In January, we delivered our annual outlook seminar. As is our custom, we described the range of risks and uncertainties we faced entering the New Year. We highlighted supply chain issues, the potential for persistent inflation, and geopolitical concerns including escalating tensions between Russia and Ukraine. We acknowledged that there were plenty of circumstances that might test our discipline in the year ahead and unfortunately that has been the case in the first half of the year.

In this update, we offer historical perspective on the current market experience, highlight issues likely to shape the path forward (for better or worse), and evaluate the likelihood of a recession. Most importantly, we remind our clients that maintaining discipline during periods of uncertainty is the most reliable course for growing and preserving wealth.

Double Negative?

Thus far, 2022 has been difficult for investors, offering limited opportunities for positive returns. Year-to-date, global equities are down about 20%. Domestic large caps, as measured by the S&P 500, are down 20.0%, while developed international and emerging market stocks are down 19.6% and 17.6%, respectively. At the same time, fixed income categories are down 7% to 14% as key rates have climbed from 1.5% starting the year to 3.0% at the end of the first half.

Historically speaking, it is rare for stocks and bonds to fall together. The table below illustrates returns for both asset classes over rolling six month periods. The upper right quadrant, which contains the vast majority of the plot, represents periods where both stocks and bonds moved higher. Most other points fall into the top left (bonds up, stocks down) or bottom right (bonds down, stocks up) quadrants highlighting the benefits of diversification. Very few points fall in the bottom left quadrant (bonds down and stocks down), although this has been the experience in the first half of 2022.

We also plot one year forward returns following each six month period when both stocks and bonds moved lower. In most cases, both stocks and bonds post positive returns (and have never posted concurrent declines) in the twelve months following a bottom left quadrant experience.

Bear Markets: Not Fun, but Not Uncommon

In mid-June, the S&P 500 officially entered a bear market, closing down more than 20% from the January 3 high water mark. Large drawdowns can be unsettling, but are much more common than most might appreciate. Over roughly the last 100 years, we have experienced 33 drawdowns of 10% or more. Eleven of those drawdowns were 20% or more otherwise known as “bear” markets. This means investors should expect to experience a large drawdown about once every three years on average, including bear markets about once every ten years.

The good news is that equity markets have demonstrated a perfect record of recovering from drawdowns, eventually reaching new highs over time. The chart above plots each of the historical drawdowns, highlighting that on average, much of the recovery tends to occur in the first year after a market bottom. We can see that the pace and magnitude of the current drawdown (green line) has been more severe than most, and actually looks a lot like the drawdown we experienced in the fourth quarter of 2018 (gray line).

Uncertainties Abound, Markets Pricing in Bad News.

There are several key issues that may influence the path ahead. Uncertainty in these areas is high and the range of potential outcomes wide. Peace could break out in Eastern Europe, or the war could escalate rapidly. The pandemic could be over or a resurgence in cases could elicit a variety of government responses around the world. Inflationary pressures, exacerbated by the war in Ukraine and strict Covid policies in China, could moderate or persist. Accelerated tightening by the Fed, arguably playing catch up in the battle against inflation, could be effective or push the economy into a recession. It is impossible to know which way each of these issues, and others, will break, but it is safe to say that equity markets are pricing in quite a bit of bad news half way through the year. For investors, the antidote to this uncertainty is discipline and diversification and we continue to advocate both.

Sentiment, Historically a Contra Indicator, is Decidedly Negative.

Investor sentiment is extremely negative right now. The AAII Bearish sentiment index recently notched its fifth & sixth highest readings ever (dating back to 1988) with 59.3% of investors identifying as bears as of late June. Historically, this metric has been pretty good contra indication of what’s to come. The highest readings on record were in October 1990 (oil price shock, Iraq invades Kuwait) and March 2009 (financial crisis). In both cases the most extreme levels of bearishness coincided with a market bottom. In 1990, stocks returned 33% in the twelve months that followed and in 2009, stocks returned 66% in the twelve months that followed. We also experienced elevated bearishness readings (very negative sentiment) in December 2018 (after a 20% market decline on recession fears) followed by a 28% return in 2019, and similar dynamics around March 2020.

Headed for Recession, or Not So Fast?

There are plenty of risks to the current expansion (there always are), but we also see some bright spots in the fundamentals. The labor market is strong. Unemployment is at 3.6%, one of the lowest levels observed in 50 years. There are almost two vacant jobs out there for every person counted as unemployed. Household spending remains robust, benefitting from savings built up during the pandemic. Surveys of business people (purchasing managers index, PMI) are still in expansionary territory in the United States. The Fed is tightening policy in an effort to tamp down inflation and the market is expecting (and pricing) for additional hikes. The risk would be tightening too quickly and driving the economy into a recession, but there appears to be enough underlying strength to cushion the blunt tools of the Fed. While the onset of a recession in the next twelve months is not our base case, we acknowledge that the risk has increased significantly over the first half of the year.

We Will Enter a Recession at Some Point, and That’s OK.

Dating back to World War II, we’ve experienced a recession about every 4-5 years. The question isn’t whether we will have another recession, the question is when will the next recession occur? Investors fear recessions because they often coincide with the larger drawdowns we described above. That said, a disciplined and patient approach has historically paid off. Looking all the way back to the Great Depression, the median recessionary experience includes a double-digit return in the 12 months leading up to the recession, a low single digit decline in the year of the recession and a double digit return in the year following the recession – netting an annualized return of almost 9% over the three year period.

We Knew This Would Happen… Sort Of.

Our capital market assumptions rely heavily on the historical return experience. Historical returns were not achieved in the absence of geopolitical events, natural disasters, health crises, presidential elections, legislation, regulation, deregulation, recessions etc. The world is predictably unpredictable. If we look out over the next ten or twenty years, we can virtually guarantee we will encounter recessions, temporary market drawdowns, geopolitical issues and even the occasional pandemic. We won’t always know what is coming, but if we know that certain types of events are pretty much guaranteed to happen, we can (and do) develop financial plans and construct client portfolios with that knowledge in mind.

Looking Forward – Capital Market Assumptions

As for the market experience going forward, we share our updated capital market assumptions below. These forecasts represent our expectations for average annualized returns for each asset class over the next ten years. Over the next decade, there will be years where returns exceed our expectations and years where returns trail our expectations. We believe short-term market-timing strategies are unlikely to improve long-term outcomes.

We continue to recommend most of our clients hold a full weight to global equities in accordance with their individualized risk profile and we remain marginally more constructive on international equities. Concurrently, we are less constructive on the outlook in fixed income markets and believe a modest underweight in favor of an allocation to diversifying strategies (alternative assets) remains prudent.

Despite an ever-changing landscape, our disciplined approach and long-term orientation serve us well as we endeavor to create comprehensive investment solutions that help our clients reach their financial goals. Investment decisions are made in alignment with our documented investment philosophy and always with the intention of serving our clients’ best interests. On behalf of the entire team, thank you for allowing us to serve on your behalf and well wishes for the second half of the year.