Bear markets in the current context
The current economic and market environment remains extremely challenging, as the stock market entered bear market territory in June. Historically bear markets last for about a year, and since 1946 (post World War II), the average market decline has been approximately 32%.
However, this average is somewhat negatively distorted by three major events which crushed markets: the oil embargo of 1973, the Dot-com crash of 2000, and the financial crisis of 2008. The median decline of bear markets over this time frame was approximately 27%. At quarter end, the S&P 500 was down about 20% after six months in a downward trend.
It’s not just the stock market. The significantly negative performance of the fixed-income market has added to the pain. In addition to the overall bond market being down approximately 11% through the first half of the year, corporate and high yield bond indices were down around 14% and the municipal bond market fell approximately 9%.
Currently, valuations, as measured by yields in the bond market and P/E multiples in the stock market, are at levels not seen since 2018. In the bond market, after years of paltry returns, fixed income investors can obtain yields of approximately 5% in investment grade corporate bonds, more than 8% in high yield bonds, and 3% to 5% in municipal bonds, depending on credit quality. If the Fed is successful in bringing inflation down to its 2% long-range target, current market yields will likely be rewarding for long-term investors.
In the stock market, historically an investor who buys into the market and holds for 10 years when the valuation multiple of the S&P 500 is at 16 times earnings – approximately the level at quarter end - is rewarded with returns that have averaged in the mid- to high-single digits on an annualized basis. Sectors of the equity market that are valued at even lower valuation levels than historical averages, such as small cap and international stocks, could generate even more attractive returns over that same 10-year time span.
A look ahead
Looking forward in the near term, risks remain that the stock market could decline further, approaching typical bear markets in terms of duration and overall decline. The Fed has been clear that it intends raise rates until inflation is quelled. It likely would take a more severe market downturn or a meaningful recession for the Fed to pivot to an easing stance before inflation falls.
Given this market environment, here are our views on economic and market prospects:
Volatility. We expect volatility to remain high until there is greater clarity on inflation and the economy.
Inflation. There are tentative signs that inflation may be peaking, which if sustained, would provide a foundation for markets to first stabilize and then begin to recover. We expect inflation to peak in the second half of this year. Forward market inflation expectations already have fallen due to an expected economic slowdown. A wild card is commodity prices, which are somewhat hostage to geopolitical risks, such as the Ukraine war.
Recession. Estimated probabilities of a recession are increasing but vary, with most estimates in a range of about a 30% to 60% probability, which appears reasonable. If the economy does tip into a recession, it’s likely to be moderate given the underlying strength of both consumers and companies, including low household debt levels, high consumer savings, strong business balance sheets, and a solid employment market.
Equity markets. Markets already have priced in an economic slowdown, but more downside likely remains in a recessionary scenario. Valuations and market prices, however, have reached levels that are more attractive to long-term investors, even if there are more near-term declines. The S&P 500 is at levels where the probability of long-term gains is high. Historically, once the market hits bear market levels (down 20%) average performance of the next 12 months has been 16%, with a 17% chance of a loss. Additionally, some of the sharpest upward rallies tend to be coming out of bear markets.
Interest rates. Interest rates have fallen from peak levels as markets have started pricing in Fed rate cuts next year in response to recession risks. In the near-term, we expect interest rates to trade within a range below peak levels seen in June. What could break this range? A recession likely would lead to significantly lower rates, while higher than expected inflation could trigger a renewed surge in rates.
Yields. Yields in the corporate and municipal bond market look significantly more attractive, particularly if inflation continues to soften over time and rates fall.
Real estate. With mortgages rates up, the housing market should continue to cool off. Longer-term, strong demand and a shortage of housing should support the market.
In terms of asset allocation, we’re close to our normal allocation of modestly overweight equities, with an overweight to domestic equities. Once we feel comfortable that inflation is sustainably starting to decline and economic risks are priced in, we intend to start adding to risk assets – both equities and credit, such as high yield bonds. We have been positioned for higher rates all year but recently moved close to neutral given increasing concerns over an economic slowdown, which typically pulls down interest rates.
Also, it’s important to remember that bear markets eventually do come to an end. Patience and discipline are required to not only wait out these difficult periods, but to also start allocating capital to risk assets when the environment still seems negative, and valuations are attractive.