I wanted to share a brief analysis and highlight some factors that have influenced the markets in the past year. The combination of rising inflation and interest rates, along with a bear market has certainly affected how we go about our everyday lives.
We recently hosted a webinar to discuss our Outlook for 2023 and what we expect to see this year, along with how we are positioning the portfolios to take advantage of it. I hope you had the opportunity to join the call!
So, how did we get here?
Last year was the first time in recent history where both the stock and bond indexes were down double digits.
This happened after an extended period of time where interest rates were kept ultra-low, and followed with significant inflation, which drove interest rates up. Who could have imagined a year when government bonds went down over 30%?!
But that’s just what happened:
S&P 500 + Bloomberg US Agg down 20% vs 13%
NASDAQ vs 20 year bonds – both down over 30% last year
Many of us do not have strong memories of inflation, especially when it was just getting started in the mid-1960s. This is the fourth inflationary wave we have had since the 1900s.
There are some simple and important things to know:
- There has never been a time when significant inflation was not preceeded by massive government spending.
- When the government can’t tax or borrow enough to meet their needs, they print money. This “fake” money devalues currency which causes the price of goods to go up.
- Inflation has never gone away easily. I don’t know of an instance where it has gone away without an eventual recession. The reason is when we get inflation, interest rates go up, and the Federal Reserve decreases the money supply. When costs go up and there is less money, consumers buy fewer items because they are not willing to pay more for them. This causes corporate profits to shrink, which leads to layoffs.
We can see this playing out as we speak. The demand for employees is contracting significantly.
It is important to remember – recessions are a normal part of the business cycle. This isn’t the end of the world!
Our aim is to take advantage of this cycle the best we can.
This requires a lot of patience though. It has been a long time since we’ve experienced a bear market and a recession. By the numbers, Covid was technically a recession and bear market, but it was over very quickly, so much that it’s hard to count it.
As a point of reference: recall the market during the DotCom bust in the early 2000s (March of 2000 to October of 2002.) You can see from the graph it is not uncommon for these cycles to last 15 months or longer (represented by dark blue bars in between the orange recovery periods.) Going back to 1956 there have been 6 periods lasting that long or longer, more than half of them.
While we don’t know how to perfectly time the markets, there are signals that can tell us where we are in the cycle. The VIX is one of those signals, and another is valuations.
Historically, as mentioned, inflation leads to a recession. Recessions lead to the price of stocks going down. The price of stocks is determined by the P/E ratio (Price / Earnings). Other than 2020, there isn’t an incidence where P/E doesn’t go below 15 without a recession. Right now, we are closer to a P/E multiple of 20.
The great investor Ben Graham (Warren Buffet’s mentor) warned you can’t time the market, but he was a firm believer in fair valuations.
When looking at the broad indexes, the markets are still expensive. To boil it down, all that happened last year is P/E went from 24 to 20, and that caused a 20% decline in stocks.
Based on current inflation and interest rates, a fair P/E is closer to 15, which corresponds to a recessionary P/E.
Below is a chart showing P/E lows in relation to recessionary periods.Both 2020 and 2023 are major anomalies.
Bear vs Bull Markets
A bull market typically starts with high interest rates that are dropping. This allows businesses to be able to expand faster and faster, driving corporate profits and the ability to take on more risk. It also forces investors to pay more for a stock. On the opposite side, a Bear Market starts with low interest rates that are increasing. This slows economic activity and forces investors to move away from stocks as they can get a good return in bonds.
The secular bear and bull markets never last, but rather rotate between one another through time. People always talk about average market returns, but it is rare that we get average returns – we get much better or much worse. There are certain periods where we are planting (bear markets) and other periods of harvesting (bull markets). Both are a normal part of nature and the business cycle. Some winters are colder than others, but they eventually end.
The Market vs the Economy
The stock market normally ‘leads’ the economy. In other words, the market goes down before the economy does. At the same time, the market will recover before the economy does. This is because the market anticipates what the economy is going to do.
An example: below is a graph looking at the two recessions in the 1970s. In both cases the markets (purple) saw an upswing well before the economy did (orange)
As the market goes, so does the economy:
- The United States reduced its productivity at the same time it expanded its money supply.
- Upon the reopening of the economy, this led to inflation.
- This led to higher interest rates and to lower stock prices.
- This could lead to a recession causing stock prices to decline further.
- This goes on until investors ‘give up’. Once there is no one left to sell, the market starts to recover.
Strategies to Weather the Storm:
In a bull market, investors are rewarded for taking on risk as was seen in the explosion of growth stocks.
In bear markets one must be more mindful of downside risk.
We are taking advantage of some well-established strategies for investing during bear markets:
- High Quality Stocks – sectors that benefit from inflation and interest rates. Last year, this could be seen in energy stocks. Consumer staples and health care are examples of sectors that can also do well. Consumers tend to economize during recessions.
- Bonds – buying high quality bonds and holding them to maturity to get a predictable return with minimal risk.
- Alternatives – Most people are unfamiliar with alternative strategies, but they can be very important during bear markets.
- Income Strategies – these also tend to hold up well even if the principle is down. The investor still receives the dividends while waiting for a recovery.
Our goal is to mitigate the downturns while participating in the rallies until the market capitulates. From there we should have some interesting growth opportunities.
On an individual basis, we are including alternative strategies. If you are interested in learning more about these strategies or have questions, let us know.
I hope you can tell, we don’t want to leave any stone unturned when it comes to preserving
and growing your portfolio in these most interesting times.
Longer term, I think there is much to be excited about!
SpaceX’s Starship, which has the capacity of a 747 and is 100% reusable, looks to be set for a maiden flight this year. We look to be on the verge of everything from space tourism to mining comets. There are other significant players to include, like Blue Origin and Rocket Lab. This is a multi-trillion-dollar industry.
Artificial Intelligence is also gearing up for prime time and set to increase productivity exponentially. It may be the single biggest leap in technology I’ve seen in my lifetime. If you can get access, search and check out 'ChatGPT.' The answers to questions are incredibly good in most cases.
For better or worse, we are on the brink of a new world. The economy doesn’t grow so much by old companies becoming better, but by new companies growing in value. It has been interesting to see the changes in market cap.
For a fun visual of how things have changed, check out this short 3-minute video showing the movement of the top 10 companies on the S&P – starting in 1980 and going through 2020.
It will be amazing to see how this next decade changes things!
As always, let me know what questions you have, and I will be happy to help!
I am always eager for your feedback. Let me know your thoughts!
P.S. 👋 Share this post by forwarding to a friend or colleague!
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Investing includes risks, including fluctuating prices and loss of principal. No strategy assures success or protects against loss.
Alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.