IWL - Coping With Market Downturns - Staying Invested As Markets Threaten To Decline

Summary

• This can be a challenging market for investors to navigate, especially since many are worried about a possible recession.
• Since pullbacks occur more periodically than investors would prefer, learning to invest through challenging periods is an important part of any investor’s journey.
• Past historical cycles can underscore a few key investment principles that can serve investors well.

By Seema Shah, Chief Global Strategist

The market environment has changed considerably since early 2022, and the possibility of a recession continues to be at the forefront of investors’ minds. Historic levels of inflation drove the United States Federal Reserve (Fed) to tighten financial conditions last year at the fastest pace since the early 1980s, significantly increasing the risk of an economic downturn. Consequently, last year was marked by wild swings across all asset classes and major stock market indices. Consider:

• The S&P 500 dropped into bear market territory in the second half of the year in 2022 (defined as a 20% decline from all-time highs).
• The Nasdaq experienced an even worse decline, sinking 35% last year.
• Other asset classes have too fared poorly - the bond market experienced its worst annual performance in decades in 2022 with a -13% return for the Bloomberg U.S. Aggregate Index.

With the persistence in economic concerns and volatility, some investors may still be tempted to sell - pulling their money out of this seemingly gloomy market. Yet, while downturns can indeed be difficult, and despite how long the last year felt, history shows that they are often shorter-lived than bull markets. While the past is no guarantee of the future, and the exact length of the current pullback is difficult to predict, there are reasons to believe that staying invested in a diversified portfolio is still the best approach for most investors.

S&P 500 price index, recessions are shaded, 1956-present

Note: Bear markets are 20% declines in price from prior peaks. Bull markets begin at each market bottom.

The impact of inflation and monetary tightening

Businesses and consumers alike were challenged in 2022 by the Fed’s attempts to combat rising inflation pressures. In fact, leading economic indicators in 2023 are already residing at levels that are historically consistent with recession. The performance of the equity market, however, has been relatively sturdy considering the headwinds facing the economy:

• Despite 425 basis points (bps) of Fed monetary tightening in 2022 alone, the S&P 500 “only” fell 18% and is still considered historically expensive - likely supported by the fact that aggregate earnings estimates have only weakened slightly.
• This year, not only are further rate hikes expected but, with fears of sticky inflation likely to continue haunting policymakers, the Fed is unlikely to deliver any significant monetary relief even as the economy falls into recession. As a result, markets will likely start shifting their attention to the next serious concern: earnings recession.
• Gross margins are under threat from both tight financial conditions and hawkish banks, as well as tight labor markets.
• With wage growth still so strong and consumer anxieties building, corporate profit margins are being squeezed from both sides, signaling a meaningful fall in earnings that is yet unaccounted for by markets, and will likely heap further pressure on investors this year.

Conference Board LEI year-over-year percent change, recessions are shaded, 1970-present

Making sense of bear markets and recessions

The history of bear markets has been covered in detail by economists and historians, but there is always renewed interest during times of uncertainty. While each situation is unique, with a different set of market and economic dynamics, what matters for investors today are the lessons that can help guide behavior in the months and years to come.

On average, bear markets since World War II have resulted in market declines of 36% - much worse than the 20% threshold that defines the beginning of a bear market. Recent episodes have varied. The dot-com bust of the early 2000s experienced a 49% drop in the S&P 500 and a 79% loss for the Nasdaq Composite, lasting a total of two and a half years. The Global Financial Crisis of 2008 led the S&P 500 down 57%. The crash that followed the COVID-19 pandemic and nationwide shutdown resulted in a 34% fall.

Bear markets tend to occur alongside recessions, since an economic downturn hurts sales and profits, pulling asset prices downward. In some cases, such as during the housing bubble in the 2000s, these problems can spread to other sectors - often referred to as “contagion” - and can result in a bear market that is much worse than the initial problem might suggest. The housing bubble, for example, quickly became a banking and financial system problem due to financial derivatives and trading activity.

The market crash of 1987 was a bit different. On Black Monday, the Dow fell nearly 23% in a single day, while the S&P 500 fell a total of 34%. However, this was primarily a market event and had little to do with the economic conditions of the time. As a result, stocks bounced back quickly, and the market cycle continued soon thereafter. More recently, investors had a similar experience during the pandemic recovery - stocks recovered soon after the economy reopened.

S&P 500 total returns since World War II, the bold line is an average across bear markets

Note: Bear markets are peak-to-trough declines of 20% or worse.

How bad will this economic and market downturn eventually be? It’s always difficult to forecast while events are unfolding, but there are reasons to believe that growth will remain resilient through the first half of this year, with recession only hitting in the second half of 2023. Even then, the recession will likely be shallow and certainly shorter than the nine-quarter recession of the Great Financial Crisis.

• While higher inflation has significantly squeezed U.S. consumer purchasing power, the impact on consumer spending has been tempered by households’ willingness to draw down excess savings. However, excess savings can’t cushion the pain from higher prices forever.
• Strength in the labor market remains key for keeping recession risks at bay. While the labor market will likely slow in the near future, pushing the economy into recession, the elevated level of job vacancies suggests that mass layoffs are unlikely. As such, the recession is unlikely to be particularly deep.
• As the Fed has been raising rates to control prices, mortgage rates have followed suit. Subsequently, mortgage applications, building permits, and housing starts have declined. Thankfully, a housing market crash akin to 2008 is unlikely, as loans today are made to high-quality prime borrowers, reducing the risk that higher rates will trigger a wave of defaults.
• Recessions are typically deeper when there is a credit crunch. However, corporate balance sheets are currently in strong shape, and the maturity profile of corporate debt is fairly benign this year. For low-quality borrowers, although there will be stress, there is unlikely to be a sharp spike in default rates. As such, after a recession has passed, economic recovery should be swift.

Positioning portfolios for challenging market environments

There are no silver bullets for handling market crises. Since pullbacks occur more periodically than investors would prefer, learning to invest through challenging periods is an important part of any investor’s journey. However, past historical cycles can underscore a few key investment principles that can serve investors well:

Stick to a well-crafted financial plan

A plan that considers an investor’s unique situation and goals (rather than being one-size-fits-all) can be the difference between staying the course and making proper adjustments when needed and making the potentially costly decision to flee the market when pullbacks occur. In fact, for long-term investors, when prices are down, inherently, the valuation of investments is more attractive. Today, a valuation level of 18x for the S&P 500 forward price-to-earnings ratio is significantly more attractive than the 21x the market was trading at just a year ago.

Maintain a properly diversified portfolio

Assets often behave differently during changing market environments. In 2008, during the height of the Global Financial Crisis, fixed income returned 5.2%, while large-caps were down 37.0%. Then, in 2020, despite plunging during the depths of COVID, large-caps ended the year up 18.4%, and fixed income 7.5%. Even last year, when it seemed that all broad indices were down, commodities, as measured by the Bloomberg Commodity Index, returned over 15%! This year, while economic weakness likely spells further drawdowns for equities, it should spell good news for fixed income - particularly as additional rate hikes should be limited. Maintaining proper diversification can help reduce the volatility that investors feel, particularly during challenging markets.

Over the past 25 years, the effect of exiting the market the day after a -2% market move or worse, and staying out for each period of time shown. Based on an initial $1,000 investment using S&P 500 returns before transaction costs

Looking through near-term market swings

Focusing on the big picture can help investors to stay on track. The stock market has a long history of rising alongside the growing economy. This has certainly been the case over the past century, during which countless investors have been able to retire due to the growth in the market. However, markets can fluctuate over monthly and quarterly periods. Zooming out at longer time frames can help investors to see the larger patterns that occur over many years and decades.

Staying the Course

This can be a challenging market for investors to navigate, especially since many are worried about a possible recession. Investors ought to apply the lessons learned from previous cycles: stick to a financial plan, stay diversified, and maintain a longer time horizon. Doing so allows investors to not just minimize risks in downturns, but to benefit from eventual market recoveries too.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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