We recently shared the below note with our clients and are now opening it up to the broader investor community. Referenced data is as of end of 2Q 2022.
The cacophony of bear market rhetoric is deafening. It consumes traditional and social media. To be fair, it’s perfectly warranted as we are now seven months into a bear market. As we noted in last quarter’s update, the current regime began on, or about, November 10th, 2021, when the FOMC made its most recent hawkish pivot. A few highlights to remind you of an otherwise unpleasant period since then:
In other words, wealth is shrinking, the cost of financing anything is higher, and just existing is a whole lot more expensive than it was seven months ago. We aren’t exactly sure what a “soft landing” looks like, but these stats don’t seem to ‘bear’ it out.
Before we go too far down the bear market rabbit hole, let’s remember that “this too shall pass”. In challenging times, we try to zoom way out to gain perspective. The long-term trend for equity markets is clearly up and all downturns were definitively not permanent. From our extensive research we know that markets are generally driven higher by:
If you believe that corporations will grow earnings and pay dividends, markets should move higher over a long enough time frame. Of course, the trip higher has many twists and turns. Bear markets are a useful, if not painful, byproduct of the accumulation of excesses in the previous bull market. As a result, bear markets are wide-ranging in magnitude, length, and recovery, but they lay the foundation for the next generational bull market. For that, we are very excited!
Nobody truly knows when or where the Bear of 2022 will end. However, as we saw during the bursting of the Tech Bubble, bear markets tend to mess with investors’ psyches through multiple trend and counter-trend moves. Using the S&P 500 Index as a proxy, we have experienced four bear market declines and are probably in the midst of our fourth bear market rally.
The Bear of 2022 is unique in that it is of the inflationary variety. The nuances of this regime tend to be different than say, the Global Financial Crisis, which was more about systemic risk. We haven’t seen a bear market like this one since the 1970’s. As we highlight in a recent piece here, the structural drivers of the current inflation are very different than the 1970’s “Great Inflation”, but it is safe to draw some parallels around how financial assets act in this rare type of bear market.
In Q1, we highlighted three themes that we still think should be top of investors’ minds as we move forward:
Inflation will likely run hot for a while. As highlighted above, inflation has not been ebbing despite the best efforts of monetary authorities to jawbone (the practice of guiding markets through speeches and forward guidance). This is a bit of a problem. Unexpected inflationary pressures introduce tremendous uncertainty into the first two of the market drivers mentioned above—corporate earnings and return of capital through dividends and buybacks. To the third driver, there is a clear historical precedent, multiple compression. This has mostly manifested on the growth side of the ledger over the last seven months.
Fundamentals will matter again. During times of uncertainty, it likely behooves investors to focus on portfolios that are fundamentally sound. Since the beginning of this bear market, low quality and negative earnings stocks have been substantially punished relative to less expensive names that have reliable earnings and dividend streams. The latter category had notably taken it on the chin following the GFC relative to high-flying growth names. With inflation running hot, liquidity contracting, and the cost of capital rising, a more conservative posture seems warranted. We have been waiting quite some time for fundamentals to matter again, so this is another source of excitement that we believe has legs.
Bonds will behave differently moving forward. Another biproduct of unexpected inflation is the re-introduction of a risk premium for fixed income investments. For example, though uncertainty on economic growth has surged since the start of 2022, real yields have risen. This would otherwise suggest that expectations for economic growth were rising. This, of course, has not been the case. It seems more likely that the rise in real yields is a repricing of the risk premium associated with real yields. The disinflation since the bursting of the tech bubble has gotten us a little too accustomed to 1) a risk-free return in safe assets like Treasuries and 2) via the negative correlation between stocks and bonds. Historically, this relationship is generally positive, and notably so in high inflation regimes. This has implications for structuring portfolios that are drawdown sensitive (what portfolio isn’t!?!).
To these themes, we will add a fourth.
International diversification may work again. Following the GFC, policy rates among Central Banks converged around 0%. In retrospect, this was an unsustainable situation in a broadly free-floating exchange rate regime as it implies that economic growth and inflation were static across the global economy. The liftoff from the 0% bound provides greater flexibility for global policy rates to differ based on economic fundamentals. Rather than having a one-way flow of capital to safe-haven U.S. stocks and bonds because there was no alternative, we might see investors evaluate non-U.S. opportunities on their merits, not their monetary policy.
In Q2, we managed portfolios according to our time-tested process—adding and trimming as our factor models suggested while being cognizant of transaction costs and tax implications. We don’t know when the Bear of 2022 will end, but it will probably have something to do with clarity on the monetary and inflation front.
Until then we expect volatility to continue and the dispersion between winners and losers underneath the indexes to remain quite large. Once we settle into some sort of new normal, rates could settle in higher than we have been accustomed to over the last several years and fundamentals will likely remain important.
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MORE ABOUT CANVAS®
CANVAS® is an interactive web-based investment tool developed by O’Shaughnessy Asset Management, L.L.C. (“OSAM”) that permits an investment professional (generally a registered investment advisor or a sophisticated investor) to select a desired investment strategy (the “Strategy”) for the professional’s client. At all times, the investment professional, and not OSAM, is responsible maintaining the initial and ongoing relationship with the underlying client and rendering individualized investment advice to the client. In addition, the investment professional and not OSAM, is exclusively responsible for:
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Model Deviations: As indicated above, OSAM, with minor deviations that it does not consider to be material*, currently use the Models to manage actual client portfolios (i.e., the live Models). The deviations include:
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