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.