How to survive a bear attack
“The mountains have always been there, and in them, the bears.”
“It’s the escalation of fear that leads to bad decisions. There have been a number of bear attacks that I’ve read about that could have been avoided if the situation hadn’t been misread.”
The first six months of 2022 were not kind to investors. To put the experience into perspective, the first half of 2022 has been the worst performing six months in the investment markets since the great financial crisis in 2008 and ranks as one of the worst 3% of all 6-month revolving return periods since 1926. So, if you feel like your investment portfolios have punched you in the gut this past six months, you are right in feeling that way.
In the first half of 2022, the S&P 500 was down -20.6%, while the tech-heavy Nasdaq dropped -29.5%. The MSCI EAFE Index (Europe, Asia, and the Far East); (representing a broad measure of the non-North American markets) also fell 21.0% during this same period.
The S&P/TSX, the primary Canadian stock market indicator, fell by 11.1% during the first six months of 2022 which might suggest we fared better than most other markets so far this year. However, digging a bit deeper into the performance of index constituents shows that had it not been for the performance of the energy sector, Canada’s stock market performance would not have been near as “good” as it was relative to other global indexes. Other sectors did not fare as well. Energy and resource stocks in general make up a bigger part of the overall stock market index here in Canada than it does in other parts of the world which can distort numbers if one is not careful to peel back a layer or two from the number.
Stock market drops like this have happened a number of times over my (David’s) 40-year career. The difference in the first half of 2022 is what happened to the fixed-income (bond) markets during the same period. Historically, we could count on the fact that as stock markets fell, cash would move from stock markets to the bond markets, bidding up bonds and acting as a shock absorber of sorts in our core balanced portfolios. This did not happen this time around. Bonds went down along with stocks when interest rates went up as central bankers moved aggressively to fight inflation. Remember the “teeter-totter of fixed income investing”; as interest rates go up, bond values go down and vice-versa. So, portfolios took the full brunt of what was happening in both stock and bond markets this time around when the portfolio shock absorber did not function as it has historically.
The default 60% equity/40% fixed income portfolio we use in many household investment accounts saw returns in the bottom 2% of ALL rolling 6-month periods going back to 1926. This has only happened four times before over that same time frame. So, experiences like this are relatively isolated. This does not make them any less painful when they happen, but as I have said on several occasions over the last several weeks and months, “This too shall pass.”
Humans have 3 ways of dealing with an encounter where conflict arises: fight, flight, or freeze. Many humans may also react similarly when encountering a bear. As most real bear experts agree, the first two options, fight (definitely a bad idea!!!) or outright flight (running away) are NOT recommended options when a bear is involved. The same can be said for investment bear markets.
In this bear market, many investors might be in freeze mode, keeping cash on the sidelines as global markets continue their rough ride.
U.S. inflation, as measured by the Consumer Price Index, rose 9.1% in June 2022 compared to 12 months earlier, but there are signs that we’re getting closer to a peak. Core CPI (which strips out the more volatile components like food and energy) was 5.9% higher compared to the previous year. The Core number was down ever so slightly from May, which might indicate that the momentum of inflation might be slowing. Oil prices have moderated ever so slightly over the last several weeks as consumption dropped because high pump prices seem to curtailed the anticipated summer travel bump. The U.S. Fed is still widely anticipated to increase its Fed Funds Rate by .75% at its meeting next week.
In Canada, the picture is very similar to the inflation situation being experienced by our American cousins. The year-over-year inflation in Canada for June was just announced as 8.1%. The Bank of Canada took the extraordinary step of increasing its benchmark overnight rate by a full 1% in its July rate announcement last week in anticipation of a high inflation number and the evidence that it might persist for a while longer before a noticeable decline takes hold.
These rapid and significant moves by North American central bankers will impact economic activity, which should slow demand and inflation. Lower inflation along with a slowing economy may prompt the U.S. Federal Reserve and Bank of Canada to be less aggressive with interest rate hikes as the fall progresses (though both are still telegraphing increases in September of as much as another .75%). This could be a boost for stocks and bonds as the year progresses.
The rapid interest rate increases being served up by central bankers are feeding the predictions of a possible recession being in the cards later this year and/or in the first half of 2023. Economic activity actually peaked last summer (2021) and has since fallen off. But a “real recession” (where unemployment skyrockets) is unlikely in 2022. The demand for people is robust in many economic sectors.
Market fundamentals lie, valuation earnings are better than they have been for some time. Stock valuations were ridiculously high by historic measures at the end of 2021, largely because of the exceptionally low-interest rates driving investors into risk assets for any yield on invested capital. This said some suggest that valuations are still too high and have room to fall further.
The first earnings announcements for the last quarter indicate earnings remain strong. However, companies like Apple, Meta, and Tesla are announcing workforce adjustments (hiring freezes and possible layoffs). These adjustments align with past periods of extraordinary expansion in certain sectors (i.e., technology) and would be reasonable to expect.
If the primary drivers of inflation recede (governments stop pumping liquidity into the economy and supply chain issues stabilize), the central banks will again have the option of lowering rates if economic activity slows too much later this year or early next.
To be clear, though, central bankers are walking an interest rate tight rope. Central banker credibility is on the line here. Getting interest rates into a more normal range is an ideal objective for all sorts of reasons. Rates were ridiculously low and were distorting many areas of the economy like home prices. If they pursue a single-minded focus on inflation and overshoot on interest rate increases, they may well trigger a recession and create more pain in the economy.
Supply chain issues
Global supply chain challenges have persisted in the spring, partly due to China’s closing of major cities. We are now seeing supply chain restrictions easing and, by some measures, halfway back to normal trend lines from where they were six months ago.
Consequently, we can likely expect some growth in overall manufacturing in the second half of the year. This will influence inflation as goods shortages continue to moderate.
During the COVID-19 pandemic, many employees were able to work from home and generally spent less due to restrictions. Consumers are now making up for lost time and spending money on things and activities sitting on the back burner for a while as far as life planning is concerned. As goods begin to move through ports more fluidly and people (and their luggage!) move about more freely, we should see a healthy normalization for consumers.
Higher interest rates will impact residential real estate prices. This is not a bad thing. Home prices were out of line with reality in many markets. The combination of higher mortgage rates and increasing supply should provide budding homebuyers with some hope they too, will be able to own a home sooner rather than later or ever.
While we do not make a habit of predicting the future, we believe these factors should support stronger equity and fixed-income markets in the second half of 2022 and into the first half of 2023. The one risk we see is a possible economic recession being triggered by the significant interest rates central bankers are making. However, given the tightness in labour markets and current demographic trends, we may see shifts in where people go to work, but we do not see any significant increase in unemployment anytime soon. We think if a recession occurs, it will be a mild one.
This said we do see additional volatility in the coming months. We have seen markets bounce off the lows seen in June, but there are still a lot of unknowns out there. There is still the war in Ukraine and possible food shortages in vulnerable countries in Africa and the Middle East. Europe is still on tenterhooks as far as energy is concerned as Russia threatens to cut gas supplies this coming winter. The stronger U.S. dollar is impacting commodity prices which are largely traded in U.S. dollars, making many goods more expensive.
Markets are swinging wildly right now on an intraday basis. Traders are grabbing on to any fresh news, good or bad, to buy or sell assets as they try to guess where the big picture is headed. The fact that many traders are on holiday at various times over the summer months often adds to the volatility. The central bankers in North America have no scheduled rate change announcements in August, so we have to wait until September to see what they might do next after the July moves. They could always call an emergency meeting, but that would be very highly unusual and is not likely to happen unless we get an explosive upside move in inflation over the next month. There is opportunity in the volatility we are seeing and that we see continuing in the coming months.
Once investor sentiment shifts from the current negative state that presently dominates, at least some of the high cash holdings will move into market-based investments. In fact, investment markets may improve before the Fed signals a slower pace of rate increases or takes a break. Markets generally tend to anticipate rather than react to economic developments over time. Markets don’t always get it right but over time they get it right often enough that you don’t want to be entirely on the sidelines for any length of time when indicators start to turn.
Investment market timing is a very tricky game, and most investors, including the professionals, get it wrong. Instead, we focus on making sure our client household's portfolio asset allocations (the mix of equities, fixed income, and cash) align with their risk tolerance, capacity, and life circumstances. This approach generally allows us to ride out the inevitable bear markets that occur from time to time.
For those in the accumulation phase of their investing lives? Just keep buying. The best way to keep your brain out of the way is to set up pre-authorized monthly contribution plans for your various investment accounts. Such a plan will see you buy more shares of your favorite investments when investment markets are down and less when they are up, the ideal way to build sustainable wealth over time.
Final thoughts—don’t run from a bear
As stated earlier, one of the key rules when coming across a bear in the wilderness is not to blindly turn and try running away, and that applies to investing too. The odds are overwhelmingly in the investor’s favour in a bear market. The fact is that investments made today have a higher long-term return potential than those made at the start of 2022 or anytime in the previous 12 to 18 months or farther back still, from where we are today, depending on the tilt in your portfolio. By the time we have additional clarity on the challenges above, markets will have rallied, leaving many investors behind.
The best advice?
Take a step back, survey the environment, revisit the plan, confirm your objectives and stay on course.
Those with high cash holdings waiting for an optimal time to invest might want to consider investing cash over the next several months. We are strongly recommending clients focused on growing their investment holdings invest “tranches” (slices) of their unallocated cash holdings into portfolio investments over the next several months. We are reaching out to households with cash holdings with us to get their permission to place trades right now. If you have come into cash over the last few months that we are not aware of and have been holding off investing, please call or email us to let us know so we can discuss this strategy with you to see if it is a fit for your particular situation.
We are pretty confident that the investing we are doing now will look like a wise move 12 to 24 months out.
As always, if you have questions about the markets or your investments, we are here to talk.
Thank you for your continuing confidence.
David J. Luke, CFP, CLU, CH.F.C., RFP, CIM, RIAC | Financial Advisor
Bjorn Kragh-Hansen, BComm (Hon.) |Associate Advisor
360 Private Wealth Management / Manulife Securities Incorporated