Markets in Review
The third quarter started with renewed investor optimism but ended with a crushing reminder that the worst is yet to come. The bear market rally that started in mid-June continued through July and into August. However, further signs of sky-high inflation, necessary interest rate hikes, and increasing probability of a “hard landing” and recession in 2023 smashed all hope. Between mid-August and the end of September, the S&P 500 Index dropped almost 17% and closed out the quarter at a new bear market low of 3585.62 (over 100 points below the prior low reached in mid-June).
Once again, almost every market sector suffered this quarter. The S&P 500 plunged down another -5.28% for the quarter to end the year down almost -25%. The tech-heavy NASDAQ fell slightly less at -4.11% for the quarter but is now down -32.40% for the year as the former “tech darlings” of the past decade continue to get dumped by institutional and retail investors alike. The Dow Jones Industrial Average is now down -20.95% for the year after ending the quarter down an eerie -6.66%.
The Russell 2000 Index, which includes 2000 of the smallest companies in the market, also continued its bear-market plunge while finishing out the quarter down -25.86% for the year. Value-based investing, which focuses on buying companies that exhibit quality fundamentals but appear to be undervalued, exhibited slightly worse returns on a relative basis this quarter. The Russell 3000 Value Index fell -6.09% for the quarter vs. the broader Russell 3000 Index which fell -4.85%. Fixed income traders continued to deal with tighter monetary policy including two additional 0.75% rate hikes this quarter which sent yields – which move in the opposite direction of prices – soaring and increasing several Treasury yield curve inversions where long-dated rates fall below short-dated rates. With the background of tighter monetary policy, higher inflation and fears about future economic growth, fixed income in general continued to offer almost no protection for investors looking for cover. The Bloomberg US Aggregate Index, which includes a broad cross-section of U.S. fixed income assets overall, has now dropped -14.61% year to date. So, for the average investor who had passive exposure to the broad equity and fixed income markets in a “60/40” equity/fixed income type portfolio this year, losses of -20% or more are to be expected.
Please Fasten Your Seatbelts…
I didn’t hear anyone tell us to fasten our seatbelts and return our tray tables to their full upright and locked position, but the markets are clearly preparing for a crash landing once again. After the worst first half of a year since 1970, the markets hoped the bear market bottom was behind them as they attempted to rally through July and into August. However, reality set in again with an extremely hawkish Federal Reserve scrambling to do whatever they can now to tamp down inflation from its 40-year highs after flooding the economy with zero interest rates, cheap leverage and manufactured asset price support for way too long.
Federal Reserve Chair Powell initially gave some, probably unintentional, fuel to the bear market rally during a July 27th press conference where he said that interest rates had reached a “neutral level” after having just announced a 75 basis-point rate hike (a basis point is one hundredth of one percent). This led investors to feel that the Fed was signaling that its monetary policy was close to being set to deliver price stability along with maximum employment. In other words, the markets started to think that the Fed was almost done with its tightening cycle and that inflation was expected to drop in the near future. Furthermore, it appeared for the moment that a soft-landing was possible in that inflation could be controlled without causing unemployment or damaging financial instability.
Shortly thereafter, Powell made sure to strongly correct the market’s perspective that a “Fed Pivot” was on the horizon by saying “Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.” Markets tanked on this revision as it became clear that the Federal Reserve’s commitment to fighting inflation was necessarily far from over and would lead to even higher short-term interest rates, lower stock market valuations, and declining corporate profits.
There were other catalysts as well. Reports came in confirming the second consecutive quarter of negative GDP growth. With the economy slowing and disappointing corporate profits looming on the horizon, we seem to already be living in a recessionary environment and potentially experiencing stagflation as persistent inflation exacerbates the declines in growth.
Existing home sales have dropped for six months in a row as borrowing costs have now increased above 7% for the typical 30-year mortgage. Those same higher borrowing costs will also have a major impact on corporations who need to refinance their debt. Unfortunately, it is the weaker companies who typically use more short-term leveraged debt that will suffer the most and we should expect to see bankruptcies and job losses across a variety of sectors. Even though unemployment remains low for now (historically low in fact), headlines have started to come through with companies of all sizes announcing layoffs and hiring freezes.
America is not alone of course. The global economic situation looks even more grim, amplified by an extremely strong U.S. dollar, supply-chain shocks related to the war in Ukraine, increasing geopolitical risks, and sharper than anticipated economic deterioration in China.
In general, we are skeptical of any market bounces right now unless they are accompanied by material improvements in the fundamental macroeconomic outlook. Markets are forward looking and so there will come a time when any future pain is fully priced in. However, the whiplash that occurred during the third quarter was to be expected as there are still a lot of headwinds that the markets have not fully accepted yet. In short, we expect to see continued volatility with some additional bear market rallies that eventually fail until fundamental conditions truly appear to be improving.
Realize that most institutional and retail traders were probably not alive during the extended stagflation and bear markets of the 1970’s. For example, the 1970 bear market took 369 days to reach its bottom. Similarly, the 1974 bear market took 436 days to reach its bottom and then 1,462 days before it finished its recovery! Current traders are much more accustomed to extremely long bull markets where everything goes up, occasionally interrupted by violent selloffs where the recoveries were very quick (like in December 2018 and March 2020). So, we unfortunately suspect that any current rallies are not based on reality, but rather on short-term relatively low impact news headlines along with greed and inexperienced expectations that the worst is behind us now.
Unfortunately, we feel that there is still more pain ahead and that the true bear market bottom has yet to be determined. Of note, the S&P 500 Index has returned a mere 2.21% since the pre-COVID high over two years ago on an annualized basis. With inflation running at 8.5% right now, real market returns are definitely not what they used to be and a lot has to change before we’re singing Happy Days are Here Again! However, we also know that whenever there is a sign of true positive momentum in one or more of the various fundamentals mentioned above, the market is going to rapidly change from preparing for a plane crash to strapping in for a rocket-ship ride to the next bull market.
WBI’s active risk-managed strategies using our proprietary cash hedging technology are designed to help investors navigate the ups and downs of the markets without taking huge portfolio crushing declines. Our first priority is to protect your capital from large losses. Maintaining the largest capital base possible through a bear market cycle is the most powerful way to unleash capital growth and compounding in powerful bull market recoveries that will eventually occur.
As markets recover, and they eventually will, relatively smaller losses are quickly overcome and the miracle of compounding on a larger capital base starts to quickly generate positive growth. At WBI, we take our risk management role seriously because investors have told us for over four decades that they are trusting us with money they can’t afford to lose.
Unless otherwise indicated, the source for all price and index data used in charts, tables and commentary is Bloomberg.
IMPORTANT INFORMATION
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