Q3 Review: Searching for Direction
October 4, 2022
by Jordan Hucht, CFP®, ChFC®, AIF®
At the year’s mid-point in June, the bear market was born when the S&P 500 declined more than 20% from its January peak, reeling from fears of deep-seeded inflation and the reactionary monetary policy response. With the Fed turned as hawkish as we’ve seen in decades and rates rising rapidly, the market’s valuation understandably contracted, as detailed in my last newsletter, Understanding the Bear.
In the quarter that followed and just concluded, the market clawed back much of its losses on hopes of earnings strength, declining inflation, and the Fed being more bark than bite. Then the August inflation report, coupled with Fed Chair Jerome Powell’s hawkish comments at Jackson Hole and at the September Fed meeting, brought the market back to its June lows.
After a quarter full of headlines and big market swings, we’re basically back to where we were, searching for direction as the market tries to predict the outcomes of the Fed’s tightening cycle.
With all the volatility and scary headlines, it’s understandable to be concerned. To that end, the two questions I hear the most are, “when will the market bottom?” and “what does this mean for my money?” So, let’s take a close look at both questions and dissect the answers.
When will the market bottom?
First, this question, of course, is impossible to answer with any precision. Calling market tops and bottoms is a fool’s errand and frankly shouldn’t be the primary driver of investment decisions. There’s an old saying that “time in the market” is more valuable than “timing the market,” and as simplistic as that sounds, it holds some truth. But just because calling a market bottom is near impossible, that doesn’t mean we can’t consider some reasonable bounds as to when things are likely to turn around.
To do so, let’s triangulate a frame of reference by looking at history, technical factors, and fundamentals. To give us historical context, we can consider the 12 bear markets (S&P 500 declines of more than 20%) in the post-World War II era. The average decline was 33.6%, with an average duration (from market top to market bottom) of just over 12 months. The current market decline (as of the time of this writing) measures 24% and has lasted 9 months. In that sense, we’re approaching average. Every bear market’s set of circumstances is unique, but from a numerical perspective, the current situation is not markedly different from what we’ve seen many times in the past.
There are several technical factors that are considered to be indicative of a market bottom, as they tend to signify a period of capitulation – a sort of “throw in the towel” moment when fear takes over and high-volume, broad-based selling occurs. One way to measure the fear in the market is through the VIX, which essentially gauges the expected near-term market volatility based on options contracts. The higher the VIX, the higher the level of concern among investors. Looking at past market bottoms, the VIX has consistently spiked to a level above 40, in essence signaling a capitulatory moment. So far this year, the VIX has hit the mid-30s several times but has not yet breached 40. To be clear, 40 is not a magic number that has any inherent meaning; rather, this is to say that the perceived fear in the market has not yet been as high as in past bear markets, but it’s been close. The takeaway here? The situation usually seems most dire just before things turn around.
Finally, and I’d argue most importantly, let’s examine fundamentals. As I wrote about in detail in last quarter’s newsletter, the market’s decline so far has been a product of multiple compression. With interest rates near zero, the market was trading at about 21 times expected earnings at the start of the year. With interest rates climbing at the fastest pace in decades, the market now trades at about 16 times expected earnings. That’s a roughly 24% decline in multiple, basically the same percentage decline of the market’s price this year. In other words, we’ve seen the market’s valuation come down but not corporate earnings expectations. Not yet, anyway.
Monetary policy works with a lag. It takes time for changes in monetary policy (interest rates and the money supply) to work through the real economy. Many argue the Fed waited too long to tighten policy, allowing inflation to become much more pervasive than the Fed initially claimed, and now is going too far, too fast in the other direction and will crush the economy. I’m not necessarily making that claim, but I’ll say this: hindsight is 20/20 and the Fed has a tough job. However, it’s undeniable that implementation of the Fed’s (and central banks around the world) monetary policy shift has wreaked havoc on not just the stock market, but also bonds, currencies, real estate, and other assets.
The results of monetary policy changes are often not apparent for months. That’s why there’s so much uncertainty right now.
So what’s going to eventually be the determinant of the market’s direction from here? In my opinion, it’s two things: (1) how high do rates go before the Fed pauses and (2) how much damage is done to the real economy between now and then? The former will inform the market as to the appropriate multiple, and the latter will dictate the earnings to which said multiple is applied.
At its September meeting, the Fed forecast the Fed funds rate to top out around 4.6% early next year, higher than was forecast after the July meeting and substantially higher than was forecast earlier this year, not to mention last year. Why do I bring that up? Because forecasts are just that, and they’re often wrong, as we’ve seen repeatedly over the past few years. Again, monetary policy works with a lag. There appears to be real-time indications of cooling inflation (e.g., commodities, energy, housing, etc), but it’ll take time for those to show up in the official inflation numbers. The Fed doesn’t meet again until November, and a lot can change between now and then. In the meantime, the bond market will be forming its own conclusions, and it’s going to be hard for the stock market to stabilize until the bond (and currency) markets stabilize.
On the earnings front, things may become clearer in the coming weeks as companies begin reporting their Q3 results and outlook for next year. It’s widely expected that the current estimates for 2023 earnings are too high and will be marked down. That was also expected to some extent during Q2 earnings season, but it didn’t really happen, which was one of the reasons for the market’s summer rally. I’d argue that the market has already discounted some amount of negative earnings revisions, but not as much as we’d typically see in a recession. The month of October will likely be very telling as we begin hearing from the country’s biggest companies.
Remember that consumer spending drives the majority of the economy, so the strength of the consumer is the linchpin to economic growth (or contraction). The strength of the economy at the moment lies in the labor market, with the unemployment rate at 3.7%. The Fed expects that number to increase as companies cut jobs and more job seekers come into the market (i.e., increasing the labor participation rate). Some amount of deterioration will aid the fight against inflation, but too much will lead us into recession.
What does all this mean? Until there’s more clarity on the fundamentals, expect volatility (in both directions) to continue. Fortunately, I think we’ll know a lot more in the coming months.
What does this mean for my money?
It’s been a challenging year across asset classes, with stocks and bonds both poised for their worst year in quite some time, challenging the resolve of investors. The year’s story isn’t completely written, and the fourth quarter brings with it positive seasonality and mid-term elections against the aforementioned macro backdrop. Nonetheless, this will almost surely be a negative year for most investors.
The goal of investing is to meet future cash flow needs and build wealth. Investment returns aren’t linear, and there will always be years like this. Over time, though, the good outweigh the bad, making achieving long-term goals possible. In our financial planning work, this is why we put so much emphasis on randomizing rates of return within the bounds of each asset class’s historic volatility. Doing so allows us to forecast a range of likely outcomes so we can assign levels of confidence in meeting future goals. In fact, this year’s volatility has been rational – stocks have been more volatile than bonds, growth stocks more so than value stocks, small-cap stocks more than large-cap stocks, and so on down the list. In that sense, we’ve planned for environments like this.
Bear markets also present opportunities. Deploying new cash into the teeth of a bear market can seem risky, but the long-term rewards can be substantial. Doing so, however, requires discipline and a steady hand, as it’s sure to be a bumpy ride with many head fakes along the way. The reality, though, is that the worst markets create the best opportunities.
One the fixed-income side, the future looks brighter than the recent past. For years, bond returns have left much to be desired, with low interest rates generating little income for investors. With the onset of tighter monetary policy and higher interest rates, bonds are now offering meaningful returns. That’s good news for balanced portfolios, as the conservative part of the allocation now seems poised to be accretive to total return, as opposed to merely providing ballast (as has been the case in recent years). Beyond stocks and bonds, alternatives also offer some of the most interesting opportunities we’ve seen in some time.
Investing is a long-term endeavor. Real wealth is created and maintained by making consistent, prudent decisions and having the patience and discipline to reap the long-term rewards. If sound financial planning is driving investment decisions and portfolio allocations, long-term outcomes should remain intact, even during bear markets. And remember that the passing of every bear market in the past has given birth to the next bull market and eventual new highs.
Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser.
Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results.