by Dave Young, President
This difficult market continues to drag on. I will be glad when we can change the headline. We’d all like to know when things will start moving to the upside again.
September is great for big game hunting and being outdoors, but it’s not so good for the investment markets. For reasons not fully understood, September has historically been a rough month.
This particular September kept with the usual negative pattern, but this year went one step further. It was the worst September for both the S&P 500 and the Dow Industrial Average in 20 years. The DJIA dropped -8.8%, while the S&P 500 declined -9.3%, and the NASDAQ lost -10.5%. The NASDAQ had its worst September since 2008.
In the big picture, this third quarter decline also capped the worst period of three consecutive quarterly losses since 2002. At the end of the month, the S&P 500 was down 24.8% year to date.
What about bonds? Aren’t they a safe haven? Traditional portfolio theory says that when stocks go down, bonds will go up and offset the decline. Most investment advisory firms use bonds extensively for that reason. In general, that has worked fairly well. This year? Not so much. Ten-year treasury bonds started the year at a yield of 1.52% and are now at a yield of 3.83%, experiencing a loss of 16%.
Fortunately, for our investors, we did not believe that bonds still provided downside protection at these low-yield levels. That helped us in our conservative Managed Income Portfolio. If we had not positioned it the way we did, rising rates would have hurt us much worse.
Bonds only provide protection when bond yields are flat to down. When bond yields go up, as we have been expecting, then bonds also get hurt. This year has been the worst year for bonds since 1926. This created a situation in the investment markets where there is nowhere to hide.
WHAT IS CAUSING THIS?
This bear market was started by our Federal government creating the highest inflation in 40 years. We haven’t dealt with this since the days of Jimmy Carter. Inflation creates a domino effect with negative consequences anywhere money is involved — and that is everywhere.
The self-inflicted issues of runaway inflation, the war in Ukraine, and the U.S. Supply Chain mess were given as reasons the FED had to raise interest rates. Inflation is the primary issue. They raised rates 275 basis points in the past five months, taking us to a FED Funds Rate of 3.25%. On a rate chart, these are the steepest rate hikes we have seen since 1980.
During his press conference, Fed Chair Powell said, “We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t.”
Actually, in my opinion, there are plenty of ways to avoid inflation. We could start by not electing politicians who drop trillions of dollars into an economy and create this giant mess in the first place. That would be a painless way to avoid inflation.
How does this domino chain work? Ultimately, price stability is the foundation of a strong economy and a long-lasting economic expansion. Meeting that
objective is why the FED has to raise rates. Unfortunately, now that we are in this mess, there is no way to stop inflation without inflicting pain.
It’s confusing, though. The Federal Reserve says it is not publicly forecasting a recession, which is odd, because the traditional metrics show we are currently in one. It seems we are playing a game called, “Let’s pretend we are not in a recession.”
The FED recently stated that its projections show its inflation-fighting campaign will boost the unemployment rate next year. Investors are growing concerned the economy could sink further into recession, which would depress earnings. Both of those are negative.
In addition, the sharp increase in interest rates has led to a much stronger dollar, since parking cash safely in the U.S. offers a higher return to foreign investors.
The dollar has soared 16% this year relative to other currencies. A strong dollar reduces the price of imported goods and the cost of an overseas vacation, but the rapid increase in the greenback against foreign currencies is raising fears the Fed could unintentionally “break” something in the financial markets, either at home or abroad.
It happened during the early 1980s, when sharp rate hikes put a heavy strain on Latin America, and again in 1994, when rate hikes exacerbated problems in Mexico, leading to a bailout. It also led to bankruptcy in Orange County, California.
We’re not forecasting an imminent financial crisis, and any unexpected shift by the Federal Reserve would hopefully alleviate financial market pressures.
That said, it is the Fed’s resolve to bring down inflation that is creating most of the pain in financial markets right now.
WHAT IS NEXT?
Taking a longer-term view, we want to emphasize that bear markets eventually come to an end, and bottoms typically occur when negative sentiment is high. Negative sentiment on the AAII survey recently hit 60.9%. That marks one of the five most extreme readings since the survey started in 1987. Investor sentiment is considered a contrarian indicator, which in this case is positive. The worse people feel about the market, the more likely it is to finally turn positive. The problem with sentiment indicators is the timing. You never know for sure when they are finally at their maximum extreme.
Another positive is that valuations have come down and many stocks may now be fairly valued. Also, from a seasonal perspective, US stocks have risen after the midterm elections following every election in the last 80 years. The S&P 500 has moved higher over the next twelve months, with an average gain of 15% in post mid-term years.
According to Charles Schwab, the average bull market since the late 1960s ran for about six years, delivering an average cumulative return of over 200% for the S&P 500 Index.
The average bear market has lasted roughly 15 months, with an average cumulative loss of 38.4%.
The longest bear market lasted just over two-and-a-half years. It was followed by a nearly five-year bull run. The shortest occurred at the outset of Covid in March of 2020 and lasted only 33 days.
We won’t venture to guess how October might end, and we would advise against making portfolio adjustments based on any short-term horizon.
From a trivia perspective, October has a spooky reputation: 1929, 1987, 2008. Since the 1970s, it has been a volatile — but historically strong — month.
No one knows how or when this bear market will end. It is safe to say when stocks are down -25%, future returns tend to be above average. For investors with a long-term horizon (which should be all investors) this could be a good time to buy.
If you have any questions, please give me or any of my team members a call.
Thank you for the trust, confidence, and the opportunity to serve as your financial advisors.