Things May Get Worse Before They Get a Whole Lot Better
Bear markets can be tiring since, historically, they average around 12-15 months in length depending on how one measures it, and this one has just celebrated its 16-month. We don’t know about you – but we are tired of this unconstructive environment for equities! Like bear markets of the past, this bear market has been rooted in a disequilibrium between economic fundamentals (excessive inflation) and a stock market unprepared for the rate hikes needed to extinguish the inflationary problem. The good news is that we are getting closer to the end of this bear market, and a new bull market is just around the corner! It may seem unlikely that a healthy stock market will begin given the long list of current headwinds, including higher-than-normal inflation, bank failures, possible oncoming recession, and the looming and always ominous debt ceiling. However, throughout history, stock prices eventually discount most of this bad news before it occurs and start their (often) robust recovery in the face of dire news – a phenomenon that can make this craft quite tricky and for which our team is up to the task. Let’s unpack some of these concepts.
The Federal Reserve Has Whipped Inflation
In January of 2022 – 16 months ago – the Federal Reserve was staring down the barrel of inflation that had quickly escalated to nearly 10% from a previous 15-year average of 2% annually. With the bluntest tool they possess, the Federal Reserve and other global central banks began their aggressive campaign of raising interest rates to thwart the escalating prices that came from economies running too hot and demand that exceeded supply. Raising interest rates slows economic growth and eventually lowers inflation. The most recent inflation data is now running at a 5% annual rate and proves that rate hikes work. However, aggressive rate hikes are a major negative for stocks, as we have all witnessed during this bear market, with some major indexes down almost 30-40% at one point. The most recent Fed rate hikes have yet to seep into the economy, but we can assume that the 5% rate is likely to trend lower towards 3% in the coming months. The Fed has pretty much whipped inflation, and we would not expect further aggressive rate hikes from here, so investors can take inflation and interest rates off their list of worries. However, the lingering effect of higher rates may still cause damage to banks and the economy and, therefore, possibly the stock market or parts of it. Here is why.
Bear Markets Final Phase
In the final phase of bear markets, it is common that past Fed rate hikes start "breaking things," which we already witnessed with the collapse of several regional banks. We are also seeing cracks in the overall economy, evidenced by corporate profits missing expectations and, most recently, a slowdown in job growth – two precursors of a possible recession on the way! Along with these negative "aftereffects" of an aggressive interest rate campaign, we also have the looming US debt crisis front and center in the coming months – this could surely increase stock market volatility and, in our view, bring us to the end of the bear market. In this last phase of the bear market, some sectors and stocks will fare worse than others, so investors should remain under-invested and be selective about sectors and individual companies that can withstand some of these headwinds. Significant stock market weakness from current levels should be viewed as an opportunity, as the bear market fully discounts the details described above, and a new bull market begins in earnest in the second half of this year. It is important to recall that bull markets usually start at the same time as recessions begin since stocks discount the recovery up to a year ahead of time. Peculiar, but that’s the way markets work!
Sectors and AI
The most resilient sectors throughout bear markets have been consumer staples, healthcare, and utilities – all areas we have embraced during this time frame. Companies in these sectors tend to perform well in contracting and slowing economies, given their "recession-proof" business models. We believe they will continue to exhibit better relative performance as the bear market comes to its end. As we look across other sectors, we continue to see value in parts of the beaten-down technology sector, particularly businesses in areas like semiconductors and cybersecurity, which have already been through a recession. Artificial Intelligence may seem daunting to many; however, we view it as a significant force for technology companies who embrace and support its growth. It may create a major windfall for companies such as Alphabet, Microsoft, and semiconductor companies. The applications for AI are limitless, and we have barely scratched the surface. AI could launch a new wave of secular growth for the tech sector and those companies that are well-positioned. We have already begun investing with this theme in mind and will continue to do so on your behalf.
Time To Go Global
As you know, we have always taken a global approach to investing. Since over 50% of the world’s capitalization of stocks is outside the US, it just makes sense, but now more than ever. Over the past three quarters, foreign stocks have outperformed US stocks by a wide margin, which may continue for some time. In the ’90s, this phenomenon lasted an entire decade. Stocks outside of the US are more reasonably priced and represent some world-class businesses that will benefit from the new business cycle we envision.
Interest Rates and the Bond Market
As previously mentioned, we don’t expect much – if any – further increase in interest rates from current levels. This presents a great opportunity to reduce money market funds in favor of short, intermediate, and longer-duration fixed income. If the economy tips into recession, which we think is highly likely, interest rates will decline from current levels, and the current "window of opportunity" for locking in these high rates will vanish.
Although we believe we are in the last phase of the bear market, there can always be events that derail our view and strategy. Therefore, you may have noticed that we remain under-invested and are buying smaller than normal stock positions with stop-loss orders to mitigate risk. We will continue to manage the risk of your portfolio by being flexible with your allocation to stocks, sector management, and the use of carefully placed stop-loss orders.
We look forward to a more constructive stock market in the second half of this year and to helping you prosper from a new business cycle and bull market. Thank you for your vote of confidence in our team and your patience through this bear market – we are almost to its end!
If you have not seen it yet, we encourage you to check out James' latest appearance on Bloomberg TV. On May 14th, James was featured on Bloomberg TV discussing much of what we covered here. Click here to watch.