An extended bear market can test everyone’s patience and unsettle the most experienced investors. Major indexes have sustained deep losses this year as the Federal Reserve raises interest rates to tame rising prices. Hiking rates is bearish for stocks and bonds. The Fed is now clearly focused on fighting inflation. The shift has clearly contributed significantly to market volatility for both stocks and bonds.
The market wrapped up its third straight quarter of declines and recorded its worst first nine months of a calendar year since 2002. At eight months, the bear market is the longest we’ve seen since 2009. Meanwhile, the Bloomberg U.S, Aggregate Bond Index is on pace for its worst year on record going back to 1976, down more than 16%. Investor sentiment is exceedingly negative and markets are oversold.
There are signs of improvement. Energy prices have declined from their highs, inflation is showing signs that it may have peaked even though it is slow to fall, and supply chain dynamics have improved notably. Other areas are steady such as the U.S. labor market remains tight and services that contribute ~ 80% of U.S. GDP are still robust which indicates Americans are employed and still spending in spite of inflation. Corporate profits remain near all-time highs, and margins have room to give without a contraction. With investor sentiment so negative, even a small change in Fed policy could result in a significant market move.
One of the worst mistakes you can make as an investor is to switch into and out of stocks hoping to avoid an upcoming correction. It’s also a mistake to sit on your cash and wait for the upcoming correction before you invest in stocks. We have explained this before, but it’s worth repeating. A review of the S&P 500 going back to 1954 shows how expensive it is to be out of stocks during the short stretches when they make their biggest jumps. If you kept all of your money in stocks throughout these four decades, your annual return on investment was 11.5%. Yet, if you were out of stocks for the forty most profitable months during these forty years, your return on investment dropped to 2.7%.
We are still emphasizing exposure to high-quality companies that can best ride out a slow growth environment. This year, we have added 14 new companies to the portfolios. There is also some good news with individual portfolio names. For example, Biogen got a shot in the arm from the recent success of an experimental Alzheimer’s drug. The company said the drug lecanemab significantly slowed the disease’s progression in a large study, bolstering its prospect of approval. The U.S. FDA is already reviewing whether to grant conditional early approval for the drug. Shares of Biogen surged 40% on the news.
What’s the case for bonds? First is yields. Right now, yields are quite high. The yield on the 10-year U.S. Treasury note has risen this year to 3.8% from 1.4% on December 31. Even shorter maturities have very attractive yields such as a 3-month U.S. Treasury currently yields over 3.25%, which is far more attractive than holding cash. Second, bonds are typically protective, so high-quality bonds typically go up in value when risk asset classes go down. This year, unfortunately, has been a rare exception. That’s mainly because inflation has entered the equation. Luckily those periods where inflation roils things up the way they have this year are relatively short, and we get past them. So bonds serve a purpose in a balanced portfolio approach even in these challenging market conditions.
In conclusion, this remains a complicated environment as the Fed tackles inflation. As we enter the fourth quarter and the Fed has one remaining meeting at which to hike rates, we expect volatility to subside. We remind clients that the market is forward discounting mechanism. The next twelve months are likely to be better than the last eight. Modest shifts remain the preferred approach in this environment, and we anticipate that the market will reward higher-quality companies, which tend to outperform over economic cycles. Please know that we remain committed to your long-term preservation of capital and upside participation to meet your financial goals. Give us a call if you have questions or would like to schedule a portfolio review.