It's a Great Time for Investors to Look for Opportunities
The inflation-related bear market in stocks and bonds continues as we enter the fourth quarter. These periods remind us that in the long term stock and bond prices are driven by underlying economic fundamentals and, in the short term, by investor psychology. Though there have been rallies in both stock and bond markets throughout the year, anyone who "bought into the dips" was mistaken, as the longer-term trend has been downward. A good reason for this lies within the fundamentals of the global economy and inflationary forces. Every investor should consider: Is the bear market in stocks and bonds still intact? And are we getting closer to the end of the bear market? To both of these, we think the answer is yes. Let’s dive in and examine some critical data points.
The Current Bear Market Heads Toward Its Ugly End!
Bear markets can be painful for investors who do not use risk management tools. They can seem like they last years, however, historical bear markets last somewhere between nine and fifteen months. That’s right – months, not years. Since financial markets discount the economy’s future potential growth, interest rates, and corporate profits, it does not take long for prices to head toward their final destination. In this case, that could mean slower growth or, more likely, a global recession. Therefore, financial markets arrive at a bottom during a recession and begin their recovery before it is over. The fact that almost all global central banks, including our Federal Reserve, are committed to a policy of raising interest rates to extinguish inflation, enhances the risk of a global recession. In terms of this bear market, our research suggests that we are about two-thirds to the end, both in time and stock prices. As we enter our tenth month, with indexes down between 25-35%, we can envision the possibility of another 10-20% decline over just a few more months. This decline is typical of recessionary bear markets and is a reminder to maintain our defensive posture. At the same time, we are ready to "scoop up" some incredible values that these lower prices will provide in high-quality companies. The good news is that we are almost there!
High Inflation in the Rear View Mirror
As we head toward the end of the bear market, one thing is certain: inflation will fall. In fact, it has already begun declining although at a slower pace than policymakers wish for. Fed Chairman Powell has made it clear that they will do everything it takes to increase interest rates to squash inflation – even at the risk of pushing the economy into a recession – which we believe is quite likely. Based on our research, we see the economy contracting and inflation declining to a rate of around 4% over the next couple of quarters and further over time. This rate of inflation, along with lower stock prices, will make equity markets very appealing for future growth and returns on bonds much more attractive not just in terms of yield but also price. Things are headed in the right direction!
The 5 Big Factors that can End the Bear Market (Updated)
A few of these factors have improved since our last update and continue to move in the right direction.
- Inflation has peaked, and we expect it to decline further – a positive.
- A recession now appears to be highly likely – this helps us calibrate the extent of market decline.
- Equity market valuations have declined – but are not yet at bottom levels.
- Investor sentiment indexes are still a little too complacent – but improved.
- Geopolitical tensions have not improved significantly.
Getting Ready to Change Our Defensive Posture
Although many investors think we are in a "crisis" with inflation and interest rates, we would strongly suggest that this is a business cycle phenomenon and one that has occurred several times throughout history – the late ’70s being the most recent example. As in prior cases, economies recede to ward off inflation, equity markets decline, the economic cycle is reset, and a new business cycle and bull market ensue. As you know, we have maintained a very defensive posture in your portfolio with much less stock exposure, short positions, lots of individual bonds, and exposure to the stability of the U.S. dollar. As we approach the end of the bear market, we stand ready to become more growth-oriented by increasing your stock exposure and removing the short positions. Thus, we have created the ideal Bull Market Recovery Portfolio. It is an exciting list of some of the best companies in the world from the technology, telecommunications, consumer discretionary, and financial sectors. Many of these stocks are down 25-60% from their previous highs, and we are confident they will be rewarding investments over the next few years.
Current Portfolio Holdings
You own just a handful of stocks at this point, all of which are high-quality businesses. Given that we are getting closer to the end of the bear market, we do not see a reason to sell these stocks at this time. Even if they fall further, they will have little effect on your overall portfolio, and we want to own them as we enter recovery mode.
Re-Entering the Stock Market in Recovery Mode
Buying stocks at what we believe will be the bottom can be tricky, but we are up to the task and have done so successfully in prior cycles. The key will be to re-enter at good values and to do so in phases – not all at once. In many respects, our initial purchases will be tests of whether the market has truly bottomed out. Therefore, we will only buy ½ of the shares of a handful of companies to begin and will add a stop loss to each. Doing so will allow us to monitor their behavior and adjust the position based on changing market conditions. This process of phasing in with stop losses orders is a prudent way to manage the re-entry in a risk-managed fashion.
Taxes and Availability of Funds
Keep in mind that to mitigate your downside risk, we sold stock earlier this year before additional market decline – this is the best way to manage stock market risk. However, these sales created capital gains taxes in your taxable account(s). In most cases, the capital gains you pay are between 2-4% of your total portfolio value, which pales in comparison to the declines this bear market may see before its end. Remember, we will keep sufficient funds available for any tax payments you may have.
The Power of Recoveries!
Once the bear market comes to an end and a reset of the business cycle is in sight, the power of the stock market’s recovery can be just stunning – often exceeding 30% in just the first year. This recovery is not to be missed and is something we should look forward to sometime next year.
We hope this update is helpful for you. Over the next few weeks, market conditions may worsen before they improve but remember that our team has positioned you in a conservative portfolio and stands ready to participate in the eventual recovery. Please let us know if you have any questions or if your financial circumstances have changed.
Thank you for your continued confidence in our work,
Your Team at MSR
If you know of friends or family that can benefit from a no-cost portfolio review, please do not hesitate to reach out.