The term “bear market” is commonly used once prices decline 20% from their peak. The three types of bear markets are event driven, structural, and cyclical. The quickest is the event driven bear market. On average, event driven bear markets fall about 30% from the prior peak. We experienced this in 2020 when concerns about COVID caused the market to fall about 35% in a month. Another example is black Monday in 1987. These bear markets reverse very quickly. They tend to bottom out in 8 months, and fully recover to new highs about a year after the prior peak.
Structural bear markets are the most challenging. Examples of structural bear markets include the decline that was triggered by the global financial crisis, the deflation of the NASDAQ and dot-com stocks, and the crash of 1929. On average, structural bear markets fall about 60% and take almost ten years to fully recover.
Structural bear markets coincide with extreme imbalances like unsustainable levels of debt. The debt crisis results when the market recognizes that too much debt is collateralized by overvalued assets like housing fifteen years ago, or the dot-com stocks a decade prior to that. That is not the situation today. Private sector balance sheets are very healthy. Debt is low. The banks are probably as strong as they have ever been due to new capital restrictions imposed in response to the global financial crisis.
Like event driven bear markets, cyclical bear markets drop about 30% on average from their prior peak. The average recovery time of the four cyclical bear markets since World War II is 14 months. There has yet to be a bear market from which the market did not fully recover to all-time highs, so the relevant question for investors is how long it should take to fully recover.
Three months ago, I suggested that the market was close to fully discounting the peak in interest rates. It looked as if 3% would be the ceiling for the Fed’s tightening cycle. The behavior in the stock market seemed to confirm this as the market bounced about 15% from late June 30th through mid-August.
The change in market expectations caught the attention of the Federal Reserve. Since mid-August, the consistent message from the Federal Reserve is that they will use every opportunity to bring inflation down, even if that requires inducing a recession. The market got the message and since then, two-year treasuries jumped up to 4.55%.
The two-year treasury yield is likely the most critical indicator of where the market thinks the Fed’s current tightening cycle will end. Investors watch the two-year as it should capture the entirety of the Fed’s tightening cycle. A peak in two-year yields implies that the market has fully discounted the rate hikes.
Equities are particularly sensitive to the moves in the two-year rate as it is widely utilized as the “risk-free rate.” As the risk-free rate increases, the required rate of return increases. A higher required rate of return for investors forces valuations, like the price to earnings ratio to come down. The good news is that we are likely much closer to the peak in rates than the trough. As the economy shows signs of cooling off the discussion is not about how much higher rates need to go, but whether the Federal Reserve has gone too far already.
Stocks perform very well immediately following a peak in short-term interest rates. It doesn’t seem like it, but the market is up more than 8% from its low in early October. It’s volatile, but it’s possible that we’ve already seen the bottom. The news on the interest rate front has gotten worse over the last three months, but the market is up. That kind of “action” is indicative of a market that has discounted the worst-case scenario – not a market that is excessively optimistic. We are also past the worst periods of the mid-term election cycle. As we move past the election, the market traditionally rebounds.
The S&P 500 is in the middle of an historic bounce back. This is the 7th time since 1952 that the S&P 500 has rallied more than 1% six days out of nine. The average return for the next year was more than 27%.
So, it seems that the market has discounted the worst-case scenario. During the worst of the sell-off, it didn’t matter what you owned. The sell-off was taking no prisoners. Now, the market is differentiating between companies with good fundamentals, and companies with disappointing outlooks. Quality matters again.
The economy continues to show strength. GDP rebounded in the 3rd quarter, after two quarters of slightly negative GDP growth. The odds of a recession occurring sometime in 2023 are high, but for now, the economy continues to grow, and earnings results are surprisingly strong.
In my experience, when our urge to react to the market is the strongest, our instincts are at their least reliable. When the consensus is leaning one direction, the market tends to move in the other. Right now, the consensus is strongly pessimistic, and they have some pretty good arguments to make, but their arguments are widely known. 200 plus years of history tells me that the market will eventually get to a new high. When that occurs, any investments made while the market is below its all-time high will have a better than average return.
The question is whether it makes sense to react to the market volatility, and if so, do we become more defensive or aggressive. We’re clearly not at a top, but that doesn’t mean we’re at the bottom either. Two analysts for which I have the utmost respect have wildly different views. One views the S&P 500 as worth 4,800—20% up from here. The other thinks the S&P 500 will fall to 3,000 before it bottoms. Today, the S&P is priced right in the middle of those two appraisals. If you are not intending to use these funds within the next five years, then I am confident that increasing your exposure to the assets that have sold off this year is a better response than decreasing your exposure to risk assets.
We continue to make subtle changes to the portfolio as underlying business fundamentals dictate. The most defensive portions of the market are very expensive, but it seems that low valuation stocks should continue to outperform large growth stocks. We are looking for companies with idiosyncratic growth. We want to own quality companies with substantial growth prospects, but we want to avoid over-paying for those companies. Our stock portfolio currently reflects this as it has lower valuations than the overall market, but also has earnings growth prospects more than the overall market.
It’s been a terrible year, arguably the worst since 1969 when you combine the performance of stocks and fixed income. The fixed income positions that we hold are very high quality. I do not see an increase in the default risk of our bonds. Worst case scenario is we hold our bonds until maturity when they pay all the principal back and the prices go back to 100. We earn the coupon while we wait.
I’m optimistic that we’re through the worst of the market turbulence, even if we see a recession in 2023. The pendulum is poised to swing back in our direction. It’s critically important to remember that the best gains almost always occur immediately after the worst downturns. Our focus remains on identifying companies that are strongly positioned to outperform during the forthcoming recovery.