“The current superbubble features a dangerous mix of cross-asset overvaluation, commodity shock, and Fed hawkishness. Each cycle is different – but every historical parallel suggests the worst is yet to come.”
-Jeremy Grantham
Are we having fun yet? The stock market entered 2022 with valuations at or near all time highs. Bond yields started the year near all time lows. At the time I wrote, “The combination of extreme valuation and economic headwinds sets the market up for a high risk of a major sell off… the only prudent course of action for investors in this climate is to take a cautious approach in their portfolio.” It didn’t take long for that sell off to appear!
At the end of the third quarter, US stocks were down nearly 24% for the year and the US bond index was down nearly 15%. 2022 has been a house of pain for investors who have not taken a cautious approach. The combined drawdown of stocks and bonds is the largest in the past 20 years:
Stocks experienced a bear market rally in July and August off their June lows as investors started looking forward to a Fed pivot. Oil prices dropped nearly 30% and the global food price index dropped to its lowest level since the start of the war in Ukraine. There was hope that Fed Chairman Jerome Powell would stop hiking rates and even start easing soon. Those proved to be false hopes. The Fed is focused on core inflation, which remains stubbornly high. I think inflation will remain elevated until the economy really gets ugly.
At its September meeting, the Fed indicated they would tighten as much as needed to bring down inflation. That poured cold water on the market’s hope for a pivot and ended the bear market bounce. Powell said that the Fed will bring pain to households and businesses. “We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t.” In another speech Powell again argued against any impending pivot when he stated, “History cautions strongly against prematurely loosening policy.”
As we enter Q4, the stock market is once again hopeful the Fed will pivot. The Bank of England was the first to capitulate as it announced it will engage in quantitative easing (reportedly to stop pensions and other institutions from blowing up). However, Federal Reserve Bank of New York President John Williams said Monday, “Tighter monetary policy has begun to cool demand and reduce inflationary pressures, but our job is not yet done.” New Fed Governor Philip Jefferson echoed that sentiment Tuesday stating, “Inflation remains elevated, and this is the problem that concerns me most… Restoring price stability may take some time and will likely entail a period of below-trend growth… We have acted boldly to address rising inflation, and we are committed to taking the further steps necessary.” That certainly does not sound like a Fed that is ready to pivot, especially with inflation still roaring. As long as inflation remains high, expect further rate hikes and pain for the stock market.
Unprecedented Carnage in Bond Markets
The Fed raised rates by 1.5% during the third quarter. They’ve hiked rates 3% during 2022, creating unprecedented losses for fixed income investors. The following chart shows the path of annual returns for the US Aggregate Bond index since its inception. The blue line at the bottom shows the return for 2022, by far the lowest the index has ever experienced:
The good news for investors is that you can now pick up yield in conservative assets. Short term treasuries yield over 4%. The Fed is getting closer to hitting their terminal rate. The fed funds rate is currently in a range of 3-3.25%. They expect the terminal rate to be 4.6%, meaning they expect to raise rates an additional ~1.5%. The November raise is expected to be .75%, so most of the increases will be done by the end of the year if projections hold steady.
As the fed funds rate gets closer to the terminal rate, bonds have become a much more attractive asset class. If intermediate and long term bonds hit their peak this cycle, an enterprising investor could gain equity-like returns if the economy weakens and the Fed cuts rates.
I believe the fixed income opportunity is limited to treasuries for now. The majority of the damage in bond indices was caused by rising rates. The spread between ‘safe’ treasuries and riskier junk bonds remains too narrow for my taste. The following chart shows the spread between treasuries and risky high yield bonds (aka junk bonds).
While the spread has increased this year, it’s still well below levels reached in 2016 and 2020. There would be major downside if spreads went to levels reached following the tech bubble and housing crash.
Opportunity in Stocks?
I’m finding more and more equities that could be potential opportunities. Some of the stocks on my watchlist are now at or below their Covid lows. Famed investor Michael Burry (highlighted in the Big Short) recently tweeted out his newfound optimism:
However, I worry it’s still too early to really take advantage of equities. As I pointed out in my last update, I think this bear market will last much longer and the ultimate bottom in equity indices will be a lot lower than their current levels. Additionally, most of the opportunities I see are in stocks/industries that historically perform poorly during major recessions.
Conclusion
“I will be stunned if we don’t have a recession in ’23. Don’t know the timing, but certainly by the end of ’23. I will not be surprised if it’s not larger than the so-called average garden variety, and I don’t rule out — not my forecast, but I don’t rule out something really bad. Why? Because, if you look at the liquidity situation that has driven this, we’re going to go from all this QE to QT, we’re following an asset bubble.”
-Stanley Druckenmiller
The overall stock market remains expensive by any reliable measure of historical valuation. We’re 9 months into this bear market, which would still put us in the eary-mid part of a typical bear market. Historically bear markets that follow bubbles result in losses of 50%+ for stocks. While it’s encouraging to see individual stocks trade to more attractive levels, I think caution remains the most sensible approach in the current environment.
Fortunately, the rise in rates has made fixed income a viable option. As rates approach their terminal levels there may be even more opportunity in longer dated bonds.
Scott Caufield, CFA, CPA
October 5, 2022