Q2 [Bear] Market Recap, Now What?

Congrats!

Q2 has come to a close and you all have endured one of the most gut-wrenching markets in modern history. That’s no hyperbole, either.

This does not imply we should be fearful. In fact, we are cautiously optimistic (and if you know us by now, calculated in our approach).

Should I be worried about markets?

Cautious, yes. Wary, perhaps. Afraid or worried? No.

Here’s why:

Many of the stocks leading the fall were high flyers during the pandemic, so the pullback could be a healthy correction of overblown prices.
Bear markets don’t last forever. On average, they tend to linger for roughly 15 months. However, the 2020 bear market only lasted 33 days.
Half of the market’s best days have happened during a bear market, so I expect some good days ahead.

To give you some historical perspective here’s what happened during the last few bear markets:

You can see that in a couple of cases, markets bounced back within months. However, the 2008 bear market was a sustained pullback that lasted much longer.

Is history always an accurate predictor of the future? Definitely not. But we can look to it for hints about what may come.

What happens next?

Markets will likely continue to be extremely volatile over the next six months as investors digest the Fed’s aggressive rate hikes as well as concerns about an economic slowdown.

Any market that is so at odds about inflationary growth versus a recession may very well end up somewhere in between- a no-growth low-inflation environment with a minor-to-medium sized recession. We could be experiencing plain-old stagnation before a market reacceleration with low [future] inflation.

So far, GDP estimates are beginning to paint such a picture along with recently reported inflation rates and possibly even disinflation in the near future (a reduction in the rate of inflation). According to the Atlanta Fed, we are likely already in a technical recession, which is defined as two consecutive quarters of negative GDP growth.

Furthermore, the Fed is technically an independent entity (scholars would even argue it’s a private bank), but it faces political headwinds like any other elected or appointed official. If the Fed were to raise the fed funds rate per their forecasts then the U.S. government interest payments on its outstanding debt would actually exceed the budget for national defense in several years. Politicians don’t want to risk losing their positions and could likely push for lower rates and/or a more balanced budget. If you still don’t believe us, observe Powell’s beads of sweat when he speaks before Congress.

This could likely lead to a scenario where the Fed is forced to cut rates earlier than their original 2024 forecast assuming inflation cools off (Powell likes his job title, after all). The Fed may be winning the war against commodity inflation. It is definitely winning its war against housing and rental inflation. It may eventually win against the wage inflation spiral, which can be the most difficult of the three to tackle.

We’ll have to wait and see.

How the Fed Plans to Beat Inflation

Ultimately, the Fed is aiming to reduce the total money supply (defined as M2). One could argue that it needs to revert to the long-term growth rate.

Interesting Trivia:

Developed economies expand their money supply at approximately 6-8% annually in good times. 13-18% in bad times.
Highly underdeveloped economies can grow their money supply 14-30% (sometimes more) per year.
38% of the total U.S. money supply was created in just a two-year span. Reference the charts below (Source: https://fred.stlouisfed.org/series/WM2NS)

“All Models Are Wrong, But Some Are Useful” — George Box

The bottom line is that at these market prices many stocks already reflect a recession. If we merely get a stagnant economy that will then reaccelerate then stocks could go higher. However, if the Fed disagrees and hits us with several more massive rate hikes we will have to recalibrate and we could see some further downside.

Earnings from corporate America are now front and center. By extension, so are their valuations. We can measure this using Price-to-Earnings Ratio (P/E) as the price of the total stock market over earnings. Historically, it’s averaged around 16.6.

In a better context, it would take an investor 16.6 years to recoup their initial investment.

Currently, we are in line with historical averages. The markets are fairly valued at the moment.

What could change is if forward earnings are revised downward by a significant number of companies. Markets can and have historically overextended P/E corrections in bear markets. This makes the markets cheaper for long-term investors.

Benjamin Graham was known for teaching his students (Warren Buffett being one of them) that “in the short run, the market is a voting machine but in the long run, it is a weighing machine.”

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Section 1031 of the Internal Revenue Code provides an effective strategy for deferring capital gains tax that may arise from the sale of a business or investment property. By exchanging the real property for like-kind real estate, real property owners may defer taxes and use the proceeds to purchase a replacement property.

Some key benefits of DSTs include:

No management responsibility.
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Limited personal liability.
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Want to learn more? Reach out to our team with questions. Just hit this link and let us know.

Reassuringly,

Mike Cortes & Gregg Hartmann

Investment Advisor Representatives

Summit Investment Advisors

The S&P 500 is an unmanaged composite index considered to be representative of the U.S. stock market in general. Returns based on closing price performance. Past performance is no guarantee of future results. Indices are unmanaged and cannot be invested into directly. For illustrative purposes only. Chart source: https://www.wsj.com/livecoverage/stock-market-today-dow-jones-bitcoin-fed-rates-06-14-2022/card/how-the-s-p-500-performs-after-closing-in-a-bear-market-yBwgfJwW8HGSNJaKg6LB