We all know the story of Chicken Little. A squirrel collecting acorns in a maple tree drops an acorn on an unsuspecting Chicken Little, who in turn believes the sky is falling. A perfect example of catastrophizing an otherwise ordinary occurrence (though the odds of getting hit directly in the head are likely low!). Often when we’re in a bear market and/or approaching a recessionary bottom, it feels like the world is coming to an end and conditions will only worsen. Yet investors often feel remorse after stocks have recovered from these massive swoons and wish they had taken action when markets were inexpensive. Our blog this quarter aims to outline why the proverbial acorn fell and when we should stop hiding from an onslaught of more acorns and instead take productive action.
How Did We Get Here?
Heading into 2022, we had accommodative monetary policy (low interest rates) and low inflation dating back to the Great Recession of 2008. Just as the Federal Reserve was attempting to normalize interest rate policy, the COVID pandemic hit in 2020, forcing the Federal Reserve to once again lower interest rates to support the US economy.
The pandemic crippled global supply chains as factories across the world shuttered their doors. Local and international travel screeched to a halt, leading global consumption of fossil fuels to pull back. Global energy companies’ capital investment dropped accordingly, reducing global inventories. As we’ve emerged from the pandemic, demand for goods and services is outpacing supply, creating price inflation. The Russian invasion of Ukraine led to additional constraints of corn and wheat and oil/natural gas supply (among other commodities), sending food and energy prices even higher.
In March of this year the Federal Reserve made the decision to hike rates aggressively to quash demand, in the hopes this will bring inflation down. The side effects of this interest rate policy include:
- Supporting a rise in the value of the US dollar, which has soared by over 16% in 2022, a 20-year high and the biggest yearly increase since 1972.[1]
- A repricing of bonds (higher rates sends prices of existing bonds lower) sending the Barclays Aggregate Bond Index down -14.61% through September 30th.[2]
- An increase in recession odds, triggering a “risk off” trade driving US equities lower by -23.9% through September 30th.[3]
- Nearly 80% of major global central banks have followed the US in increasing interest rates, sending international bonds and stocks lower.[4]
Current Environment
While it’s easy to assume a “Chicken Little” view of the world, let’s look at history and fundamentals to support our thesis that while there are clouds on the horizon, the sky is in fact not falling.
Through September, the pull back in global equities has left stocks trading at discounts to their historic average values over the past 25 years. While US stocks trade at a 10% relative discount to their 25-year history, European and Chinese stocks trade at discounts of greater than 28% and 17% respectively, marking an attractive entry point for international stocks.
[5]
Bond valuations in the US have dropped to the lowest levels we’ve seen in a decade. US Treasuries now yield 4.1%, or 2.9x what their yield was at the beginning of the year. Even the most risk averse investors now have an opportunity to earn substantially more income without taking on much risk. In addition, high quality bonds now offer more downside protection in the event of an extended stock market downturn and recession. This protection comes from higher yields. When there is a flight to quality bonds and/or the Fed cuts interest rates, bond yields fall and prices rise. The higher yields are when this occurs, the more room they have to drop, offering the opportunity for greater price appreciation.
[6]
Consumer sentiment, a contrarian indicator, has bounced off all time historic lows this year. Sentiment troughs, (while not to be viewed in isolation) have led to subsequent 12 month returns on US stocks of 24.9% (on average) over the past fifty years.
[7]
Lastly, when looking at historical bear markets in US equities dating back to 1961 with at least a -25% drop in value, the average peak to trough decline has been -38%. In other words, the market has already priced in two thirds of total market decline incurred during an average bear market with at least the magnitude of losses we’ve experienced year to date. There’s no guarantee the market exceeds or even reaches this average before recovering, but it’s worth noting the worst of the market decline is likely behind us.
[8]What to Watch For
While we could spend our time trying to identify the next acorn that will fall, it’s more productive to plant the one that has dropped to benefit from its shade in the oppressively hot summer months. So, what is productive for us to keep an eye on in the markets?
First and foremost, we consider most bear markets and recessions a liquidity problem. You only lock in permanent losses if you sell your stocks and bonds when they have lost value. If you have adequate reserves and a time horizon that affords you some level of risk, these periods can become great opportunities.
Now is not a terrible time to invest in the stock market. There could certainly be a better time if stocks drop further, but we won’t know where the bottom is until it’s behind us, and we already know stocks are cheap by historical standards. This is also true of bonds for the risk averse. It’s a good time to put cash to work in the bond market too. It’s unlikely that high quality bonds will remain this cheap, even if we head into a recession. When the Fed cuts interest rates (which they do to stimulate the economy in recessions) bond prices rise, resulting in capital appreciation in addition to collecting interest income.
For turning points in the market, look for these events, which could point to the end of a market retraction and add weight to an argument for a reversal in market prices:
- A ceasefire in the Ukraine (this would help curb some inflation pressures and reduce geopolitical risk in Europe, boding well for international stocks)
- If the Federal Reserve pivots to a less hawkish interest rate policy (not even cutting rates, but a pause or reduction in the size of rate hikes could trigger some recovery – remember the stock market is a leading indicator and always moves ahead of the official data that acknowledges a recession has occurred)
- The US dollar dropping from its historic highs (this will bolster international equity returns as foreign currencies recover and reduce global inflationary pressures since roughly half of global trade and debts are denominated in US dollars)[9]
- China stepping back from its zero-COVID policy, and more generally, an increase in global manufacturing data (a boost in manufacturing would help mitigate supply shortages, thus reducing inflationary pressures)
- Stabilization in forward earnings estimates for stocks (stocks are priced relative to their future cash flows, so confidence in forward earnings growth will underpin prices)
Our recommendation is not to wait for a confluence of these factors to occur, but rather observing these changes would increase the odds of a bottoming in the financial markets. Based on the data today, we believe the next six to twelve months will present a good point of entry to receive rewarding long-term returns. Even though stocks are falling, it doesn’t mean investing in them today is riskier than it was at the beginning of the year; in fact, the converse is true. As David Herro, portfolio manager for Oakmark International, notes in his quarterly commentary, “Equities become LESS risky as they become more attractively priced…despite and because of the pain of falling equity prices that we have experienced, we believe the opportunity for gain is higher and the exposure to risk is lower.”[10] While this sounds paradoxical, history reinforces a “sell high” and “buy low” discipline is the best investment strategy. Yet we acknowledge this strategy isn’t always easy to execute.
In summary, it’s completely normal to feel a little chicken at times like this, but don’t be Chicken Little. Take stock of your liquidity and time horizon and act prudently to participate in an eventual market recovery. Like acorns that fall and rise again as trees, stocks too will return to growth. We just need to rub our noggins and treat this time as an opportunity to plant seeds for our financial future. And if all else fails, someone told me Cabernet Sauvignon is on sale...
[1] https://www.reuters.com/markets/europe/dollar-ascendant-investors-gear-up-fed-2022-09-21/
[2] https://am.jpmorgan.com/us/en/asset-management/protected/adv/insights/market-insights/guide-to-the-markets/ (as of September 30th 2022)
[3] https://am.jpmorgan.com/us/en/asset-management/protected/adv/insights/market-insights/guide-to-the-markets/ (as of September 30th 2022)
[4]Haver Analytics, Goldman Sachs Global Investment Research. https://www.gsam.com/content/dam/gsam/pdfs/common/en/public/articles/global-market-monitor/2022/market_monitor_092322.pdf?sa=n&rd=n
[5] https://am.jpmorgan.com/us/en/asset-management/protected/adv/insights/market-insights/guide-to-the-markets/ (as of September 30th 2022)
[6] https://am.jpmorgan.com/us/en/asset-management/protected/adv/insights/market-insights/guide-to-the-markets/ (as of September 30th 2022)
[7] https://am.jpmorgan.com/us/en/asset-management/protected/adv/insights/market-insights/guide-to-the-markets/ (as of September 30th 2022)
[8]Source: Bloomberg and Goldman Sachs Asset Management. As of October 6, 2022. https://www.gsam.com/content/dam/gsam/pdfs/common/en/public/articles/global-market-monitor/2022/market_monitor_100722.pdf?sa=n&rd=n
[9] https://crsreports.congress.gov/product/pdf/IF/IF11707
[10] https://oakmark.com/news-insights/david-herro-market-commentary-3q22/