What Did We See?
- U.S. Large Cap stocks, or the S&P 500 index, were down about 5% in Q3.
- The developed market of Japan was down almost 1%.
- Europe and the U.K. were down about 4.5% and 3.5% respectively.
- Emerging Markets and Asia (Ex-Japan) were down about 11.5% and 14%.
- Global fixed income returns ended the quarter down between 0% and 10%.
Where Do We Stand?
- The market continued to slide to the downside in Q3.
- Valuations have moved to below historic averages in most markets but earnings remain at risk.
- The severity of any future corrections will continue to be dictated by inflation and the actions of the Fed.
- We remain in a position to weather the volatility while taking advantage of opportunities as they present themselves.
Markets across the board suffered through another negative quarter of returns, marking the third consecutive quarter of negative outcomes. This was the first time we have seen three consecutive negative quarters since the global financial crisis of 2008. September was especially poor with the S&P 500 losing more than 9% in that month alone, something we have not experienced since the pandemic sell-off. In fact, this proved to be the worst September on record since the dot-com bust in the early 2000’s. The bond market also suffered some of its worst losses in years as higher rates continued to pressure bond prices.
Not So Soft Landing
After a strong rally in July, equities and bonds sold off sharply in August and September after central banks around the world indicated that fighting inflation would take precedence over supporting growth. This dashed any hopes of a “soft landing” for the US and global economy. Many have come to believe that the Fed (and other central banks) made a grave error last year when they cited inflation as “transitory”. Had they not believed inflation was transitory at the time they could have slowly raised interest rates in a measured approach. Because of this error they are now being forced to aggressively combat inflation with massive rate hikes. The Fed raised rates by 1.5% in the quarter and one could expect them to continue the practice. The number and magnitude of these hikes are very disruptive to the markets and the economy overall.
Operation “Break Everything”
I expect the result of these aggressive moves is that it will begin to break things. We are already hearing murmurs of a major investment bank going under, possibly Credit Suisse or Deutsche bank. Last week the UK had to bail out their own pensions, which looked to be insolvent as they struggled with collateral calls on their underwater derivative positions.. This is what central banks around the world are now forced to do. In order to combat inflation, they need to quickly induce a deflationary environment. The only way to achieve that goal is to presumably break things. Break the Real Estate market, break the stock market, break the ancillary markets (Bitcoin, NFT’s, Art, Pokemon Cards, etc…). They are treading into uncharted waters that unfortunately will induce pain for many.
Not all is Lost
The positive news here is that it seems to be beginning to work. While inflation has not turned down yet, the growth in inflation has stopped. Furthermore, there certainly has been evidence of deflation in several key areas. Stock prices are down, Bitcoin is down and Real Estate is cooling. Through all this, corporations are navigating as well as they can. Any bankruptcies and disasters at the corporate level will mean those companies were weak going into the recession. And the ones left standing will be stronger for it. (Those are the ones you’ll want to own for the recovery!) At the same time, unemployment remains low thus far. While I expect it to move higher, entering a recession with low unemployment puts a certain level of support on the US economy. Further support will be provided by the strength of corporate and household balance sheets. Households are much stronger than they were going into the Great Recession. There just isn’t enough evidence yet to suggest a steep and permanent recession like some in the financial media would have us believe.
The Death of Diversification?
Global Bonds fell about 7% during the quarter as bond yields rose sharply. Thus far this year Global Bonds are down almost 20% while the S&P 500 is down almost 24%. Rarely have bond prices been so negative especially at a time that the market is negative. The premise of diversification relies on the long term inverse relationship between stock prices and bond prices. Historically when stock prices have crashed, bond prices have risen (or at least remained flat). This is because bonds (especially US Treasury debt) have acted as a safe haven during times of market turmoil. However, this bear market has been anything but normal. Both bond prices and stock prices are down in concert and down by a large margin. There really has been no place to hide except for cash. While this experience has been painful to say the least, I expect it to pivot to much more traditional relationship as we move through the recession. That is why we must keep our cool.
Keep your Cool
As we sit in a bear market there are several things to consider. Bear markets and recessions are turbulent. As well, trying to predict when and where the next bull market begins is a fraught endeavor. In fact, trying to predict anything in the midst of a bear market is much more difficult than attempting to do so in a bull market. The short to medium term indicators just won’t work as well as they do in a bull market. The safest move to take in a bear market is often the one that works against our very nature. As humans, we are hard-wired to react to incoming stimuli (fight or flight). However, in a bear market, oftentimes the best thing to do is to not react to the incoming stimuli (i.e.: the news reports, the negative sentiment, etc…). History has proven time and time again that price declines are a temporary phenomenon. From 1926 to 2021, the US stock market has averaged a 41% cumulative return over three years AFTER dropping 20% or more. The average 5 years after a 20% or more decline is a cumulative almost 72% return. The trick now is to not miss the upside after the market finds its bottom. Lengthen your time horizon and keep your cool.
Several years ago I formulated a “Bear Market Toolkit”. Now would be a good time to review it by clicking here.
If you have any questions or have experienced any changes in your financial situation please do not hesitate to Contact Me.
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