I have to say, January could not end soon enough for me. As many of you know, we have been managing money professionally for a long time – and in all types of environments. Difficult market conditions are to be expected and are part of investing. To be successful over the long term, you must be able to weather the bad times in order to be there for the good times. Like everything else in life, nothing worth doing is easy and your outcomes are a direct result of your effort. Unfortunately, enduring pain is part of the effort.
All of us got a real dose of what I am talking about during the past four weeks. Depending on which assets you are looking at, January was the worst start to a year in history. For me personally, the current environment is equaled only to a several week period in the last half of 2018 in terms of protracted losses across all major asset classes. During that time, stocks dropped more than 20%. Sure, there have been faster declines and more noteworthy events… The 2008-2009 financial crisis was tough and lasted for many months. The March 2020 COVID-19 pandemic was a true black swan event and rivaled the 1929 and 1987 crashes in terms of steep drops. Over the past decade, we have seen the taper tantrum of 2013 and the Chinese currency crisis during the summer of 2015. These as well as lots of other corrections and bear markets in stocks have occurred and are an omnipresent part of the investing landscape. What makes this time and 2018 unique is that all assets converged and headed down together, unabated for several weeks. Safe positions that are designed to protect you when risk assets fall don’t do much protecting when they converge and behave the same way. For a period, there becomes no place to hide. What makes this month’s selling even more unusual is that it happened when the broad equity markets were at or near all-time highs. Earnings have been good – really good and rising. Earnings drive stock prices. Bear markets happen when earnings drop, not when they are going up. Earnings were also rising heading into the last half of 2018.
So, what is different about January 2022 and the last part of 2018 that would cause all this sudden and comprehensive pain? The answer is, as I see it, interest rates. And more particularly, interest rates’ response to rising inflation. When inflation rises, two important things happen. The first is the markets themselves (investors worldwide) begin repricing assets and looking at things like input costs, which are tied to those assets. When costs rise, it impacts the relative attractiveness of assets. Some become more or less attractive when compared to others. Stocks in particular can become less attractive because it costs more for companies to run their business. If they don’t pass those costs on to customers in the form of higher prices, they lose their ability to generate profits (earnings). The second thing that happens is the Federal Reserve steps in and tries to slow inflation down by raising borrowing costs (short term interest rates) in order to reduce consumer demand. Both circumstances work together to cause interest rates to rise. It is at this juncture when asset classes like stocks and bonds tend to converge and go down together. Stocks get sold because of the forecast difficulty continuing to generate earnings. Bonds get sold because as yields rise, they become less attractive. After all, who wants a bond earning 1% when interest rates are at 2% and new bonds are being issued at the higher rate. This is why bond prices move opposite to bond yields. The effects of all this ripple through almost everything else in the same fashion.
Below I have provided an updated end of month summary of the approximate returns for the major asset classes since their recent highs. I am referencing corresponding ETFs for each:
- Large Cap US stocks (SPY): -6%
- Blue Chip US industrials (DIA): -5%
- Large Cap US Technology (QQQ): -11%
- Small Cap US stocks (IWM): -17%
- US Transportation stocks (IYT): -8%
- US Real Estate stocks (IYR): -9%
- US Financial Stocks (XLF): -6%
- 20 Year Treasury Bonds (TLT): – 9%
- 10 Year Treasury Bonds (IEF): – 4%
- Emerging Market stocks (EEM): -6%
- Gold (GLD): –1%
About the only thing that didn’t get sold was energy (XLE), which is up 18%. I believe the reason is that energy prices are a symptom of inflation. Energy, along with other commodities, are the input costs!
So where does that leave us today? I cannot predict the future, but I can give you my thoughts. I will start with what happened in 2018. Rates jumped in response to rising inflation and the prospects of the Federal Reserve raising rates throughout 2019. Bonds began selling off first, along with other interest rate sensitive assets (preferred stock and real estate). Stocks turned down next and all types dropped and kept dropping. Then bond prices suddenly bottomed, and prices began to rise. Yields (interest rates) followed suit and began falling. Like clockwork, stocks then bounced from very oversold conditions at the end of December. Low and behold inflationary pressures dropped and the Federal Reserve backed off. Money rotated back into stocks while bond prices continued to rise as yields dropped; and 2019 turned out to be a great year for domestic investors of all types.
I don’t have any idea if we are set up for a similar happy ending, but I do believe that money must flow somewhere in search of yield. If inflation persists at 4% or 5%, investors can’t park themselves in money market accounts earning next to nothing. I also believe the bond market will lead the way. Look there first for clues that inflation has subsided. When rates stop rising, we will know. In the meantime, if earnings remain robust and growing, we know the cyclical bull market continues and stocks are likely to be the place to go in search of real return. Maybe not all stocks, but the good ones with positive earnings and cash flow. At the end of the day, you don’t have to be perfect. You want to avoid catastrophe and give yourself an opportunity to stay in the game for when things improve. It’s kind of like the joke about two guys camping in the woods when a grizzly bear walks up. One guy starts putting on his shoes. The other guy says, “You can’t outrun a grizzly bear.” The first guy says, “I don’t have to…I just have to outrun you.”