The first six months of 2022 were historically challenging for investors. The S&P 500 lost 20%, its worst first half since 1970, with growth stocks falling at an even faster rate.
What made the period truly unique was that the U.S. aggregate bond market suffered a loss of even rarer magnitude, down just over 10%. Depending on the data source, that hasn’t happened in more than a hundred years.
Stocks & Bonds
Typically, bonds are lowly correlated with stocks and provide an important ballast in falling markets. Since 1926, there have only been two calendar years when large cap US stocks and US intermediate bonds were both down. 2022 will mark the third if conditions hold. On top of all that, inflation is eroding spending power at the fastest rate since the 1980s.
Global stocks officially entered bear market territory (down 20+%) in June after U.S. inflation numbers showed an 8.6% yearly increase in consumer prices, surprising many who believed inflation had already peaked.
The Fed responded aggressively by raising interest rates 0.75% and signaling short term rates would approach 3.5% by year end. Higher interest rates make stocks less attractive relative to bonds while rising rates suppress economic activity and increase the odds of recession.
Many of the speculative excesses from the last few years either have been or are in process of quickly being reversed. The growth and meme stock bubble has popped. For many with large concentrations, it has been quite painful. The average stock in the NASDAQ is down around 50% from peak levels and many pandemic era favorites are lower by significantly more.
Bear Market Perspective
Bear markets are uncomfortable and difficult. However, steep drawdowns are part of every market cycle and are required for high gains to be possible over time. At Personal Capital, our focus is discipline and efficiency in all market conditions — finding opportunities and avoiding big mistakes. We remain confident our approach provides clients the best chances for long-term success.
Less than a year ago, greed was rampant. Now fear is dominant. Both are dangerous without a strategy. While the first half of the year was bleak, it is now part of history.
While it has been a dour six months in capital markets, we urge investors to keep a wider lens. Trailing three-year annualized returns remain solidly positive and roughly in-line with historical averages, even including the pandemic crash in 2020. Scary times often prove to be the best opportunities, but the biggest key to success for most people is maintaining a strategic allocation and avoiding emotional mistakes.
We see many comparisons to the 2000-2002 and 2008-2009 bear markets. These can be useful, but perspective is important. Those were two of the worst bear markets of the last hundred years, with stock prices cut roughly in half.
Between the 2000 and 2007 bear markets, the dotcom bust is the more relevant comparison as it also featured a large and perhaps irrational run-up of growth stocks. However, in that case, valuations had reached much more extreme levels, especially in the largest technology companies. There should be less room to fall this time around.
Most bears are significantly less painful than those two, and we think it remains unlikely the current one turns out to be as deep. If this turns out to be an “average” bear market, it suggests there is more to endure. However, a moderate bear followed by a moderate recession is a reasonably probable scenario in our view.
Missing the next up move is likely a bigger risk to long term results than participating in whatever downside may be left in this bear. As a reminder of how fast recoveries can happen, in 2020 U.S. stocks were down over 30% on March 23rd but finished the year up over 20%. With yields now higher, we expect bonds to contribute positive returns in the second half of the year.
Falling markets are always accompanied by a frightening narrative.
Now, the combination of high inflation and the end of easy money make it easy to envision bad scenarios. We are not downplaying the situation, but note that free economies tend to be incredibly resilient. The natural path is growth, and it is a powerful force.
We believe the odds of recession in 2022 or 2023 are high. History may show we are already in one. The long expansion was fueled by low interest rates, a flood of liquidity, and government stimulus. Now, rates are rising, and the Fed is draining money from the system by selling bonds. According to data from the National Bureau of Economic Research, a vast majority of previous rate hike cycles culminated in recession, though on average not until about two years after the first hike. In the current cycle that first hike was in March of this year.
Officially, unemployment is just 3.6%, far below historical averages. However, there is increased talk of hiring freezes and sporadic layoffs. While not great for workers, a somewhat softer labor market may be a positive for stock prices as companies attempt to maintain profit margins well above historical averages.
Other headwinds for the economy include inflation, high energy prices (especially in Europe), and a likely softening of home prices. With higher mortgage rates and lower affordability, we expect home prices to drop, but only moderately. In the subprime crisis, a flood of foreclosures spiked the supply of homes for sale in several markets, causing prices to plummet. Unlike in 2008, credit quality of homeowners is quite strong. Supply and demand should remain more balanced in this cycle. Falling home prices dampen sentiment and shut off cash-out equity refinancing, but it is the volume of home sales which contribute most to economic activity. Home sales have been trending lower but remain at or above pre-pandemic levels.
Putting it all together creates a rather gloomy outlook for the U.S. and global economy. However, the stock market and economy are two different things. Markets usually move in advance of economic data, with sharp recoveries often materializing before the depths of an economic slowdown are reached.
We believe equity prices already reflect at least a mild recession and that an economic slowdown does not necessarily imply further market declines. A steeper recession remains a risk, but there is considerable upside potential if a slowdown can be sidestepped.
Valuation & Sentiment
Equities are considerably cheaper than they were at the beginning of the year. Prices are down and aggregate earnings are up. At the end of May, the trailing PE of the MSCI World index was 17, implying an earnings yield of 5.9%. This is relatively attractive given U.S. bond yields in the 3% range and most other developed country yields are lower. International stocks, which have held up somewhat better so far this year, remain more attractive in this regard.
For much of the last 30 years, 10 Year Treasury yields were higher than the S&P 500 earnings yield (the trailing PE ratio flipped on its head). That meant you could get a higher immediate yield with lower risk bonds. Currently, stocks provide a significantly higher yield, even more so if you were to use forward looking earnings. This is bullish, especially because earnings should continue to grow over time while bond yields, once purchased, will not change if held to maturity.
Valuations should provide some comfort to those with a long-term view, but they tell us little about where markets will go next. Just as investors can become irrationally exuberant around bull market peaks, extreme pessimism can push valuations to irrational lows.
Until recently, the U.S. stock market featured an overhang as many growth stocks grew unreasonably expensive. This has now largely corrected itself already. Six months ago, it was hard to find a growth stock that felt approachable. Now, many do. Still, the momentum swing toward value likely has more to go, potentially a lot more if it overcorrects, which tends to happen when major cycles reverse.
From a sentiment perspective, pessimism pervades, but we do not see the level of fear one may expect if we’re near the end of this bear market. We view sentiment as a contrarian indicator. Six months ago, it was a red flag. Now, it is hard to judge and open to interpretation.
Spiking inflation is driving expectations for more and faster rate hikes, pressuring bond prices. The U.S. aggregate bond market fell 4.6% for the quarter and is now down around 10% for the year. This is one of the worst periods on record and if it holds would mark the worst annual return in over 100 years by some accounts. Bonds typically offer more stability and income, but even despite this, they have outperformed equities on a relative basis for the quarter and year.
We believe the immediate and long-term diversification benefits of bonds remain. While highly uncertain, we expect bonds will produce a positive return for the balance of 2022. If there is a recession, it will likely be deflationary, giving the Fed space to moderate its tightening program, which would be bullish for bonds.
When interest rates rise bond prices go down, but rising rates also translate to higher yields looking ahead. The best predictor of bond returns is current yield, which is currently around 2.9% for the U.S. bond market. This is despite maintaining a lower duration profile. The increase in yield comes primarily from having some exposure to high yield corporate debt as well as emerging markets.
Just because the Fed will almost certainly continue raising short rates does not mean bond prices will continue to fall. For example, at quarter end, a 1-year Treasury bond featured a yield of about 2.8%. Effective Fed Funds sat at 1.2%, meaning this bond already anticipates short rates to rise to well past 3% in the coming year. If they don’t the 1-year bonds should provide both yield and price appreciation.
It is very difficult to predict changes to longer term bond yields. Increases in short term rates influence but do not dictate yield further out the curve. Currently, the yield curve is relatively flat beyond one year, suggesting continued higher risk in higher duration bonds. While a deep recession may favor longer term bonds, we continue to see a more favorable risk/reward outlook in maintaining somewhat lower duration than the aggregate bond market.
Inflation can be more damaging than bear markets. The CPI report in June was disheartening because many expected to see that inflation had already peaked. We take inflation risk very seriously but urge people to not panic. Looking beyond 2022, we concur with the Fed outlook that price increases should moderate. There are several factors supporting this:
- The Fed is prioritizing price stability above growth.
- There is a high chance we are or will soon be in a recessionary environment.
- Higher mortgage rates are beginning to impact home prices.
- Supply chain issues should abate over time and are likely already improving .
- The temptation for U.S. shale companies to drill more should eventually prove irresistible, potentially helping depress prices.
- Innovation and technology continue to drive efficiencies.
- The five-year breakeven rate for TIPS is just 2.5%, which means market participants expect only modest inflation over the next 5 years.
Many high-priced growth stocks have been decimated in recent quarters, and those concentrated in this area remain at higher risk in our view. Earnings expected far in the future are generally worth less now if interest rates and inflation rise.
While markets are likely to remain volatile and unpredictable, cash is all but guaranteed to lose value to inflation. This makes it more important to properly evaluate extra cash beyond typical emergency fund levels. The best place for cash that isn’t expected to be used for many years is generally in a properly diversified long-term growth portfolio. That remains the case even in times of market volatility, perhaps especially so.
Inflation’s Impact on Retirement Readiness
Higher inflation means we may have to consume less. For now, we do not believe retirement plans need to be significantly altered. Those considering early retirement may look more closely and consider adding to reserves. Our Retirement Planner has a default inflation rate of 3.5%. This was a conservative stance for a long time but may no longer be. While it still feels valid to us as a long-term assumption, it can be instructive to see the impact of moderately higher inflation by adjusting this setting in a “what-if” mode in Retirement Planner. It is also worth reviewing existing retirement spending goals in light of higher prices.
At least for now, digital assets are highly correlated with other risk assets. Bitcoin is down close to 60% for the year and many other digital assets have fared worse. Some crypto lending platforms promising high yields for lending dollars or crypto are proving to be insolvent. Counterparty risk in the crypto world is often very hard to decipher. As a rule, anytime someone is offering yields higher than junk bonds, one should start with the assumption the risk is also higher than junk bonds. Those who own crypto assets should review to ensure they remain confident in their method of custody.
Recent activity serves as a reminder of the volatility of digital assets. For those who believe in the long-term prospects of Bitcoin and wish to own a certain amount, this can now be achieved while putting less capital at risk.
While losses in digital assets have been significant, there is relatively little exposure in the core financial system, and we do not believe they create risk of a credit or liquidity crisis in general.
The Bottom Line
As always, sticking with a strategy doesn’t mean doing nothing. Financial tools like our Retirement Planner often bring clarity and can highlight if you should consider changes in your approach to investing, saving or spending.
On behalf of our clients, we continue to rebalance in a disciplined manner. We have been tax-loss harvesting throughout the year and expect to accelerate it.
Especially with higher inflation, excess cash that you’re putting toward retirement should typically be invested in a diversified strategy meant for growth. If there is a need to hold significant cash, yields are no longer zero, but that is what many bank accounts continue to pay. It is once again worthwhile to be thoughtful about where cash is invested.
Personal Capital’s financial advisors are available to connect with you on markets or any part of your financial life – it’s what we like to do.