The first half of year was the worst for the S&P 500 stock index since 1970, as it fell by nearly 21%. The technology-heavy NASDAQ index fell by 30%, a record. Many of the most speculative favorites of the prior two years fell even more – 70% to 85% below their recent peaks.
What Is This? A Market Correction or a Bear Market?
The short-term direction of the stock market is anyone’s guess, but a decline this abrupt is usually followed by a significant rebound. Whether a rebound persists depends on a key distinction. Market corrections are usually sharp, short-lived declines of between 10% and 20%, and the economy does not fall into recession. A bear market, however, lasts longer, and the market typically falls between 25% and 55%. A bear market is also accompanied by a recession, and corporate profits usually fall by more than 20%.
What Does This Market Cycle Look Like?
This seems to be a major bear market, following the epic bull market of 2009-2021. The market decline is likely only about halfway complete, both in terms of magnitude and duration. The economy is faltering and is possibly already in recession.
Historic Policy Blunder?
The Federal Reserve held its overnight funds rate near 0% for years after the Great Recession of 2008 to keep the system flush with cash, to stimulate borrowing for economic growth, and to encourage investing (but which led to rampant speculation). From 2016 to 2019, the Fed gradually raised rates to 2.5%, but with the onset of the pandemic in early 2000, they cut rates to zero again.
As inflation measures surged over the past year, an alarmed Fed has begun sharply raising the rate to curtail borrowing, reduce demand, and purportedly reduce inflationary pressures.
This seems to be a grave policy error. The Fed is aggressively tightening monetary policy while the economy already is weakening rapidly. Leading economic indicators are falling fast, and it seems likely that GDP has already fallen in two consecutive quarters (-1.6% in Q1, and an estimated -1.2% in Q2). Unemployment claims have been rising since April, consumer sentiment surveys show the greatest pessimism on record, and small-business owners have the lowest expectations for business conditions in the 48-year history of the survey.
In addition, overall inflation seems to have already peaked. Inflation measures, like most economic statistics, reflect what has already happened. Furthermore, the recent spike in inflation has been due primarily to factors beyond the Fed’s control, specifically energy and food prices.
Yet oil and agricultural commodity prices are already falling. Since 1974, oil prices have fallen by at least 25% in every recession, with an average drop of 50%. This time might be different because of the Russian supply cutoff, but crude prices have recently fallen by 20%. Wheat prices, despite no exports from Ukraine and Russia (one-third of global wheat exports), are down by 30% from their peak.
Observers tend to extrapolate recent economic and market experience, which is often a big mistake. For example, in the mid-2000s, the housing bubble was combined with booming economic growth in China, whose voracious appetite for raw materials and oil led to $150 per barrel of oil. Forecasts of $200 were common. Yet a year later, the price of oil had plunged to $35, and there was deflation in the overall economy, with falling prices year over year. If we’re right that inflation has peaked, there are significant implications for the other main investment category, bonds.
Bonds Are Attractive
The first half of the year was even worse for bonds than for stocks, as bonds had their biggest price declines on record. The price of the 30-year U.S. Treasury bond, for example, fell by 20%, as the yield went from 2% at the start of the year to 3.25% on June 30.
Despite the Fed’s forecast of continued sharp rate increases through this year, we think it’s likely that a peak in inflation and a sharply slowing economy will cause the Fed to soon halt the rate increases. (Besides, the Fed has a lousy forecasting record.)
We expect falling bond yields (and higher bond prices) to lead to attractive income and capital appreciation. On a risk-adjusted basis, bonds seem far more attractive than stocks. Short- to intermediate-term U.S. government agency notes, for example, now yield about 3%, with a virtually guaranteed return of principal upon maturity. Contrast that with stocks, offering only a 1.5% dividend yield, with no assurance of a return of principal.
Though we expect a significant short-term rebound in stock prices, we urge investors not to be fooled. Pundits and the media will be eager to declare an “all clear” after prices have rebounded. That would likely be a costly mistake.
With Wall Street analyst profit forecasts ridiculously high in our view, we expect earnings shortfalls will push stock prices lower. In addition, profits have historically fallen by at least 20% in recessions.
The end of a bear market usually requires widespread pessimism among investors and consumers, much cheaper stock valuations, and the passage of 18 to 24 months after the market peaked.
As a result, though we are finding some undervalued stocks, we are maintaining our allocations to stocks at the low end of investment policy ranges in client portfolios. We’re selling or trimming outperformers and adding to or beginning to buy undervalued stocks that have been laggards.
“Are we there yet?” It’s probably going to be quite a while longer. No one rings a bell to signal the end of a bear market, but as prices fall and valuations improve, we expect to accelerate our buying.