Jul 20, 2022
If you’ve been on a road trip with kids, you know the sound of the constant question: “Are we there yet?” As investors living through a bear market, we all find ourselves asking that same question. During times of uncertainty, we grasp for answers; but when it comes to markets, we don’t get the privilege of truly knowing how things will play out until after the fact.
Naturally, the big questions right now are:
- Has the stock market bottomed (or near the bottom)?
- Are we going into a recession?
- What the heck is happening to my bonds?
To answer the first question, we need to have a general idea about the answer to the second. The answer is almost certainly yes, a recession appears likely (but we’re probably not quite there yet). The stock market has already anticipated a recession to a certain degree as it tends to adjust early to expectations (usually to the tune of 6-12 months ahead of time), hence the current bear market we are experiencing (defined as a move greater than 20% from the last high watermark). Likewise, the stock market will anticipate an economic recovery well before we actually know it has happened.
But as it relates to anticipating stock market movements, the more critical questions to ask are actually: 1) how long the recession will last; and 2) how severe will it be. These are exceedingly difficult things to know, but at this stage we feel that a recession would likely be relatively mild in duration and severity. It is normal to have a lot of anxiety when you hear about an impending recession, particularly due to the effect of “recency bias” where our minds jump to the more extreme recessions we experienced not that long ago (the 2008/2009 Global Financial Crisis and the 2020 Pandemic, for example). However, there are plenty of historical examples of recessions that were more mild “cooldowns” rather than major economic crises.
The timing and duration of the recession will have an impact on how the market behaves from here on out. If we are in a recession, it doesn’t quite feel like it yet. We don’t have the classic data confirming we are actually in a recession as unemployment rates are still at historic lows and most US consumers still have strong balance sheets (meaning a good amount of savings and modest debt utilization). Consumers also continue to spend on things that were deferred during the pandemic (such as travel and “experiences”). However, inflation is hurting consumer confidence and that will likely lead to an economic slowdown. Let’s put it this way, we all tighten our belts when it costs more than $100 just to fill up the tank!
To address the third question about bonds we must highlight the fact that we just experienced one of the most dramatic declines in bond prices since the 1970s! It is rare to have performance this weak in the bond market and stock market at the same time. So, what the heck happened?
As we recovered from the pandemic crisis, the emergency low-interest rate policy was no longer needed. In fact, the medicine (in the form of fiscal stimulus and very low interest rates) were causing unintended side effects in the form of rising inflation, thus putting the Fed in the position of needing to raise short-term interest rates quickly and aggressively. The prices of all bonds have adjusted accordingly, as the new prevailing higher rates essentially make all fixed-rate bonds worth less on a relative basis compared to last year when rates were quite a bit lower. This is more noise than substance, however, particularly for owners of individual bonds as opposed to bond mutual funds.
The most important thing to remember about your bond portfolio (and the way we are managing it for our clients) is the cash flow from the bonds held in your portfolio were essentially locked when the bond was initially purchased. Andas long the bond is held to maturity, you are going to get that “set” rate of return by collecting the interest income and principal value when the bond matures. We would only “lose” money if we sold early (or if the issuer was unable to meet the contractual obligations of the bond, which is mitigated by the overall quality of the bond portfolio). There is a silver lining about rising rates however: when your interest income and principal redemptions get reinvested you will now be locking in better yields for the next several years. Let’s keep looking at the positives here!
So back to the question about the stock market bottoming. We’re not going to know the bottom until after the fact, so there’s no sense guessing where/when it will be. But what we can say is that we still likely have more steps ahead for the bottoming process. For one, corporate earnings likely have yet to go through a decrease in expectations if there is a recession in the cards. So far, we haven’t seen much of a “reset” and expect to watch how this plays out in the coming months.
The bottom line here is that things will probably continue to be bumpy for a while (stocks and bonds) but remember that the stock market can have big up days in addition to big down days (and those two things can happen on days fairly close to each other). Trying to outsmart or time the market is typically a losing strategy. Instead, we continue to focus on quality businesses that know how to navigate both up and down markets and will remain resilient even if faced with an economic contraction. Maintaining the correct asset allocation and diversification strategy continues to be as important as ever. And if you have cash to put to use, gradually getting it invested into stocks at lower (and maybe even more attractive prices yet) over the coming months is a good idea.
Remember, we always planned for these types of markets to occur and built portfolios accordingly to meet your risk tolerance and investment objective needs. This isn’t the first one and won’t be the last you will likely experience during your investment time horizon. You can’t always predict when markets go backward, but you can be prepared. At NPF we are pleased to be your guide through all stages of the market cycle. If you want to chat some more, please call or email anytime.
Sincerely,
NPF Investment Advisors
