2023-06-06 14:59:22 ET
Summary
- When analyzing stock performance, it's essential to consider the effects of inflation.
- Money illusion refers to the tendency of investors to focus on nominal returns rather than real returns.
- The current real drawdown for the S&P 500 Index stands at -15.6%, while the NASDAQ is at -17.4%.
Don't part with your illusions. When they are gone, you may still exist, but you have ceased to live. - Mark Twain
Despite claims that we are in a "new bull market," a closer look at the numbers reveals a different story. In real after-inflation terms, a bear market is still very much underway. Investors may be falling for classic money illusion, driven by charts looking like we are in a strong uptrend for both the NASDAQ ( QQQ ) and S&P 500 (SP500). However, when considering the impact of inflation and the possibility of an incoming recession, the true state of the market becomes clearer.
Inflation's Impact on Stocks
When analyzing stock performance, it's essential to consider the effects of inflation. Inflation erodes the value of money over time, which means that nominal returns may not accurately represent the real gains or losses experienced by investors. To account for this, investors should focus on real returns, which are adjusted for inflation.
The current real drawdown for the S&P 500 stands at -15.6%, while the NASDAQ is at -17.4%. To recover to real highs, the S&P 500 would need to surge by +18.5% at 0% inflation or +24.7% at 5% inflation. Similarly, the NASDAQ would have to rise by +21.1% at 0% inflation or +27.4% at 5% inflation. With a potential recession looming, achieving these gains becomes an even more daunting task.
Money Illusion and Nominal Returns
Money illusion refers to the tendency of investors to focus on nominal returns rather than real returns. This can lead to an inaccurate perception of market performance, as nominal returns do not account for the impact of inflation. I understand we trade and invest based on nominal, but the reality is that what matters is real return. The perception and optimism isn't match by high inflation reality.
The Presidential Cycle and Post-Pandemic Market Dynamics
Historically, pre-election years have been among the strongest in the presidential cycle for stock market performance. However, post-pandemic market dynamics have disrupted traditional cycles, making it difficult to predict whether the real bear market is truly over. We can see that by looking at small-caps ( IWM ), which are unequivocally not behaving according to history at this point in the cycle. Investors should exercise caution and adapt their strategies to account for these changing market conditions, and not get caught up in the narrative of the moment.
What To Do About It?
If I'm right, and we are actually still in a bear market, that suggests that defensive sectors like Utilities ( XLU ), Healthcare ( XLV ), and Consumer Staples ( XLP ) still have the potential to outperform, while cyclicals struggle on recession reality. Investing in defensive stocks, which are less impacted by changing market trends, can provide relative stability in a bear market.
Conclusion
The current state of the market, characterized by stocks struggling in the face of inflation and money illusion, serves as a reminder for investors to focus on real returns rather than nominal figures. With the potential for an incoming recession and the disruption of traditional market cycles, it's crucial for investors to adapt their strategies and stay informed about market developments. We are not out of the woods, risk remains very real, and path matters more than prediction. You can't invest properly unless you define the current cycle correctly. And I'm not convinced the cycle has changed just yet.
For further details see:
The Real Bear Market: Everyone Is Falling For Money Illusion