Things to Remember When the Market Is Bearish

The markets had a historically terrible week last week. As news reports keep stirring up emotions among investors, I'd want to provide some more context about the gravity of the situation. A six percent decline in the S&P 500 was the worst weekly decline since the US economy shut down to combat COVID-19 on March 20, 2020. For example, over the previous eleven weeks, the S&P 500 has fallen, and during the last twelve weeks, the Dow Jones Industrial Average has fallen.

Capital markets are bracing for unprecedented levels of inflation in the first half of 2022 as a result of the Federal Reserve's tightening monetary policy and other factors. Few investing opportunities remain when the main stock indexes enter bear markets, which are defined as a 20% or more decline from the most recent high. Some numbers up to last Friday, June 17, 2022:

• Domestic large-cap equities, or the S&P500, have fallen 23% from their 52-week high.
• From its all-time high, the Nasdaq composite (US equities) fell 33%.
• The domestic small-cap index Russell 2000 fell 32% from its all-time high.
• International stock market capitalization (ACWI) was down 24% from its high.
• There was a 44% drop from the top in the average stock price of the Russell 3000, which is an indicator of broad equity markets.

Among the other noteworthy features of the second quarter so far are:

• Eight percent yields have been generated, a level not seen since the pandemic extremes in April 2020, as high-yield bond spreads—the difference in yield between high-yield bonds and investment-grade corporates—expanded by 100 basis points in June alone, reaching 513 basis points.1
• Standard investment portfolios consisting of 60% equities and 40% bonds have lost around 18% so far this year. The second-worst six months to start a year at "just" down six percent can only be found by looking back to 2002 and 2008. To find a worse beginning to the year, you must return to 1976.2
• Reducing its prediction for second quarter GDP growth from 1.9% a month ago to nil, the Atlanta Federal Reserve has just lowered growth expectations for the US economy.
• According to the University of Michigan's Survey of Consumers, US consumers haven't been this gloomy since 1978.

Looking at the Big Picture

There is a genuine sense of economic and commercial pressure. War in Eastern Europe is adding to the pandemic supply chain problems and inflationary pressures, and the result is food, petrol and housing prices at levels not seen in decades. It makes perfect sense for markets to reflect the realities of these extraordinarily hard times. That being said, in an environment where the majority of investors are negative and gloomy, we must force ourselves to seek for evidence that proves the inverse: a rationale for beginning to be more hopeful.

If the S&P 500 does in fact fall by more than 15% in the second quarter of 2022, it will be the sixth time this has happened since WWII. The next year, the S&P 500 gained an average of 26% on the eight instances that this occurred. Furthermore, during each of the eight prior cycles, the S&P 500 ended the subsequent six months and year in the black. In a similar vein, the S&P 500 has a 22% increase over the following four quarters whenever it has fallen 20% for consecutive quarters.3

Historically, investors would have seen average yearly gains of 22% over one-year periods, 14% over three-year periods, and about 13% over five- and 10-year periods if they had purchased the S&P 500 precisely when it entered bear market territory (remembering that markets can and have declined much further than 20% thereafter). That is to say, investors saw above-average returns when their time horizon was longer than a year.4

If the economy is really in a recession (which we won't know for sure until after the fact), there is some good news: stock markets often emerge first from recessions. So, this recent fall might be the beginning of the end for this bear run, though bear market endings can be long. Recessions have a way of cleaning up excesses, bringing back the significance of fundamentally sound investment, and helping our active exposures, so it's possible that we'd be better off if we're already six months into one.

Expectations of long-term inflation are acceptable, albeit they are greater than they have been in previous years. Looking at the 10-year Treasury Inflation-Protected Securities (TIPS) and their projected inflation rate of 2.6%, it seems that inflation expectations are still quite stable and might perhaps prevent stagflation.

As demand is destroyed by higher prices, the result is reduced prices. Already, commodities prices are showing signs of stabilization or even decrease. Fascinatingly, energy stocks, which often signal the future of petrol and oil prices, are now in a bear market, having fallen more than 20% from their most recent peaks. Since inflationary pressures and higher rates are already accomplishing most of what the Fed plans to achieve, it has to exercise caution.

Things to Remember

Do your best to avoid keeping tabs on your portfolio's value on a daily or weekly basis; doing so may put your risk tolerance to the test. There is a great deal of noise and illogical behavior on the part of certain market participants motivated by things other than long-term fundamentals in those figures.

In the near future, market prices may fall even lower. Regrettably, it is impossible to predict how low they will fall, when they will bottom out, or when the trend will reverse. We spend a lot of time during bull markets and economic periods when recessions are not happening, even though bear markets and recessions may be very painful. If your investment horizon is greater than a year, the chances are in your favor, and they become even better when your time horizon is three years or longer, according to historical statistics.

While we wait for things to calm down, we remain confident that diversified portfolios that use a variety of risk and return factors will be able to weather the storm.