The media has a history of endlessly repeating the same story again and again until the next hot topic comes along, and now is no exception. If there is a media outlet, magazine, or periodical out there that hasn’t mentioned “inflation” and “recession” dozens if not hundreds of times, I am unable to find it. So, let’s get those two topics out of the way up front: inflation will come down over the next year or two, and in the process the US economy will at some point enter a short and shallow recession. I would gladly go into as much detail as you might care to hear on why I believe those two statements are true, but I will not do so here[i].
Why not? Simple: most of our clients won’t personally be materially impacted by either recession or inflation, so don’t or shouldn’t really care.
Which actually makes perfect sense when you think about it. Yes, we would all rather pay $3 then $8 a gallon for gas, and not see our grocery bill go up 20%. And of course, skyrocketing house prices have caused headaches for those looking to buy a house at a reasonable price. However, we have not heard from our clientele that gas, food, or housing inflation is having a major negative impact on their lives. Likewise, while a recession brings with it higher unemployment, there are currently 2 job openings for every one unemployed person in the United States and, so we are a long way from not having enough jobs for those who want and need to rely on earned income[ii].
What everyone does care, and ask, about is what the inflation/recession combo means for their portfolios, specifically the stock market decline this year, and what to expect/how to position going forward. So I’ll direct my commentary today to that topic, and leave the endless inflation/recession conversation loop to the media.
The S&P 500 has reported its worst first half of the year since 1970 on last Thursday and has declined in value approximately 20% YTD. Since 1945, there have been 14 bear markets, with the average bear market lasting for an average length of 289 days, or 9.6 months. While declining stock prices and perceptions of a weak economy may discourage investors, bear markets have historically created excellent entry points for equities. In fact, over the last 20 years, half of the S&P’s strongest day happened in bear markets, while another 34% of the best days occurred in the first two months of bull markets.[iii]
So what about this bear market? Are we at the bottom? Near the bottom? Already past the bottom? Acknowledging that we never know where the bottom was until long after it passed, my position is that we are much closer to the bottom than the top. The worst offenders of over-valuation from 2021 have seen the largest declines, and I am very comfortable adding to equities at these levels, especially if the market has any additional big drops from here. With the Nasdaq & biotech stock indices down 30% and 60% respectively from their highs, much of the air has been let out of the most over-valued equities, to the point that those areas of the stock market have probably overshot the mark and now offer attractive asymmetric risk return characteristics[iv].
Could the Nasdaq & biotech indices drop another 5% each? Of course, they are both highly volatile and often move up and down that much over a few days. But drop another 20% each? Barring some completely new “tail event” risk coming to pass, I put the likelihood of additional 20% or similar declines in those areas which have already declined the most at close to zero. Many of the companies comprising those two indices are highly profitable, have stellar earnings growth, excellent positioning for the future and, thanks to the recent massive drop in share prices, attractive valuations. Combine that with the trillions in cash sitting on both individual and corporate balance sheets, and it creates effectively a back-drop on how far those companies can drop in value before their shares, or whole companies, are purchased if they become dramatically undervalued[v].
So how bullish am I? From looking at our current asset allocation models, one might assume moderately so. Our flagship Global Dynamic asset allocation model is currently 57% equities, which implies a slight underweight vs. the 60% long term average, but significantly more than the 45-50% allocation we had early in 2021. But that 57% allocation understates our bullish leanings at this point. We have our “finger on the trigger” to increase our allocation to equities, hoping (strangely perhaps) that another market drop from some short-term negative data point will give us an even more attractive entry point. Likewise, in our individual equity models, there are a raft of low-ball limit buy orders in place waiting to be filled if those company shares have another drop. Put another way, we are decidedly bullish at these levels, and think that equities will have and attractive return profile from these levels a year out, and will become, all else equal, even more bullish if the stock market sees another big drop[vi].
A few months ago, when the market was down around 17%, I was called by a client who wanted to deploy a large cash position into equities he had held for that purpose. I recommended he deploy a small portion at that level and hold off on investing the rest in hopes of a larger pullback. He pushed me on what level I would “let” him deploy the rest, so said if stocks got down to a 24% correction I would green light him going “all in”. A couple weeks ago the S&P 500 did indeed, briefly, get down to more than 24% below its high-water mark, so we deployed the rest of his cash, and wanted to increase our equity exposure in our models as well, but equities quickly rallied more than 5% from that level back and have stayed around 20% correction ever since.
We would love to see another pull-back to that level, as a correction of 25% or more would turn us from merely bullish to “Raging Bull”.