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BEAR MARKET Q&A

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Jeffrey Buchbinder, CFA, Equity Strategist, LPL Financial

        

The bear market that started on June 13 has left the S&P 500 Index 23.5% below its January 3 high. After the initial positive reaction to the Federal Reserve’s first 0.75% rate hike since 1994 and tough talk on inflation, heightened fears of recession and that the Fed might “break something” sent stocks down for the 10th week out of 11 for only the second time in history (The first was in 1970). To help investors manage through this difficult period, we answer some of the top questions we’re getting about bear markets and list some things to watch to assess progress toward an eventual durable low.
 

HOW LONG DO BEAR MARKETS TYPICALLY LAST?

The current bear market, which began at the January 2022 highs for the S&P 500 Index, is actually already old by recent standards. At about five-and-a-half months old, it is already older than six other bear markets going back nearly 40 years, with only the 2000-2002 tech bubble and 2008-2009 financial crisis bears lasting longer. This means the bear market may be closer to a bottom than many expect. The average bear market since 1950 has taken about 11 months to mark its low, but six out of the last eight bear markets ended within six months [Figure 1].

How this bear market will end will likely hinge on the pace at which inflation comes down, which will dictate the timing and magnitude of the Federal Reserve’s (Fed) rate hiking campaign. How fast the Fed moves will determine how much the economy slows and whether something breaks (like a large financial institution going under, though that’s not our expectation). If a full-blown crisis and recession such as in 2000-2002 and 2008-09 can be avoided, this bear market may bottom soon.

HOW MUCH FURTHER MIGHT STOCKS FALL?

The average bear market since 1950 has seen the S&P 500 lose an average of about 29% (including the near bear markets that saw declines of 19-20%), as shown in Figure 1. That suggests that if this bear market ends up around the average, that stocks may drop another 5% or so. Based on current economic conditions, one could make the case that this bear market could be shallower than typical bears because consumer balance sheets and the job market are still in good shape, and interest rates are still low by historical standards. At the same time, however, the inflation problem won’t be solved quickly, suggesting we could see a slow bleed and end up down near the average of 30%.

IS THE 60/40 PORTFOLIO DEAD?

Barry Gilbert, PhD, CFA, Asset Allocation Strategist, LPL Financial

Jeffrey Buchbinder, CFA, Equity Strategist, LPL Financial

This year has been tough for investors, not just because stocks have fallen but also because bonds have not helped mitigate those losses as they have historically done. Below we discuss the outlook for diversified portfolios of stocks and bonds to make the case that the 60/40 portfolio isn’t dead. It may have been wounded this year, and took another blow on Friday after the hotter-than-expected inflation data, but we believe the losses in stocks and bonds this year increase the chances of positive outcomes going forward. Long-term investors take note.

TOUGH YEAR FOR THE TRADITIONAL 60/40 PORTFOLIO

It’s been a tough year so far for a traditional “60/40” portfolio, a portfolio of 60% stocks and 40% bonds. Using the S&P 500 Index and the Bloomberg U.S. Aggregate Bond Index (“Agg”) to represent stocks and bonds, the traditional 60/40 was down 15% as of market close on June 10 on a total return basis. If the year ended now, that loss would trail only 2008 as the worst year on record (the Agg’s first year was 1976).

Bonds have typically seen gains during historical periods of equity volatility, although not always. But low bond yields in 2020 and 2021 and steep bond losses due to rising rates in 2022 have led many to speculate that the 60/40 portfolio is dead. But there’s something of a silver lining in the declines. Recent stock and bond losses have improved valuations for the 60/40 portfolio considerably, based on a combination of the price-to-earnings ratio for the S&P 500 and the yield for the Agg. Valuations aren’t an effective market timing mechanism, but they are an important consideration for longer-term return expectations, and that picture has improved quite a bit.

The time to talk about the death of the 60/40 portfolio was six months to a year ago, and even then it was probably exaggerated. The 60/40 portfolio may not get back to the level of returns we’ve seen over the last several decades, but over the last year the 10-year outlook for the 60/40 has improved by about 2 percentage points annualized in our view, about as big a one-year improvement as we’ve seen at any time in the last 20 years, as shown in Figure 1.

ECONOMY SLOWING BUT NOT SHRINKING

Jeffrey Roach, PhD, Chief Economist, LPL Financial

Lawrence Gillum, CFA, Fixed Income Strategist, LPL Financial

Many pundits are issuing recession warnings and saying the economy is heading for a hard landing. Amid the cacophony of voices, we think the economy is slowing just like central bankers want but not shrinking. Further, we argue that a slowing economy is very different than a shrinking one.
 

ECONOMY SLOWING, NOT SHRINKING

We believe the domestic economy will continue to grow this year. Other than the anomaly in Q1 GDP (gross domestic product), we think the economy has sufficient momentum to offset the inflationary pressures. “Our base case forecast includes an inflation rate that moderates as supply bottlenecks improve and we get some closure to the Russian war with Ukraine,” explained LPL Financial Chief Economist Jeffrey Roach. Figure 1 shows our most likely scenario: the economy avoids a recession as forecasted growth approaches 2.6% in 2022 with another downshift to under 2% in 2023.
 

LOOKING THROUGH THE CLOUDS

Jeff Buchbinder, CFA, Equity Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

At the risk of sounding cliché, making the case for stocks to stage a second half rally back to the prior highs requires investors to see through some heavy cloud cover. If you prefer another market cliché, it’s times like these when investors need a crystal ball. We fully acknowledge how tough it is to see the bull case for stocks right now, and a retest of recent lows is certainly possible, but this week we lay out the bull case for the second half of the year. It starts with inflation.
 

THE WALL OF WORRY IS TALL

Needless to say, it’s been a tough year. The S&P 500 Index started 2022 with its worst first 100 days since 1970. There is no shortage of bearish headlines. Some of the smartest investors out there are urging caution and calling for recession (though Warren Buffett has been buying). The anxiety among investors is understandable given stock market losses, sky-high inflation, and rising recession risk. Consumer buying power is being eroded by sharply higher prices. The stimulus cavalry is not coming to the rescue. Wages are rising, and while good for consumer buying power, that worries the Federal Reserve (Fed). Materials and transportation costs are rising rapidly as supply chains remain snarled and China’s lockdowns are ongoing. It’s tough out there.

Adding to the angst, the Fed’s track record of fighting inflation without causing a recession is not good. More often than not, its rate hiking campaigns have preceded (or caused) recessions—though typically at higher interest rates than we are seeing today. Nonetheless, high inflation has been a common ingredient in recessions since WWII—see the 1970s, early 1980s, early 1990s, and even 2008. Simply put, the Fed is fighting an uphill battle.

So how can we still like stocks here? We’ll give you three key reasons.
 

BULL CASE #1: INFLATION PRESSURES WILL LIKELY EASE

The amount of time it takes for stocks to return to prior highs will be determined by the path of inflation. LPL Research expects perhaps 1.5 percentage points to come off core consumer prices by year-end—the latest reading for the Fed’s preferred inflation measure, the Core Personal Consumption Expenditures (PCE) Index, excluding food and energy, was 4.9%.

It’s fair to say a lot has to go right for that to happen, including easing supply chain disruptions, more workers entering the labor force, and a cease-fire in Ukraine. But our view is progress on these fronts over the next seven months is more likely than not. As shown in Figure 1, lower inflation tends to bring higher valuations.

DAWN OF A NEW ERA FOR BONDS

Lawrence Gillum, CFA, Fixed Income Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial
        

Core bond investors have experienced the worst start to the year ever. However tough this year has been so far though (and it has been tough), the potential for future returns has improved meaningfully, in our view. Starting yields tend to be a good predictor of future returns and have become more attractive in a number of markets recently. With yields on most fixed income markets moving sharply higher, now could be a good time to revisit fixed income markets.
 

REASONS TO OWN CORE BONDS?

For us, the value proposition for core bonds (as defined by the bonds within the Bloomberg Aggregate Bond index) is that they tend to provide potential for liquidity, diversification (to potentially counter equity market risk), and positive total returns to portfolios. Unfortunately, none of those values are 100% certain all the time. Like all markets, fixed income investing involves risks and at times, negative returns. However, despite the historically poor start to the year, the value proposition for core bonds has actually improved recently. Investing is a forward-looking exercise, and with the back up in yields already taking place this year, we believe now could be as good as it’s been in quite some time for core bonds.

Importantly, yields are moving higher because of the expectations of higher short-term interest rates and not an increase in credit risk. Coming into the year, markets were only expecting one or two short-term interest rate hikes by the Federal Reserve (Fed) this year with most of the hikes expected to come in 2023. However, markets have aggressively re-priced the number of expected Fed rate hikes and now expect as many as 11. As such, the yield on the 10-year Treasury security has doubled this year after increasing around 100 basis points (1.00%) off its lows in 2020. The 260 basis point (2.6%) move higher that has already taken place this cycle is the biggest move higher in yields since 1994, when rates moved higher by 280 basis points—and that was at the end of the rate hiking cycle. With so many rate hikes priced in at this point, we think the worst is behind us.

So have rates peaked? Historically, rates have tended to move a lot before the first rate hike, (like they’ve already done this year) but they still move marginally higher throughout the rate hiking process and don’t actually make a top until the Fed stops raising rates. This cycle has only really just started. That doesn’t mean we will see significantly higher yields—we don’t think we will—but we could see 3.25-3.35% on the 10-year this year, which would likely be the top in yields for this cycle, in our view. However, we still expect yields to trade in a range between 2.75-3.0% for most of the year and then fall slightly from current levels throughout the year with the 10-year Treasury yield ending the year around 2.5%. So, as mentioned, we have seen a big move higher in rates this year but we do think the worst is behind us.
 

NO MORE TINA?

TINA, or “there is no alternative,” has been a big reason diversified asset allocation portfolios have been overly geared towards equities over the past few years. The relative attractiveness of equities over fixed income was undeniable when interest rates were hovering around all-time lows. Now interest rates have moved higher recently, though the relative attractiveness between the two broad asset classes is much more balanced (albeit still leaning favorable towards equities by at least one measure as we explain in this blog found here).

But, for investors unwilling or uninterested in taking on additional equity risks, there are a number of fixed income markets with yields trading above long-term averages. As seen in Figure 1, the yield-to-worst on most fixed income asset classes is hovering around the highest yields we’ve seen in a decade. And for the Bloomberg Aggregate index, which is the broad based core bond index, outside of two months in 2018, yields are the highest they’ve been since 2010. Since starting yield levels have been a good predictor of future returns (see below), with yields increasing meaningfully this year, future returns look more attractive than they have in years. With interest rates so low over the past few years, the back-up in yields could be an attractive opportunity for suitable income-oriented investors. And while we can’t guarantee that interest rates won’t go higher, at current yields, the risk/reward for owning fixed income has improved, in our opinion.

CORPORATE AMERICA DELIVERS, MARKET ATTENTION FOCUSED ELSEWHERE

Jeff Buchbinder, CFA, Equity Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

First quarter earnings season was solid by just about any measure, but based on recent market behavior it’s obvious that in general market participants paid little attention. This is a macro-driven market, so it will likely take positive macro developments, i.e., better news on the inflation front, to turn stocks around. However, these results are impressive on their own and shouldn’t hurt the case for the bulls. The question is when will the micro stop getting drowned out by the macro.
 

BY THE NUMBERS

In our earnings season preview, we expected a high single-digit increase in S&P 500 Index earnings for the quarter, and that is what we got. The consensus estimate coming into reporting season was calling for a 4.7% earnings gain, and now it looks like 10% is possible with more than 40 index constituents still left to report results [Figure 1].

HAVE WE REALLY SEEN EXTREME PESSIMISM YET?

George Smith, CFA, CAIA, CIPM, Quantitative Strategist, LPL Financial

Scott Brown, CMT, Technical Market Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

It’s been a very tough start to the year with both stocks and bonds down sharply. Adding to the “wall of worry” for investors are the highest levels of U.S. inflation in decades, an aggressive Federal Reserve (Fed), Chinese lockdowns, and continuing war in Europe. So perhaps it is no surprise that investor sentiment polls are showing signs of extreme pessimism. Extremes in sentiment tend to be contrarian indicators for the stock market over the short-to-medium-term, but have we really seen extreme pessimism yet? Below we look at some of the latest investor sentiment data and share our thoughts about the disparity between what investors are saying and what they are actually doing.

WHAT INVESTORS ARE SAYING: EXTREME PESSIMISM

When investors are asked their opinions about the outlook for the stock market, recent responses have been very bearish. The sentiment data derived from these surveys and polls has in some instances reached multi-decade levels of pessimism (which as a contrarian signal would be positive for markets):

WHY YOU SHOULDN’T SELL IN MAY THIS YEAR

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Jeff Buchbinder, CFA, Equity Strategist, LPL Financial

“Sell in May and go away” is probably the most widely cited stock market cliché in history. Every year a barrage of Wall Street commentaries, media stories, and investor questions flood in about the popular stock market adage. In this week’s Weekly Market Commentary, we tackle this commonly cited seasonal pattern and why it might not play out this year, similar to recent years.
 

THE WORST SIX MONTHS OF THE YEAR

“Sell in May and go away” is the seasonal stock market pattern in which the six months from May through October are historically weak for stocks, with many investors believing that it’s better to avoid the market altogether by selling in May and moving to cash during the summer months.

BUSINESSES AND CONSUMERS LIKELY PROTECTED FROM NEAR-TERM RECESSION

Jeffrey J. Roach, PhD, Chief Economist, LPL Financial

Lawrence Gillum, CFA, Fixed Income Strategist, LPL Financial

Not all recessions are created equal. Previous downturns in the U.S. were prompted by various shocks, with the most recent recession started by health and government-induced shutdowns. Other recessions started in the corporate sector, whereas some started from commodity shocks. The next one could start from geopolitical tensions. Nonetheless, we think the current business and consumer environments are safe from near-term recession risks.
 

NOT ALL RECESSIONS ARE CREATED EQUAL

Recessions are sometimes difficult to describe, let alone predict. Definitions vary widely. To make matters worse, some coin their mixed forecasts as a “growth recession.”1 Some simply describe a recession as two consecutive quarters of negative economic growth, which is clearly not true because the 2001 recession was shorter: growth in the first quarter of 2001 declined by 1.3% annualized but between strong quarters both grew above 2%.

The National Bureau of Economic Research (NBER) is the official arbiter of recessions and their definition is not much better. “A recession is a significant decline in economic activity spread across the economy and that lasts more than a few months.”2 The NBER specifically looks at economic indicators such as production and employment. Because the definitions can be elusive and ambiguous, we think it behooves investors to focus on the overall trajectory and economic environment for both businesses and households.
 

THIS TIME IS DIFFERENT, OR IS IT?

As we emphasize above, each recession has different causes and different impacts, but one thing that is not different is the required analysis. Whatever the circumstance, investors should look at multiple signals, not just the infamous and often misused inverted yield curve indicator. Our base case is the domestic economy will weather through this current storm of elevated prices, geopolitical risks, and clogged supply chains. Serious risks remain, but we think business and consumer metrics support our base case thesis that the U.S. will not fall into recession this year.
 

CONSUMERS ARE MUCH LESS LEVERED THIS TIME AROUND

After the Great Financial Crisis, consumers started deleveraging. Both the Debt Service Ratio and the broader Financial Obligations Ratio gradually declined and remained steady until the emergence of COVID-19. Government pandemic assistance programs including stimulus and forbearance periods added volatility to consumers’ financial obligations, but if consumers are able to keep relatively low debt levels, we think the consumer can successfully navigate a period of rising borrowing costs without squelching spending.

WHAT TO WATCH THIS EARNINGS SEASON

Jeff Buchbinder, CFA, Equity Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

First quarter earnings season is rolling. BlackRock, Delta Airlines, Goldman Sachs, JPMorgan Chase, and Morgan Stanley were among the first 16 S&P 500 companies to report March quarter results, following 20 index constituents with quarters ending in February that had already reported. Below we preview earnings season, highlight what we are watching, and share our latest thoughts on the 2022 profit outlook.
 

WHAT TO EXPECT

We expect corporate America to again report earnings above consensus estimates in the first quarter. The consensus estimate is now calling for a 5% year-over-year increase in S&P 500 Index earnings per share, not an easy target by any stretch [Figure 1].