3%. During the past decade it has averaged closer to 2%. Predictions for where the inflation rate will settle – and when – are all over the map. But it seems unlikely that we are headed back to the era of historically low inflation any time soon. It also seems unlikely that we are headed to 70’s style hyper-inflation. We are in an Alice-in-Wonderland world in which good news on the jobs front becomes bad news on the economy, because it may counsel the Fed to continue to raise rates.
The Inflation Reduction Act has taken some very helpful steps to reduce the impact of rising prices on retirees.
Will There be a Recession?
As Yogi said, making predictions, especially about the future, is really hard. For starters, the economy is very close to full employment, as defined by economists. Can we really have a recession under such circumstances? Policy makers around the globe have a very difficult job ahead of them. There are economists who think the Fed was too slow to start raising rates after the unprecedented stimulus needed during Covid. And now there are economists who say they are tightening too fast.
Some signs are pointing in the direction of a recession. Others are not. The Fed actually has a decent record of navigating to a soft-landing.
The Winds of War
The war in Ukraine is among the most serious headwinds facing the global economy and investment prospects. What could be more disturbing than the threat of nuclear war from an unstable dictator backed into a corner? Less apocalyptic, but disturbing nonetheless, is Putin’s threat to cut off the flow of natural gas to the west for the coming winter and potentially causing a severe economic shock to Europe.
There have been recent strategic gains by Ukraine followed by merciless revenge attacks on civilians by Russia. How this ends is most uncertain.
The Road Ahead
One of the few things (I believe) we can say for certain is that expected returns in both stocks and bonds are higher today that they were at the end of December, 2021. That’s simply because prices are lower. Of course, that’s not to say that prices can’t go lower from here. But if you have a long-term horizon, it’s just axiomatic that starting valuations are going to have an impact on your returns.
Stick to Your Plan
I know I’m starting to sound like a broken MP3. But having an investment plan that’s tied to your goals and risk tolerance is the most likely way to succeed. Portfolios should be designed for sustainability over the long run. Not the occasional home run.
Volatility is the price of admission for investors to receive the long-term returns offered by the market. Selling into down markets and recessions is not likely to improve returns. Especially, because your timing then has to be right on the way back up.
It’s best to have your fixed expenses covered by your steady income sources like social security, pensions, interest and dividends.
But Be Flexible and Resilient
If we’ve learned anything during the last couple of years, it’s that whatever forecasts and plans you make, it’s very likely you’re going to be wrong. In January of 2020, how many of us predicted Covid? And who woulda thunk that two and half years later we would be experiencing 80’s style inflation?
But if you’ve made it this far, you’ve proved yourself to be pretty adaptive. We are overwhelmed with uncertainty and this should inform how much and what kinds of risk to take. And it’s likely you’ll be able to navigate the next unpredictable event.
Pro Tip
A useful tool for dealing with bad markets – or any kind of stress – is to get out of your head. Stop thinking about it for a few minutes. Find something that enhances your resilience, such as a mindfulness practice and regular exercise; especially outdoors.
