In its worst start to a year since 1970, the S&P 500 finished the first half of the year down almost 21%. The NASDAQ fell 28.6%, its worst first half year since the dot-com crash. International developed stocks and emerging markets struggled as well, down roughly 20%. In even more compelling news, the bond market provided zero buffer for investors, with the aggregate index down almost 10% YTD. All during a time when inflation is red-hot, facing a multi-decade high. Do you feel all the oxygen being sucked out of the room, yet?
Pressure. Pushing down on you.
Countertrend rallies may continue this year, but aggressive monetary policy tightening by the Federal Reserve, the end of “free money”, and slower economic growth will likely keep pressure on stocks. As a backdrop, the U.S. economy and markets greatly benefited from the historic jolt of trillions of dollars’ worth of liquidity freely distributed by the Fed and Congress over the last two pandemic-filled years. That liquidity tide has turned, and the Fed has committed to “expeditiously” tighten policy until inflation comes down. As with any tightening cycle historically, the risk of recession is rising.
Based on past cycles, the chances of the Fed achieving a "soft landing" for the economy are not great, noting only two tightening cycles (1994 and 1984) that avoided a decline into formal recession. It's worth mentioning each recessionary period is unique, however. The current environment seems most similar to the early 1980s where inflation too was elevated due to oil price spikes. In response, the Fed raised nominal and real interest rates aggressively. The economy was otherwise relatively healthy, with a solid banking system and consumers who weren't overextended on debt. Nonetheless, there were two steep back-to-back recessions during that time period, from January to June 1980, and from July 1981 to November 1982. Housing and manufacturing experienced sharp declines and the unemployment rate soared to double-digit levels. While the Fed is determined to push inflation lower, there's a good chance it won't have to go to the extremes of the early 1980s. A key difference in policy this time around is the use of "forward guidance" by the Fed. In the 1980s the Fed provided very little information about its plans to the markets, often surprising consumers and businesses, increasing volatility. Markets going forward should be able to anticipate changes, mitigating some of that surprise factor.
Global economic uncertainty high. Consumer confidence abysmal.
Stocks around the world slumped during the first half of this year as economic uncertainty surged with the war in Europe, a lockdown-induced recession in Asia's biggest economy, stubbornly high inflation led by surging energy prices, and several major central banks pursuing the most aggressive series of policy rate increases in decades. Consumer confidence, currently sitting around 50 as illustrated in the chart below, is at the worst reading in the history on the survey, dating back to 1952. Even during the Great Recession (November 2008), the lowest dip was 55.3, which means there is more negativity priced in today than back in 2008 amidst the most serve global financial crisis ever seen!
Can the housing crisis cause a recession akin to 2008?
A spike in prices and interest rates has dealt a significant blow to housing affordability, elevating the potential for the housing market's weakness to dampen economic growth. While home sales initially collapsed under the weight of the global economic shutdown, they rebounded at an incredibly sharp rate for a host of reasons—not least being the desire for individuals to look for more space, accommodative monetary and fiscal policy, and consumers' lack of ability to spend on services during the depths of the shutdown phase. Suppressed inventories, bidding wars, and hotter demand created a perfect storm for surging home sales and prices. After falling by nearly 28% during the pandemic-induced recession in early 2020, existing home sales spiked by 63% in just eight months. New home sales experienced a shallower drop during the recession but surged by 78% in just four months off the pandemic low. The boom seems to be over for now, as existing and new home sales have rolled over considerably from their peaks, but Americans are left fighting an acute affordability crisis.
At this time last year, the average American worker had to work an average of 47 hours to cover a monthly mortgage payment. That same figure has shot up to 66, the same level at which the housing bubble was starting to burst in 2005. Both prices and rates have put homeownership out of reach for a broad swath of the population, which has been exacerbated by a 40-year high in inflation and aggressive monetary policy. While there are linear comparisons to the Great Financial Crisis (GFC), we take comfort in the fact that the amount of leverage tied to the housing market—be it in risky lending or securities—is nowhere near what we saw in the subprime bubble. Lending has been decisively in favor of those with superior credit scores, housing as a percentage of gross domestic product (GDP) has fallen significantly since the GFC, housing supply is not raging alongside demand, and household balance sheets are in much better shape (the household sector has in fact led the charge in deleveraging since 2008).
Is there any reason for optimism?
The S&P 500 index reached bear market territory (that is, a drop of 20% or more from a recent peak) in mid-June. However, looking at every bear market since 1950, the average duration is only 11 months, which suggests that although bear markets are painful, they come and go swiftly, respective to long term investing.
Using the same data from above, the average bear market results in roughly a 29% S&P 500 correction. Near term this suggests if the market follows historic patterns, stocks may have more room to fall, likely caused by weakening earnings and profit-margin outlooks. Also, short, sharp rallies within an underlying downward trend are typical of bear markets, which have transpired recently, so investors should be prepared that volatility could certainly continue.
Time the market at your peril – a recession is not a “reason” to sell.
So, are we in a recession? The history of economic cycles teaches us we may very well be in one, even before economists make that call formally. But one of the best predictors of the economy is the stock market itself. Markets tend to fall in advance of recessions and start climbing earlier than the economy does. If you are worried, other investors are too, and that uncertainty is reflected in stock prices. Market downturns can be unsettling. But over the past century, US stocks have averaged positive returns over one-year, three-year, and five-year periods following a steep decline. A year after the S&P 500 crossed into bear market territory (a 20% fall from the market’s previous peak), it rebounded by about 20% on average. And after five years, the S&P 500 averaged returns over 70%.
The biggest mistake an investor can make is attempting to time markets during periods of heightened volatility, thinking “I’ll sit out until things get a bit better.” Remember, to be successful at timing markets you must be “right” not once, but twice: getting out and getting back in – which is incredibly difficult, arguably impossible. By the time markets are less volatile, you’ll have often missed part, maybe even most, of the recovery. The big return days are often hard to predict, and you really do not want to miss them. If you invested $1,000 in the S&P 500 continuously from the beginning of 1990 through the end of 2020, you would have $20,451. If you missed the single best day, you’d only have $18,329—and only $12,917 if you missed the best five days.1
In Summary
We believe staying invested puts you in the best position to capture the recovery. If you take risk out of your portfolio, it should be a strategic, not tactical, choice. If your investment goals and/or long-term risk tolerance haven’t changed, be very careful making material changes to investments. One of the best ways to deal with volatile markets and disappointing returns is to have planned for them. Confidence comes from working with us to plan for these periods and determine if you can weather them.
After a bear market, stocks historically generate some of its best performances, and long-term investors do not want to be left out sitting on the sidelines during those periods, wondering when to get back in. Markets historically reward patience.
Sources and Citations: “Schwab Mid Year Market Outlook” by Schwab Center for Financial Research, Charles Schwab Institutional, June 16, 2022 (paraphrased);“Can’t Find My Way Home” by Liz Ann Sonders, Charles Schwab Institutional, June 27, 2022 (paraphrased); “Reasons for Optimism?” by Daniel G. Noonan, Savant, July 7, 2022 (paraphrased); “Three Crucial Lessons for Weathering the Stock Market’s Storm” by Marlena Lee, Dimensional, June 17, 2022 (paraphrased)
1Past performance, including hypothetical performance, is no guarantee of future results. Growth of $1,000 is hypothetical and assumes reinvestment of income and no transaction costs or taxes. The analysis is for illustrative purposes only and is not indicative of any investment. S&P data © 2022 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment.
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