WHAT DO ALL BEAR markets have in common? By definition, stock prices must fall at least 20%. But often, that’s pretty much where the similarity ends.
For instance, ponder the differences between 2020’s one-month, 34% plunge in the S&P 500 and this year’s grinding nine-month descent, which saw the S&P 500 yesterday close 25% below its early January high.
The 2020 slump had folks fretting about the economic shutdown and possible deflation, while this year’s big worry is surging inflation amid a 53-year low in unemployment. Indeed, if you factor in this year’s loss to inflation, stock market investors have suffered a hit in 2022 that rivals that of early 2020.
As inflation has accelerated in 2022, the yield on the benchmark 10-year Treasury note has jumped from 1.51% at year-end 2021 to 3.81% as of Friday. That’s meant double-digit losses for the broad bond market, leaving even conservative investors licking their wounds. By contrast, in early 2020, Treasurys rallied as stocks plunged, offering some solace to diversified investors.
Every bear market is not only different from earlier declines, but also each one feels different—with unique issues that trick us into thinking the problems will snowball and the financial damage will be permanent. Such feelings aren’t surprising: If every bear market seemed similar, we’d all be emotionally prepared and there would be little or no panic.
That raises the question: Have we seen any panic this time around? Market soothsayers look for it, saying share prices won’t bottom until we see “capitulation.” I have my doubts about such market “wisdom.” Still, we certainly had days in September when investors appeared to dump stocks indiscriminately, notably Sept. 13, when the Nasdaq Composite fell more than 5%. I find signs of indiscriminate selling encouraging because it means share prices may have become detached from their intrinsic value and perhaps offer a great buying opportunity. And, yes, I’ve been regularly adding to my stock funds throughout this decline.
On the other hand, what looks like indiscriminate selling may, this time around, be a revaluation of stocks in the face of higher interest rates. Think of today’s share prices as the sum of all expected corporate earnings, with those future earnings discounted. As interest rates rise, expected earnings get discounted at a steeper rate, and the haircut is especially steep for earnings in more distant years.
With growth stocks, investors are betting on company profits that may not materialize for many years. Result: Growth stocks have been hit especially hard by 2022’s rising interest rates, while value stocks have held up better. But whether it’s growth or value stocks, when rates rise, almost all will get their prices trimmed. That’s why big down days can feel like indiscriminate selling but may, in fact, be entirely rational.
All this is different from 2020, when interest rates were falling, and the focus instead was on which companies would see their earnings hit hardest by the pandemic’s economic shutdown. That year’s market plunge was bigger, but the winners and losers seemed to make more sense. Goodbye, airlines and cruise lines. Hello, Netflix and Amazon.
So where do we go from here? This is the story that investors appear to be telling themselves: When inflation abates, we’ll see a decline in short-term interest rates, which are currently above longer-term rates—the infamous inverted yield curve. In the meantime, the hope is that a slowing economy won’t put too much of a dent in corporate earnings, but that’s clearly a danger. What if the economy does slow significantly? That would presumably lead the Federal Reserve to cut short-term interest rates. And that, in turn, should help spur both economic growth and the stock market.
This seems like a reasonable story. Will it turn out to be true? I have no idea.
Still, I think what’s happening in the stock market in 2022 offers an important lesson for longer-term investors. The story of the financial markets over the past four decades can be told with two data points. In September 1981, the yield on the 10-year Treasury note almost reached 16%. In August 2020, it got as low as 0.52%. The intervening decline in interest rates drove up not only bond prices, but also the value that investors were willing to put on stocks.
But the long tailwind of falling interest rates is all but spent. I suspect today’s sense of economic crisis will pass soon enough, bond prices will stabilize and stocks will rally. But without the tailwind of declining interest rates, longer-term gains for stock and bond investors will come much more grudgingly, and thus the fundamentals of smart money management will be more important than ever.
What does that mean? We need to save diligently, spend prudently—and do everything in our power to pocket whatever the markets deliver. That means buying low-cost broad market index funds, trading infrequently, minimizing taxes and standing our ground in the face of market turbulence. We may not control the direction of the financial markets, but these are things we can control.
Sound like yet another reiteration of the HumbleDollar gospel? It is indeed. That’s the nice thing about sound financial principles. The markets may change, but the principles endure.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.
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JC, another well written article. Thank you.
Perhaps the greatest long term wealth allocation for 90% of investors is their real estate. Imo, the fundamental question really ought to include stocks, bonds, and real estate long term value holdings of an investor, not only stocks and bonds.
In your opinion are buying declining stocks a better long term fundamental hedge than buying bonds? Thanks again
If there’s money you won’t need to spend in the next five years, I think the vast majority of it should be in diversified stock funds — and I find it especially easy to make that suggestion when the market is off 25%.
I understand you have been buying more stocks during the bear market; however, I’m wondering if you have increased your stock allocation % during this time. I think you previously stated your goal was 80% stocks. Are you at that level now or are you holding some cash reserves back for further declines? Thank you.
I’m now somewhat above 80% stocks. I realize I’m “sinning” — straying from my target asset allocation — but it doesn’t seem like much of a sin to me. While others grow ever more concerned about risk as this decline drags on, I feel just the opposite: The further stocks fall, the better valuations get and the more dire the predictions become, the less risky the stock market is, at least in my eyes.
Your statement about the long term direction of interest rates struck me as one of the most important in thinking about long term returns on stocks:
”But the long tailwind of falling interest rates is all but spent. I suspect today’s sense of economic crisis will pass soon enough, bond prices will stabilize and stocks will rally. But without the tailwind of declining interest rates, longer-term gains for stock and bond investors will come much more grudgingly, and thus the fundamentals of smart money management will be more important than ever.”
It may be that interest rates will remain at these higher “more normal” levels for quite some time – maybe many years. No more “tailwinds.” And according to the Shiller PE ratio (see http://www.gurufocus.com/Shiller-PE.php) current stock levels are not bargains. The Shiller PE ratio suggests future stock market return will be around 5.1% per year (not their long-term average annual return of 10%) for the foreseeable future. Despite the fact that stocks are in bear market territory, they don’t seem like much of a bargain when you compare their expected (at least per Shiller ratio) return of 5.1% against a risk free 10 year Treasury Bond returning more than 3.8% or aaa corporate bonds with return above 4.9%.
I would be cautious about reading too much into the Shiller P/E. It’s indicated that U.S. stocks have been overvalued for the past three decades and, indeed, Shiller himself is now proposing an alternative version of his P/E:
http://www.econ.yale.edu/~shiller/data.htm
Thank you JC. Just when I find myself beginning to think “Yeah this time it really is different”, you swoop in to remind me that it’s really not.
Thanks Johathan, enjoyed the article.
“What does that mean? We need to save diligently, spend prudently—and do everything in our power to pocket whatever the markets deliver. That means buying low-cost broad market index funds, trading infrequently, minimizing taxes and standing our ground in the face of market turbulence. We may not control the direction of the financial markets, but these are things we can control.”
Sound advice.
Great article, as always, Jonathan. I think the other thing that’s happening now is that as interest rates rise, people becoming more interested in low-risk, stable fund alternatives such as CDs and money markets that had been offering next to nothing. That, too, reduces the attractiveness of stocks. Of course, those CDs and money market funds won’t keep up with inflation. But still, a 3% return looks a lot better than the double-digit declines we’ve seen this year in the stock market.
The good news is, when it comes to recent stock fund returns, past performance is no guarantee of future results….
Thank you, Jonathan. I’m still an optimist, but felt a little anxious this morning after I finished updating my monthly spreadsheet of investment balances. Gulp. I will stay the course, though, as I did in 2008.
Yet, saving diligently at least you can control, so do it. Just hope the markets don’t tread water like the 1970’s with no particularly great places to hold money.
The 1970s were indeed a rough stretch for large-cap U.S. stocks. But small-cap U.S. stocks and foreign stocks performed fairly well.
In 1973/1974 the market went down 45%. My mother borrowed money to invest in the stock market. That was good training for me. It also provided a little inheritance. Thanks a million, Mom!
Different players but same game. Love it
I like that notion of familiarity with market cycles as a buffer against panicking. I think it also holds across different kinds of investments. Based on their family’s or their own investment experiences, some people may find it easier to withstand a real estate bear while others may have a higher risk-tolerance for stock debacles. The refrain, “I’ve seen this picture before,” is helping me stay the course.
Interesting that you should compare holding real estate to holding stocks. I’ve been thinking lately, about how we’ve been homeowners for more than 30 years now. And in that time, we’ve seen at least as much fluctuation in our home’s value as we’ve experienced in our diversified stock index funds in our retirement accounts. And yet, in all that time, I’ve never lost a moment’s rest worrying about home prices. I’m (slowly) learning to think of our retirement accounts in the same way; as long as we’ve got our money in a broadly diversified market portfolio, there’s actually less to worry about than real estate prices. And yet, it’s still a struggle sometimes…(sigh).
Yes, but people don’t sell a bedroom every year for living expenses or a bathroom for a new car during retirement. While working they can seem similar, but when retired very different. Unless you have land you can subdivide and slowly sell off.
I have come to think real estate investment trusts (REITS, companies that operate real estate that trade as stocks) may offer a solution. If REITS are part of your overall real estate portfolio, you can sell some shares to raise cash rather than be stuck with only illiquid privately owned real estate. Just a thought.
Yup, the marketing arm of the real estate industry is a thing to behold. Owning property is “safe, profitable, admirable,” while the stock market is “risky, unpredictable,” and a little sleazy. Meanwhile, if I can put any trust in the Zillow estimates, my properties are down about 15% since the Fed started raising rates a few months ago. I feel your pain.
I also am an optimist and appreciate Jonathan’s view. I have a concern about the long term prospects for Ukraine and Europe as a whole. This situation has the possibility of not ending well but should be recognized as what could be a watershed event. If the west can put a stop to the opportunistic aggression on countries surrounding Russia we could have an era of stability that follows.
The top corporate tax rate declined from 46% to 21% in that period, and labor costs grew relatively slowly. Both may be hard to sustain. I’m still an optimist but am saving and investing more to hedge the chance of lower returns from here.
Thank you, Jonathan. You are consistently diligent to deliver reassuring articles at appropriate times.