Strategy Update - Last Phase of the Bear Market in Place

Banking Crisis does much of the “heavy lifting” for the Fed

We are now approaching the 16th month of the bear market in stocks and bonds, and according to our research, we have thankfully reached its last phase. As you know, we have remained in a defensive posture throughout this period, which has significantly reduced your portfolio’s volatility and downside. At one point, stocks declined almost 30%, while the tech-heavy Nasdaq declined almost 40%. Although recent market strength is welcome, indexes are still nowhere near their pre-bear market levels. This is a reminder of the “ugly math” of market declines and recoveries and the adage that “a decline of 40% requires an almost 80% return to break even." There is a significant amount of negative investor sentiment. One doesn’t have to look far for bad news ranging from the recent banking crisis, the Federal Reserve's restrictive interest rate policy, and the potential of an oncoming recession. Within these headwinds, you may ask yourself, “how can we see light at the end of this dark tunnel? And, how do we know it is not an oncoming train?” Let’s review a few important concepts and metrics.

Bear Market Statistics
Although many aspects of this bear market may seem different, it is quite similar to those in the past. It started with a global economic disequilibrium – in this case, inflation – followed by central bank policies aimed at slowing the economy, profit growth, and consumer spending. Fed rate hikes and the projection of slower growth, like in past bear markets, deflate the values of stocks and bonds to levels more closely associated with a constrained economy. Historically, most bear markets last 14-18 months, and this one also appears to be within this range. Bear markets also typically decline 38-50% from peak to trough, making this one also fit neatly into the history books – so far, at least. On a time and price basis, this bear market is quite typical.

Central Bank Policy Assisted by Banking Crisis
For quite some time, it appeared that the policy of rising rates seemed to be taking longer than expected and perhaps not as effective as many thought. Inflation has trended downward but remains a bit sticky at around 6% (down from 9%). In addition, the economy, consumer spending, and corporate profits have been incredibly resilient to a massive amount of interest rate hikes. However, we believe that the recent banking crisis will put additional downward pressure on the economy, consumer spending, and corporate profit growth. While we do not expect the banking crisis to unfold into a 2008 credit default inferno, it will significantly negatively affect loan origination and the psyche of consumers and corporations. This, in turn, is “just what the doctor ordered” to further slow the economy and reduce the number of future rate hikes that central banks had planned before the crisis. The next quarter or two may be quite ugly for corporate profits, consumer spending, and economic growth – but may get us much closer to the Fed’s target of 2% inflation. Most importantly, it will likely bring the economy and markets back in equilibrium.

Prepare to Re-invest for Growth – in the Midst of the Bad News
The best time to re-enter markets is when the bear comes to an end – which strangely almost always coincides with when a recession begins or has already started. This phenomenon is why they call the stock market a discount mechanism. Equity prices decline before actual recessions appear (as we have witnessed for the past 15 months) and rise throughout recessions as investors “discount” the eventual recovery of the economy and corporate profits. Now that Fed policy and the banking crisis have brought their “one-two punch,” we expect that this bear market will come to an end within weeks or months. This will provide an ideal time to tilt your portfolio to be more growth-oriented, and we look forward to this positive change! In fact, you may have noticed we have already been making some slight adjustments in this direction.

A New Business Cycle and Bull Market Await
As mentioned in past Strategy Updates, we have made a list of the great companies we are excited to add to your portfolio in this new, better market. We understand just how tricky re-investing at the end of a bear market can be, so we have a few rules; don’t buy all of the stocks at once, buy partial positions so we can add to them later within ongoing volatility, and use stop-loss orders in case the bear is more extended than we think. Although we are optimistic about the future of the market in the second half of this year, we also recognize that we probably have more volatility to face in the next weeks and months, so we will be very careful to invest in phases. If you have additional capital outside our management, this is an excellent time to add it to your portfolio and take advantage of the upcoming opportunities.

Equity Market Opportunities Galore
There really are great bargains in today’s global stock market. There are some great stocks that are down 30-50% from their highest value – a little more than a year ago. Some of the best values are in the technology sector as well as industrial, financial, consumer discretionary, and communications, to name just a few. Interestingly, foreign markets appear to be where the best values and market performance exist, so you will see a combination of domestic and international positions as we increase your stock exposure.

Interest Rates
In our opinion, interest rates will likely have a little more upward pressure – after a historic rise over the past year. This is still a great time to buy bonds with attractive credit quality and lock in these higher rates for years to come. If you have cash in money market funds outside of our management, it is an excellent time for us to add to your bond portfolio.

Charles Schwab
There has been a tremendous amount of negative media attention, mainly focused on banks – some of which has been well deserved. In our opinion and correspondence with executives, Charles Schwab is in much better shape than its peers or the media would lead one to believe. Certainly, Schwab Bank will be negatively affected by their earnings on deposits – but not drastically. However, the Schwab brokerage division remains very strong and is the largest part of the business. We remain confident in Schwab as a custodian of your assets and will be continuing to keep an open dialogue with their executives as the banking crisis plays out over the next few months.

We hope this Strategy Update finds you and your family well. Please let us know if you have any questions or have experienced a change in your finances.

Thank you from all of us for your continued vote of confidence in our work.

Main Street Research Team