Two Bears in Two Years?
On January 3rd of this year, the S&P 500 reached an all-time high and began a decline that on June 13th passed a critical threshold — down 20% from a recent high — and became the twenty-second bear market since 1929. The previous bear market, which has the record of being the shortest since at least 1929, began on the 19th of February 2020 and finished thirty-three days later on March 23rd after chewing up 35% of market value. The proximity in time of these two events is easy to understand: one way or another, both are largely the spawn of Covid-19. The earlier bear appeared when markets realized that the pandemic was likely to shut down the global economy for the foreseeable future. This pessimism quickly disappeared when vaccines were discovered and the Federal Reserve, Congress, and the President rolled out extraordinary fiscal and monetary measures to keep the economy afloat. The economy roared back and the resulting bull market more than doubled the prior bear market low (+120%). Alas, a bright candle often burns but briefly: at just under twenty-two months, the bull market was the shortest lived since the 1950s. The roaring economy, fueled by pandemic-inflicted cabin fever and overly zealous government stimulus, quickly turned into a hyper-inflated monster. Too many consumers with too many dollars chasing too few goods and services is a classic recipe for inflation. And with an annual CPI of 8.6% recorded in May — the highest in forty years — the Federal Reserve, the guardian of dollar stability, has been left with no other choice but to raise interest rates and tighten the money supply. Bear markets thrive on rising inflation and a central bank determined to squelch it.
There’s some truth to the observation that once a bear market is recognized as such, it is already near its conclusion. By the time a bull market has passed through the correction phase — down ten percent from its previous high — and pierced the negative twenty percent level, it has already absorbed a lot of negative news and spread a lot of angst among investors. And it must be said that after crossing the bear milestone, the market has vacillated between positive and negative days and today remains close to the June 13th marker. However, we would caution investors against trying to guess the bottom of this very young bear market: there are many more likely negative paths the economy and markets can take in the near future than there are positive ones, and trying to catch falling swords is a dangerous pastime.
There’s a large gap between what the Fed considers an acceptable level of inflation (annual rate of 2%) and the latest readings from the economy (CPI of 8.6%). At its recent announcement on June 15th, in response to the high CPI figure, the Fed raised overnight rates by .75% rather than by the originally expected .50%; it was the somewhat “leaked” likelihood of this higher increase and the expectation of future rate increases that sent stocks into their bear market swoon on June 13th. Based on current Fed guidance, it is now generally assumed that the Fed will lift overnight rates from the current range of 1.50% to 1.75% to a 2022 year-end policy rate of 3.25% to 3.50%, about a 1.75 percentage point increase. It is also conceded by a great many economists that a recession is inevitable, although this is not a view shared by the current administration, who doggedly insist that a soft landing — disinflation without a recession — is possible. Recessions are up to the National Bureau of Economic Research to determine, but if the definition is two consecutive quarters of negative real GDP, we’re already halfway there. The market in bear mode is clearly forecasting a recession, though it’s not an infallible prognosticator: Paul Samuelson, a former Fed Chairman, once famously quipped that the stock market has predicted nine of the last five recessions. Nevertheless, from this vantage point, a recession seems like the most likely scenario. Already there are signs that higher prices and higher interest rates are beginning to take their toll on consumer and corporate demand: the Purchasing Managers’ Index, while still positive, recently fell to a five-month low; May retail sales dropped for the first time in 2022; existing home sales have been in decline for four consecutive months; and the Conference Board’s Index of Leading Economic Indicators (LEI) has declined for the last three consecutive months, the first time that’s happened since April 2020.
If a recession over the next twelve months dampens inflation expectations and puts price increases back to the Fed’s target of 2%, it would be a small price to pay. Far worse would be a repeat of the ‘70s, when a determined Fed drove interest rates to insanely high levels — 90-day T-Bills at 13% — and ushered in four recessions from the fourth quarter of 1969 to the fourth quarter of 1982. Only the last of these recessions, one engineered by the then recently-installed Fed Chairman Paul Volcker, finally brought an end to inflation, or at least a forty-year end. During this time, investors felt significant pain. Long-term bond portfolios lost over 25% of their market value as rates climbed. For stock investors, there was no benefit from inflation: $100 invested in early 1973 was worth less than $100 seven years later in 1980. We remember investors in the ‘80s who refused to buy stocks because they saw nothing but red ink in their long-term portfolios. But just as it’s too early to call an end to the current bear market, it’s also too early to accept that twelve years of misery lie ahead of us.
The highly expected “hard landing” (according to the Wall Street Journal, a hard landing is a GDP decline of 1% or more from a year earlier in at least one quarter over the next 2.5 years) or recession, which we believe the Fed is unlikely to avoid, does not necessarily indicate that a long-term, teeth-rattling, asset-destroying catastrophe is headed our way. But it will have to be severe enough to halt the entrenchment of a self-fulfilling consumer mindset which favors current purchases and hoarding of goods over future purchases at higher prices. The Fed is capable of accomplishing this, but not without pain. The good news is that the Fed is operating with a low 3.6% rate of unemployment, which should buy some time before the politics of high unemployment produces undue pressure on the Fed’s independence. The not-so-good news is that the Fed can only influence the monetary causes of current inflation and has little control over supply chain bottlenecks and no control over the war in the Ukraine, the source of much of the energy and food price increases. It is likely that the supply chain issues will resolve themselves over time, but the war looks to be a long and costly slog. A global recession will limit price increases in energy by lowering demand, while grain supply will surely respond to elevated prices. Eventually, new suppliers will appear and fill supply shortfalls, but this may take time. For now, inflation minus food and energy is likely to look much better than the headline CPI.
For the next few months, interest rates and credit spreads over Treasuries should increase. For the first time in many years, fixed income investing is getting close to being attractive. Not quite attractive yet — rates are still very negative after adjusting for inflation — but getting closer. Equity investments have reflected these risks, given the Fed’s determination to tame inflation and its willingness to trigger a recession in order to do so. Although P/E ratios on 2022 and 2023 earnings (16.5 and 15 times earnings, respectively) are close to average levels, the numbers are based on inflated expectations: we expect that second quarter earnings announcements and earnings guidance in July could be lower. And if inflation during the remainder of 2022 stays near current levels, (or moves higher,) with or without a recession, we would expect the Fed to become even more restrictive and markets to respond negatively. Often, however, markets respond in their own ways, and in advance of the remedies applied by policymakers. We know that attempting to time specific policy responses and market moves is nearly impossible. We try to maintain exposure to the long-term appreciation offered by financial markets while taking steps to reduce the impacts of downturns when they occur. Sometimes the cost of this exposure is the discomfort of weathering periods of adjustment as the prices of money (interest rates) and goods adjust to a new equilibrium.
Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.