There was no place to hide during the second quarter of this year. Everything was down including International, value, growth, fixed income, and crypto currencies. The primary cause of the devaluation of assets is the higher level of interest rates, and the sense that we do not have any idea where interest rates will peak.
Markets are not known for their nuance. I have often heard the market environment described as “risk-on” or “risk-off.” I have never heard the market described as balanced and properly discounting upside potential with downside risks. Over the last thirty years, the valuation of stocks in terms of their price-to-earnings ratio has ranged from twenty-six times earnings at the peak of the dot-com bubble to just over ten times earnings during the global financial crisis.
At the beginning of 2022, the S&P 500 traded at twenty times next year’s earnings. The market was up more 31% in 2019, 18% in 2020 and 28% in 2021. For three straight years, markets returned more than twice their average long-term return. JP Morgan’s Positioning Intelligence tells us that in January of 2021 when the S&P was at twenty-two times earnings, the value of leverage that was betting on a rising market was at the 100th percentile—as optimistic as markets get.
Late in 2021, the ten-year Treasury bond was at 1.5%, Bitcoin was at $69,000. The ten-year treasury more than doubled to over 3%. Over the next six months, bitcoin fell below $20,000 wiping out wiping our trillions of dollars. Interest rates moved sharply higher. Leveraged investors were forced to sell which led to stocks falling far more than what the move in interest rates or earnings estimates would suggest.
2022 has been dealing with the shock of war in Ukraine, dramatically higher interest rates and energy costs, and a collapse in the price of bitcoin. The largest stocks in the S&P Growth index are Apple, Microsoft, Amazon, and Tesla. In the first six months of the year these stocks are down 28%, 29%, 44% and 49% respectively. Earnings estimates for Apple, Microsoft, and Tesla are sharply higher. Investor sentiment has swung from highly confident to highly pessimistic in a matter of months. Long leverage has fallen to the fifth percentile.
Markets do not bottom when the economic environment improves, they bottom at the maximum point of investor pessimism. It is less important to know what earnings are going to do over the next twelve months than it is to understand the direction of investor psychology.
Here is a look back at the previous times the market dropped more than 15% in five months. This is a scenario that has occurred twenty-six times since 1956. Following a drop of 15%, the next 12-month returns have averaged 18.6%. The next 12-month return was negative in only two cases out of twenty-six. The maximum 12-month return was over 50%. A 20% return over the next twelve months is the most probable outcome.
The human brain can be exceptionally resilient and adaptable. The definition of resilience is the ability to recover quickly from difficulties, the adaptation to adversity, trauma, tragedy, threats, or stress. The word comes from the Latin resiliens, which means “to rebound, recoil.” Unlike many of our traits, neuroscientists believe that the brain can be trained to develop resilience.
Resilience is an active progression of events, not a passive process. Resilience is a function of personality, biology, and experience, but it is also a skill that can be learned. In my professional experience, I have observed clients develop this resilience over time. I suspect that most clients who have been with us for several years can relate to the fact that each bear market is a little less traumatizing than the one before.
Living through something like the global financial crisis or the COVID pandemic builds a mental toughness. We can begin to recognize that the world is ever-changing, but that we can adapt. Sometimes we are not very quick to recognize which adaptations are most critical, but eventually we adjust, even to the most extreme circumstances.
Investors who can stay on the path of their own financial plan, and who exhibit the most resilience in the face of market turbulence are the investors who experience the most positive outcomes. My focus is on earnings results and expectations for future earnings growth.
There is no disputing that inflation has increased. Rental expenses, transportation, cars, and energy prices are the biggest sources of inflation. Current earnings reports suggest that despite higher costs across the board, companies are maintaining their profit margins.
Over the last couple of months, we are seeing increased evidence that inflation has peaked. Gas prices have fallen from 48 days in a row, dropping 16%. Housing inventories are increasing as are the number of sellers who are cutting their asking price. The benchmark ten-year treasury bond has dropped, falling 3/4% from 3.25% to 2.5%.
When disinflation starts to show up in the monthly reports, investors will become increasingly confident that interest rates have peaked. They will then begin to wonder how quickly the Federal Reserve will decrease rates in 2023. The expectation of falling interest rates, combined with resilient earnings growth should be enough to turn the market higher.
It is exceedingly difficult to sustain emotional extremes. Extreme pessimism eventually gives way and increased optimism leads to a market recovery. It is not that everything gets fixed, it is the recognition or even belief that things will get fixed eventually. The market trades at an all-time high about 60% of the time. Eventually, it will get back to the highs from earlier this year. The only question is whether this happens sooner or later. Resilience is the key to enduring these drawdowns.