|Q2 2022||YTD 2022|
|Barclays US Agg Bond Index||-4.69%||-10.35%|
The first half of 2022 was a brutal one for markets. Stocks posted their worst first half loss in over 50 years. Bonds, usually a savior in a down market, posted their worst intra year loss since the Aggregate Bond Index began in 1976.
How long could this bear market last? A typical bear market takes 24 months to play out.
How much further could we fall? Never has the stock market traded at such elevated valuation levels when inflation was this high. An average bear market loss is 36%. Bear markets that followed extreme valuation levels have resulted in losses of 50% or more.
Will we go into a recession? Historically, inflation has never come back down from 5% without the fed funds rate exceeding inflation. The Fed is now singularly focused on fighting inflation. That means they want to increase interest rates and decrease prices of assets such as stocks.
They would have to pull off a near miracle to bring down inflation without tipping the economy into recession.
If you’re bearish, this market checks every single box. Extreme stock market valuations. Speculation in IPO’s/SPACs/tech/crypto/meme stocks. Retail investing in options and riskier assets. Rising interest rates. Inverted Yield Curve. And now we’re in a downtrend that’s put us into bear market territory.
Stock and Bond Returns – Annus Horribilis
The S&P 500 is off to a historically bad start this year, posting its largest first half loss in over 50 years. The following chart shows first half returns for the S&P 500 going back to 1970
Bonds have been no help. The Bloomberg US aggregate bond index posted its largest intra year decline since its inception.
As a contrarian, seeing such carnage would normally get me excited. After all, Warren Buffett famously advised investors to “be greedy when others are fearful.” The problem is that I think we’re still very early in this downturn. The market entered the year trading at some of its highest valuation levels in history. The last two times stocks entered a bear market after such frothy valuations they lost 50% or more. Typically the process of popping a bubble involves a lot more pain than investors have had to stomach so far. As the following chart shows, valuation levels are still high relative to history:
Over the past decade, the Fed has largely had the markets back. Any drawdown in markets was met with a flood of liquidity and low interest rates. That support is now gone as inflation is forcing the Fed’s hand. To try and combat inflation, the Fed has said they will tighten financial conditions and use the wealth effect to lower demand. In plain english that means they want to raise interest rates and lower the prices of stocks and other assets. With inflation still at 8%+, the Fed will continue to raise interest rates and attempt to push stocks lower. Thus more pain is in store for markets.
Bear Market Duration
The table below shows that US bear markets have averaged 24 months. The S&P 500 peaked in January, so we’re only 6 months into the current drawdown. When the bubbles of 1929 and 1999 popped, the subsequent drawdowns lasted over 30 months. This limited history would suggest we’re still quite early in this bear market.
Source: Tobias Carlisle
Will We Enter a Recession?
Hedge fund legend Stanley Druckenmiller offered some sobering commentary on the market and the economy during his June 10th interview at the Sohn Conference:
“My best guess is that we’re 6 months into a bear market. For those tactically trading, it’s possible the first leg of that has ended. But I think it’s highly, highly probable that the bear market has a way to run…
If you’re predicting a soft landing, it’s going against decades of history…
Given the extent of the asset bubble & destruction in the markets, given what’s going on in Ukraine, given zero Covid policy in China, I don’t take a lot of comfort from that. So I assume & pretty strongly, soon we’re going to have a recession sometime in 2023.”
Historically, a recession was defined as two consecutive quarters of negative real GDP growth. Real GDP shrunk by 1.6% in Q1. The Atlanta Fed’s GDPNow estimate is predicting negative real GDP growth of 1.2% for Q2, putting us into recession based on the historical definition.
It’s worth noting that even if Q2 real GDP growth comes in negative, economists are unlikely to call this an official recession at this point. The National Bureau of Economic Research (NBER) is the body charged with officially declaring recessions. They have changed the definition of a recession and now look at broader measures to determine the start and end dates of one. The NBER now defines a recession as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” One of the significant determinants they use in that determination is the labor market, which so far has shown strength during this downturn.
Current labor market strength is why investors such as Stanley Druckenmiller think the recession ultimately won’t arrive until sometime next year. The impact of the Fed’s tightening often takes time to work its way into the real economy. But businesses and consumers are beginning to feel its impacts.
The following chart shows the average monthly mortgage payment a homeowner has to pay. The average payment has skyrocketed recently thanks to rising mortgage rates and booming housing prices. Fed chair Jerome Powell said in a recent testimony, “Homebuyers need a bit of a reset.” Given the surge in mortgage payments, such a reset may be welcomed by new homebuyers (but certainly not by the economy).
Increased borrowing costs will continue to weigh on consumers looking at things like housing and autos. At the same time entrepreneurs and businesses will increasingly feel the pinch as they try to roll over debt maturities or take on new financing.
The current investing climate looks very dangerous. The market is in a downtrend from some of the highest valuation levels in history. Yet we’re still early in this downturn and I’d argue the opportunities created so far are sparse.
The Fed is going to raise interest rates until either inflation is under control or the market cries uncle.The majority of Fed rate hiking cycles end in bear markets and recessions. I’m guessing this one ends the same.
Caution remains the friend of the prudent investor. To protect against this environment I still think the best approach is keeping equity exposure low and bond duration short (for the moment at least, there may be an opportunity in bonds soon).
If you’d like to discuss the market or your investments, please get in touch.
Scott Caufield, CFA, CPA
July 12, 2022