Vigilare Wealth Management 2022 Q3 Commentary
By Jason@vigilarewealth.com on October 18, 2022 in Investor Lounge
A combination of persistent inflation, geopolitical tensions, and an aggressive Federal Reserve (the Fed) have made for the worst start to a year in our lifetimes. The S&P 500 alone has lost an astonishing $10 trillion in value. At the time of this writing most markets have suffered massive drawdowns including: U.S. markets down over 25%, Nasdaq down 34%, REITs down 30%, International markets down 30%, U.S. Treasuries down 30%, U.S. Bond index down over 15%. In fact, looking at the comprehensive investment universe only a few select commodities (energy and grains) are up for the year. The U.S. dollar continues to rein supreme and is at the strongest level relative to most other currencies in decades.
The drawdown in the markets this year has been more broad-based than ever, even more so than the Financial Crisis of 2008 or the Dot Com Bust of 2000. This is because value stocks performed in the 2000 bear market and bonds did so in 2008, while today there are no standout performers. To put into perspective, a garden variety generic-passive moderate-allocation has suffered a staggering 22% loss, which if the year ended now, would be the largest calendar year loss on record equaling only 2008.
We will not detail the reasons for all this market turmoil as we have written about it extensively in prior commentaries, even preceding much of this year’s market turmoil. We have emphasized 2022 being a volatile year and the importance of managing risk both in the stock and bond markets and having adequate cash for liquidity. But now after three straight quarters of relentless market losses, there are some developing opportunities which are encouraging.
The name is Bond, Government Bond. Government bond yields are at the highest levels in over a decade. For example, the oldest bond ETF (AGG) is at its lowest price since its inception date of September of 2003. This surge in yields presents an opportunity because yields are finally at a level that provide impactful income. More importantly, bonds will gain in value if the economy slows, thus providing a hedge against stock market weakness in a “hard landing” scenario. This is a big deal. For the first time in years, bonds can provide good diversification and a hedge against stock losses. For example, a 1% decrease in rates would have a positive 10% impact on the bond index. This is AAA government bonds and high rated bonds, not junk bonds, which we would avoid at this time. Why would rates go down if there is rampant inflation? Because historically in every recession (including the 70s) rates and inflation peak at the onset or early into the recession. There are some risk factors that could drive yields higher in the near term. For example, forced selling from Central banks and/or pension/insurance entities (Ala U.K. recently) or Fed Quantitative tightening (QT). That temporary spike in rates would make the bond argument even more attractive longer term. Hello Mr. Bond.
What is a bad case scenario in a stock market? For a historical comparison, in a shallow recession stock markets decline around 20%-25%. We are already there in terms of market levels. In a deeper recession the drawdown is closer to 35%-40%, while the in hundred-years flood scenario the declines are around 50%-60%. We had a 100-year flood in 2008 and outside of a third world-war emerging this seems unlikely. However, a solid recession cannot be ruled out given the current economic conditions. Should this occur, the implication for markets is the possibility of another 15%-20% decline before stabilizing. That would put the S&P 500 at 2900, which would be about a 40% decline from the peak. That is not a forecast by any means but a historical benchmark of what could happen if the economy slips into a solid recession.
Going into the last quarter of the year we expect volatility to continue. Looking at past bear market durations, this could extend into next Spring. But that doesn’t mean that it is straight line down. Many of the risk factors we highlighted early in the year are now front and center and any marginal improvement could be very positive for the markets, even if temporary. At the same time, we must be mindful of the Fed’s relentless rate hikes and the negative impact this can have on future economic growth (sharper recession). We also have upcoming mid-term elections. Markets tend to perform better under gridlock conditions and historically markets have been higher after the midterms every year going back to 1942. This makes for a more constructive investment environment than in prior quarters, yet many risks obviously still loom. Also, on the brighter side the bond investments look relatively attractive now. Taken together we need to continue to be vigilant and proactive with rebalancing strategies.
Bear markets test the resolve of almost everyone and can become a battle of attrition as they seem never ending. The good news is bear markets do end, paradoxically when it feels the darkest. With a patient, risk management approach one can not only survive these cycles but be well positioned for what comes after. Ultimately, there will be some incredible investment opportunities as there always is coming out of bear markets.
Thank you for your patience and trust.
The Vigilare Wealth Management Team
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