2022 has been tumultuous for investors. We think it is crucial to put it in context.
As of 9/30/2022, we have experienced the worst ever first nine months for broad U.S. bonds and the 4th worst first nine months in U.S. equities.1 Q3 2022 was the third consecutive quarter of negative returns in both stock and bond in the U.S. The last time that happened was in 1931.2
However, it is critically important to remember the following—the S&P 500 Index has never failed to recoup the negative returns sustained in a bear market.3
Excluding this year, there have been 12 bear markets (a decline of more than 20% or more from the most recent high) since World War II. The average length of those 12 bear markets has been about 12 months. The average price decline was -33.6%, and the average price gain following the trough was 40.8%. On average, it took about 22 months to recover fully from a bear market.4
By comparison, as of 9/30/2022, our current bear market was at 270 days (and counting). We are just about 3 months shy of that post-WWII 12-month average. As of 9/30/2022, the S&P 500 Index was 25.5% below its January 3, 2022 all-time closing high. That is just about 8% above the -33.6% average price decline in post WWII bear markets.
Is it possible that the current bear market has been relatively modest compared to others? So far, yes. Then why does it feel so bad?
In our opinion, the current bear market has a different ‘feel’ because it has sharply corrected the very recent over-pricing which had accumulated in the stock market from April 2020-December 2021. This over-pricing was the result of over a decade of artificially low interest rates (continued monetary policy from The Great Recession) compounded by the infusion of record-breaking stimulus which was necessary for the COVID-19 response.
Low interest rates and record-breaking money supply were jet fuel for market returns. Coupled with Covid-related supply chain bottlenecks, wage inflation/low unemployment, and Russia’s invasion of Ukraine, it seemed like jet fuel was poured on inflation, too.
The Federal Reserve cannot take any action to resolve supply chain issues or international relations to fight inflation. However, through its rate setting and open market committee activities, it can significantly impact the demand side of inflation. From March of 2022 to September 2022, the Fed instituted 5 rate hikes totaling 300 basis points. This is the fastest rate increase since the 1980s.5 The Fed has also started reducing its balance sheet by about $90 billion per month in September.
In other words, the Federal Reserve ripped the proverbial ‘band-aid’ off interest rates in order to reverse inflation. It takes about 6-9 months for interest rate changes to be digested in economic data—even a historically fast 300-basis point increase. The equities and bond markets, which are leading economic indicators, reacted significantly faster.
The markets priced a ‘normalized’ interest rate environment into both bonds and equities over the last nine months. Based on the historical averages, we may have a few more months of this bear market and continued downward price discovery. Our view is that once the Federal Reserve terminal rate is better ‘known,’ market prices should stabilize.
We also anticipate a recession to begin in the first half of 2023. Some would argue that we are currently in a recession because of the two consecutive quarters of negative GDP in Q1 and Q2 2022. However, continued consumer demand and low unemployment levels suggest otherwise. As mentioned above, it takes 6-9 months for Federal Reserve policy to filter through the economy. We need to see real weakening in consumer demand and rising unemployment before calling a recession.
What’s the Bottom Line for You?
No markets are ever ‘average,’ but if history repeats itself, we may see another 3+ months of the bear market playing out (possibly with new lows) and a recession beginning by early to mid-2023.
Some good news is that the forward price to earnings ratio of the S&P 500 Index was down to 15.15 as of 9/30/2022. This is below the 25-year average of 16.84 and well below the January 3, 2022 level of 21.4.6 It is therefore fair to say that equity market valuations are coming in closer to a ‘normal’ range.
For a ‘60/40’ investor, unfortunately, this year has the feel of 2008 where the intra-year decline peaked at -29% and the year finished down—20%.7 If we view the Covid-19 bear market as an anomaly, we have not had a true bear market since 2008-2009. In some respects, this price correction was due and reflects the normal mechanics of equities markets.
We do note that the secular bull market in U.S. equities, which started in 2009, appears intact when looking at weekly and monthly charts. In fact, the recent price correction brings the market more into alignment with historical price trends. As a result, we remain constructive on the continuation of the long-term secular bull market.
Ideally, the result of this bear market will be the normalization of the federal reserve rate somewhere in the 3-4% range, a return to historical bond yields and stabilization of inflation. This would set the stage for a return to a more stable business and market cycle.
1-2. Source: BlackRock October 2022 Student of the Market.
3. Source: Market Briefing: S&P 500 Bull & Bear Markets & Corrections, Yardeni Research 10/13/22.
4. Source: First Trust Advisors, LP: Issue 91, October 2022.
5. Source: Comparing the Speed of US Interest Rate Hikes (1988-2022), Visual Capitalist.
6-7. Source: JP Morgan Guide to the Markets 9/30/2022.