Last week was a historically bad week for the markets. I would like to offer some additional perspective on the magnitude of what is happening as headlines continue to provoke investor sentiments. The S&P 500 dropped six percent, the biggest weekly drop since March 20, 2020, when the US economy was shutting down to fight COVID-19. To wit, the S&P 500 has dropped 10 out of the past 11 weeks and the Dow Jones Industrial Average is down 11 of the past 12.
The first half of 2022 is shaping up to be one for the record books for capital markets given significant inflationary pressures not seen for decades and a tightening Federal Reserve. The major equity indices are now in bear markets, defined as a drop of 20% or more from latest peak, with few areas of the investment landscape providing shelter. Here are some statistics through last Friday, June 17, 2022:
- S&P 500 (domestic large-cap stocks) was down 23% from its 52-week peak
- Nasdaq composite (domestic stocks) was down 33% from peak
- Russell 2000 (domestic small-cap stocks) was down 32% from peak
- ACWI ex US (international stocks) was down 24% from peak
- The average stock in the Russell 3000 (broad equity market index) had declined 44% from its peak
Other notable aspects of the second quarter so far include:
- High-yield bond spreads (the difference in yield between high-yield bonds and investment-grade corporates and an indicator of credit stress and risk aversion) have expanded by 100 basis points in June alone, reaching 513 basis points and thereby generating eight percent yields, a level we have not seen since the pandemic extremes in April 2020.1
- Typical portfolios made up of 60% stocks/40% bonds are down approximately 18% year-to-date. You must go back to 2002 and 2008 to find the second-worst six months to begin a year at “just” down six percent. You have to go back to 1976 to find a worse start to the year.2
- Growth for the U.S. economy is being ratcheted down, with the Atlanta Federal Reserve recently lowering its forecast for second quarter GDP to zero growth, down from 1.9% just a month ago.
- US consumers have not been this pessimistic since 1978 (as measured by the University of Michigan’s Survey of Consumers).
The Long View
The economic and market stresses are real. Prices on the essentials — food, gas, and shelter — are reaching highs we have not seen in decades while a war rages in Eastern Europe compounding the pandemic supply chain woes and inflationary pressures. These are extremely challenging times, as such markets reflecting that reality make sense. With that said, when most investors are pessimistic and bearish, we need to compel ourselves to look for insights that support the opposite case: a reason to start becoming more optimistic.
If the S&P 500 ends up dropping more than 15% in Q2 2022, it will mark the ninth time since WWII it has experienced more than a 15% decline in one quarter. In the eight other occurrences, the S&P 500 averaged a 26% gain over the following year. Additionally, the S&P 500 was in positive territory over the next six months and the following year in every single one of the eight previous cycles. Similarly, historically when the S&P 500 has been down 20% over two quarters in a row, the S&P 500 has risen at least 22% during the next four quarters.3
Historically, if investors bought the S&P 500 exactly at the point when it hit bear market territory (keeping in mind markets can and have declined much further than 20% thereafter), they would have experienced average annualized gains of 22% over one-year periods, 14% over three-year periods, and approximately 13% over five- and 10-year periods. In other words, if investors had more than a one-year time horizon, they experienced better-than-average gains.4
If we are already in a recession (something we won’t know until after the fact), there may be a silver lining: equity markets tend to lead out of a recessionary bottom, perhaps making the recent downturn the beginning-of-the-end for this bear run (although bear market endings can be protracted). In other words, we may be better off if we are six months into a recession, since recessions can wash out excesses, restore the importance of investing based on fundamentals and serve our active exposures well.
Long-term inflation expectations, while higher than in recent years, remain reasonable. With the 10-year Treasury Inflation-Protected Securities (TIPS) reflecting an expectation of about 2.6% inflation, it appears inflation expectations have not become de-anchored yet and therefore offset the risk of stagflation.
Higher prices lead to lower prices as the former destroys demand. We are already seeing commodity prices start to level off or decline. Interestingly, energy stocks, which tend to presage the direction of oil and gas prices, are also in bear market territory (down over 20% from their recent highs). The Fed needs to be careful since inflationary pressures and higher yields are already doing a lot of the work the Fed intends to do.
What to Keep in Mind
Reviewing your portfolio balances too frequently may start testing your personal tolerance for risk — do your best to refrain from watching daily and weekly fluctuations. Embedded in those numbers is a lot of noise and irrational actions by some market players being driven by factors other than long-term fundamentals.
Markets could continue to decline to further depths in the short term. Unfortunately, how far they go, when they bottom, and when the reversal will occur are all unknowns. While bear markets can be severe and recessionary times difficult, we spend far more time in bull markets and non-recessionary economic periods. Historical data leads us to believe the odds are in favor of those who have longer than a one-year investment horizon, with the odds increasing in your favor as the timeframe extends to three years and beyond.
In the meantime, we believe well-diversified portfolios that bring to bear different sources of risk and return will, even under these challenging circumstances, continue to do their job weathering the storm.
1 Rosenberg Research. “Breakfast with Dave.” June 20, 2022.
2 The Bespoke Report. “A Quarter From Hell.” June 17, 2022.
3 The Bespoke Report. “A Quarter From Hell.” June 17, 2022.
4 The Bespoke Report. “A Quarter From Hell.” June 17, 2022.
