Friday Reflection | October 21, 2022
While this year has been headlined by significant declines in market prices and portfolio values, the path has not been entirely linear. From mid-June through mid-August, the S&P 500 staged a 13% rally from its low point as hopes temporarily soared that inflation had peaked, the Fed would pivot, and market prices would begin a new cycle of growth. That optimism proved short-lived as economic data showed that the forces weighing on the market had not been resolved. The S&P 500 then fell to new lows, and the temporary progress was reversed.
When economic pessimism leads to a bear market, investors with a shorter-term focus often sell assets in a panic, which can lead to further price declines. For investors with a longer-term view, the lower prices present a potential opportunity to achieve higher returns over a full market cycle. This can lead to a relief rally driven by buyers who believe prices have bottomed out. However, if the forces that caused the initial market decline have not changed, these relief rallies often reverse suddenly after a few weeks or months. We have again seen the S&P 500 move decisively upward over the last week, growing by more than 6% in eight days. Time will tell whether the market can hold onto the current progress or if it will be fleeting like the mid-summer rally.
This experience – also known as a ‘bear market rally’ – can lure investors into thinking a new cycle of growth is underway when the short-term reality is pointed toward continued uncertainty and potential declines. The frustration of dashed expectations can be painful, but history tells us that these interim rallies are a normal part of the market recovery cycle.
Every investor eventually encounters a bear market, and those who are fortunate enough to be invested for multiple decades will likely be forced to navigate multiple periods of market stress. The key is remembering that while each bear market has a unique set of circumstances, investor behavior often follows recognizable patterns.
During the “dot-com crash” of 2000-2001, the Nasdaq experienced eight bear market rallies of at least 18%, all of which proved temporary. The S&P 500 similarly experienced four rallies, ranging from 10% to 25%, and lasting less than two months.1 Again, each proved temporary as the index reached new lows before ultimately finding a bottom in October 2002, poised once more for a sustained period of growth. During these chaotic periods of economic transition, similar to what we are experiencing currently, it was difficult for investors to interpret economic signals and reach consensus pricing in the short term.
During the “great recession” of 2008-2009, the S&P 500 declined by 56% as the housing and mortgage bubbles burst.2 During that period of decline, the stock index experienced four rallies that ranged from 10% to 15% and lasted one to two months each. Investors were attempting to interpret recovery signals in the midst of an economic transformation and radical Fed behavior, and consensus on a low point wasn’t reached until March 2009. For those who remained patiently invested through this cycle, the growth in subsequent years was substantial and the initial spurt of price growth came quickly.
The most recent example of a bear market rally occurred in 2020 during the pandemic crash. The S&P 500 dropped more than 20% between February 20th and March 12th as the world shut down in the early days of the pandemic, and then staged an impressive 9% rally in a single day. Investors held onto that optimism for roughly10 days before capitulating and sending market prices spiraling downward again. Although the timeline and shape of this bear market were different than most others, the phenomenon of a temporary relief rally still showed up. In 2020, the market recovery was unusually fast as Congress and the Fed stepped in with massive stimulus packages and lower interest rates. We are in a different position now, and the Fed has consistently reaffirmed that they are more focused on controlling inflation than supporting market prices.
The S&P 500 has already experienced one bear market rally this summer as investors attempted to predict the end of the current inflationary cycle. Inflation has proved stickier than many investors expected, and labor markets have remained resilient. This sets the stage for continued tightening by the Fed and other central banks around the globe.
The continued upward trajectory of interest rates adds to recession concerns, and investors have continued selling in the short term and pushing the market lower. One result of this selling is that equity funds are currently holding more cash as a percentage of their portfolio than at any point since April 2001.3 This means that many market participants are in a position to buy stocks once they see signs, even if speculative, that inflation has peaked and the Fed is able to slow down the pace of its rate increases. We expect more volatility – both on the upside as well as the downside – and will be wary of short-term equity market rallies until we see cooling inflation reflected in the data.
James Bullard, the President of the Federal Reserve Bank of St. Louis, gave some hope to investors this week when he said that he expects policymakers to halt the front-loading of hefty interest-rate increases by early next year and move to smaller moves as needed until inflation abates.4 This doesn’t mean that the Fed will achieve its goal of a “soft landing” without a recession, but it does offer a reminder that the current cycle of rate hikes will not continue indefinitely.
Growth is Not Linear
It is human nature to assume that a current trend will continue unimpeded. We assume a sports team on a winning streak will continue to win or that housing and stock prices will continue soaring higher during periods of economic growth. This assumption would also predict that equity prices will continue falling without relief during a bear market. Reality rarely unfolds in such straight lines.
Investors are unable to reliably predict when market trends will abruptly change course or whether a rally finally has traction to support sustained price growth. This is what can make bear market rallies so frustrating for investors. Our team at North Berkeley recognizes that growth is non-linear and during periods of price volatility we prioritize regular rebalancing. By rebalancing, we are able to more systematically trim overpriced assets and buy underpriced assets, keeping client portfolios at their target allocation. This approach provides no guarantees in the short term, but it can reliably add value over the long term.5
Volatility and price declines are natural parts of a full market cycle. Staying invested and having faith in the resiliency and innovation of our collective economy has rewarded investors over every time period of sufficient length throughout history.
1 Stock Market Historical Tables: Bull & Bear Markets. 9/28/22 Yardeni Research, Inc.
2 Stock Market Historical Tables: Bull & Bear Markets. 9/28/22 Yardeni Research, Inc.
3 Bank of America Global Fund Manager Survey: Highest Cash Levels Since 2001 WSJ
4 Fed’s Bullard Sees 2023 Shift With End of Front-Loading Hikes Bloomberg
5 The Benefits of Rebalancing. Winter 2002. The Journal of Portfolio Management
About Brian Kozel, CFP®
Brian Kozel is a Partner at North Berkeley Wealth Management. Brian helps clients feel confident as they navigate their financial journey.
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