3 Reasons It Feels a Little Different This Time

Introduction

While 2022 stock market volatility has been unsettling, many investors are no strangers to this type of uncertainty since it tends to rear its head every few years – only to rebound later. The bull market that began after the financial crisis has seen numerous stock declines over the past decade. From 2010-2021, the S&P 500 has seen a decline greater than 15% four times (2010, 2011, 2018, 2020), and 10-15% declines 3 times (2012, 2015, 2016). So, why does it feel different this time? In this blog post, we summarize a few reasons we believe the recent bear market stings a bit more for the average investor.

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#1 Conservative Assets & Strategies are Misbehaving

Two longstanding core tenets for moderate and conservative investors are 1) maintaining portfolio diversification and 2) owning bonds / fixed income. And just when you think you need them the most – in a bear market environment – neither has provided notable downside protection in 2022.

Most folks understand the concept of diversification: own numerous assets with solid long-term return expectations that tend to behave differently over the short-term. This historically gives investors a less bumpy ride and limits extreme moves, both to the downside and upside, which is more palatable for less aggressive investors. You can see from the Asset Class Return chart, that different asset classes can behave very differently from year to year, while a diversified portfolio of all asset classes (Asset Allocation) tends to be more stable overall. In most years, you have some major assets that are down and some that are up and together might still average a positive return.

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In 2022, all major asset classes except cash equivalents have had a negative performance, so owning a diversified portfolio has not done investors any favors. As of September 30th, the energy sector is the only US stock sector out of all 11 sectors with a positive return in 2022. Most notably, fixed income/bonds are down significantly as well. As of September 30th, the Bloomberg US Aggregate Bond Index is down -14.61% year-to-date, the worst performance for the bond benchmark in history.

For some perspective, the worst financial market environment in modern history was 2008, a year that all investors remember. However, even in 2008, the Aggregate Bond Index was up +5.24%. So, for simple math, a balanced portfolio owning 50% US stocks and 50% US bonds in 2008 would have been down approximately -16%. In 2022, that same balanced portfolio would be down approximately -20% as of September 30th.

You read that correctly, during the worst financial crisis since the Great Depression, a balanced investor could have fared similarly or better for the full calendar year of 2008 versus 2022 year-to-date. Even though stocks are down much less than they were in 2008 and the economy is much stronger, bonds have been the salt in the wound. Bonds are considered to be a safer asset class that typically bails out stocks in bad years (i.e. 2000-2003, 2008).

Year

Stocks (S&P 500)

Bonds (Bloomberg Agg)

50/50 Stocks / Bonds

2008

-37.00%

+5.24%

-15.88%

2022 YTD (9/30)

-24.91%

-14.61%

-19.76%

But rather than being a risk mitigator to stocks, this year bonds have been acting as a co-conspirator with stocks, heading downward over the past nine months. In fact, this is the first time since 1976 that both stocks and bonds have been down together for three consecutive quarters. So if you are a conservative or moderate investor and feel like the 2022 investment environment has been more brutal than other bear markets of the past, you probably aren’t wrong. Your portfolio anchor and ballast during prior stretches of rough waters (bonds) have been more like a cannonball shot through the bow in 2022. However, in our next blog post, we will address why we believe bonds are more appealing from a return standpoint at current levels than they have been in the past two decades.

 

#2 Inflation & Interest Rates are at Multi-decade Highs

In a previous blog post, we discussed the current inflationary environment and the Fed’s response in great detail. In summary, to combat inflation, the Federal Reserve is increasing interest rates to soften economic demand. The last time we saw interest rates this high was nearly two decades ago, and the last time inflation was this high was in the early 1980’s.

Perhaps more notably is the speed with which the Fed has raised interest rates, which has surprised the markets and economists a couple of times. The Federal Reserve has never raised by 0.75% in back-to-back meetings. So while experienced investors are no strangers to interest rates at these levels, the sheer velocity of the increases on an absolute and relative basis is historic. Interest rates play a major role in the financial markets and economy, and an abrupt, extreme shift tends to cause short-term volatility in the markets.

When rates move up this swiftly, asset prices seem to “reset” for the new environment – and instead of a gradual process, market participants attempt to move prices immediately rather than play a game of “wait and see.” In other words, when the Fed said they were serious about raising rates to fight inflation (and inflation has remained persistently high), traders weren’t willing to see if the Fed would make good on their word – they traded stocks and bonds down to prices in line with the interest rates the Fed said they could ultimately get to. The markets have been pricing in the worst news quickly in this environment, which is why the term “things are priced in” has been thrown around a good bit in the media.

The good news about pricing in much of the bad news is that it increases the likelihood of an upside surprise. At this point, high inflation & rate increases through the end of the year are likely not a surprise to anyone. The market has accepted bad news, higher inflation, and an austere Federal Reserve as the new status quo, so when things begin to reverse course, we believe markets could react quickly and positively.

#3 The Federal Reserve’s Role Has Shifted

Over the past several bear markets and/or recessions, the Federal Reserve has been more accommodative to help the economy. That role has now completely reversed, which is why this bear market may truly feel different than any other in recent history. Rather than implementing monetary policy that helps the economy and consequently the financial markets, the Fed is employing a restrictive monetary policy to put a dent in inflation.

A Federal Reserve that raises interest rates and decreases money supply amid market volatility is out of the ordinary. While the Federal Reserve could’ve been viewed as heroes in the spring of 2020, to many they seem more like an adversary right now. However, it’s important that we understand the Federal Reserve’s true mandate: to keep core inflation at an average of 2% and maintain full employment. Many think stimulating the financial markets is the Fed’s job, but that simply isn’t true. Their actions often have an impact on the economy at-large and financial markets, but this is a byproduct of their main mandate.

In bear markets and recessions, deflation – or at least signs of deflationary pressure – can be worrisome. For example, deflation was a major concern for the Fed in 2008 and the spring of 2020. The Federal Reserve wants to maintain the 2% core inflation rate to ensure the economy is still growing but prices are not becoming out of reach for consumers. Deflation is often a sign of a weakening economy and lower consumer spending. To combat this threat, the Fed can maintain lower interest rates and/or increase the money supply to keep modest inflationary pressures at work. This type of monetary policy ultimately makes its way into the market as lower interest rates encourages more risk taking.

Now flip the script to where we are today during the 2022 bear market – inflation is the primary concern. As mentioned above, slight inflation is viewed as good for the economy, but sustained high inflation is a major headwind for the economy. To combat this threat, the Fed has increased interest rates and decreased the money supply in an attempt to cool the economy. Unlike lowering rates, sharply increasing rates often deters risk taking and therefore creates stock market volatility. In addition, bond prices and interest rates have an inverse relationship over the short-term, creating volatility in the bond market as well – again, a double whammy in 2022.

While the Fed’s current role of eliminating high inflation and consequently causing market uncertainty can be frustrating over the short-term, it is likely needed over the long-term. Whether the Fed should be blamed for being too accommodative for too long and ultimately exacerbating the inflation issue is irrelevant to what should be done now. Getting inflation to a more manageable level is the prudent thing to do at this point in time.  

The good news is, we believe we may be closer than many think. As mentioned in previous blogs and videos, commodity prices have come down significantly from their highs. We believe inflation will begin to abate naturally over the coming months due to the lagging effect of lower commodity prices and supply chain improvement.

Conclusion: One Thing Isn’t Different This Time

While the contributors to recent market volatility might be different this time, some things remain constant: the financial markets do not like uncertainty. So, while bonds, interest rates, inflation, and the Federal Reserve’s role may seem very different this time, we expect the outcome of this bear market to be the same: it will end, and markets will reach new highs once again – just as they always have.

In good markets or poor markets, we believe patience and a long-term perspective will be the key to accomplishing your financial goals.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly

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