The Tedious Middle

Market Commentary | July 1, 2022

In our hyper-connected world, the constant deluge of information and 24/7 news cycles anchor our collective focus in the noise of the present moment. Abundant data and ease of communication across continents are benefits of the information age, but the cacophony can obscure narratives with a longer arc. Financial pundits have trumpeted stories about pervasive inflation that has increased since January, portfolio values that have steadily declined, and predictions of an impending recession. It can feel like a difficult time to be an investor. With a fractured political and legislative landscape, reverberations of the pandemic, and a lingering territorial war in Ukraine added to the picture, it can feel like a difficult time to be optimistic.
 
Long-term investing inherently requires optimism about the future. A dash of perspective can help reorient our expectations of what progress looks like, and reassure us of the benefits of staying invested through turbulence. One method of gaining perspective when faced with overwhelming data is to zoom out and understand how recent trends fit into a larger pattern. By doing this, we can gain a better understanding of the relative progress of the current quarter versus the absolute progress over a longer timeframe. Reflecting on past periods of economic and political turmoil won’t provide a precise roadmap for the current moment, but it can provide a comforting reminder about the longer arc of progress.

Over the past three months, the S&P 500 experienced broad declines of -16.5%, and the index is down -20.6% since the start of the year. Thirteen of the fourteen sub-industries in the S&P have seen negative returns over this time period, with the only exception being the energy sector which has been buoyed by higher gas prices. In particular, the first half of 2022 has been humbling for many tech companies, with the Nasdaq Composite losing almost a third of its value and many individual tech stocks have tumbled 50% or more. These declines have been in direct response to rapidly rising interest rates and a Fed that has vocally shifted its focus toward fighting inflation after years of indirectly supporting market prices via low interest rates. Lastly, the broad US bond market, normally a source of stability in investment portfolios, saw a decline of -4.6% during the quarter, and -10.2% since January, in response to the Fed’s telegraphed plan for higher rates and ending their monthly bond purchase program.

If we zoom out further, we see that current market weakness contrasts with longer-term patterns of price growth. Looking at the same fourteen S&P sub-industries we referenced above: over a one-year period, 10 of the 14 are negative, but over a three-year period, 14 of 14 have delivered positive returns.¹ The past three years included a sharp market decline and recovery in early 2020 at the onset of the pandemic, and upward volatility as federal stimulus was heaped onto the economy and interest rates were slashed to zero while the world recalibrated in the wake of the pandemic. If we zoom out even further to the past 10 years, we also see that all fourteen sub-industries have provided positive returns – and, contrary to the current year, the energy sector has actually offered the lowest return of any sector over the past ten years. This perspective doesn’t help to predict returns over the next twelve months, but these longer-term trends highlight the importance of diversification and serve as the foundation of our confidence to stay invested through the current volatility.

Shifting from investment returns to economic health, zooming out can provide helpful perspective on the other buzzword being thrust into headlines: Recession. Despite the scary connotations, and the recollections of 2008, the reality is that recessions are a normal and healthy part of the economic cycle. So, what is a recession? Simply put, it is when the economy, as measured by GDP, shrinks rather than grows for two consecutive quarters. In fact, the US economy has been in recession 14% of the time since WWII.² We don’t mean to downplay the economic and individual challenges that arise during a recession, but historical perspective can remind us that recessions are neither uncommon nor insurmountable for long-term investors.

Economist, Dave Rosenberg, recently quipped that “We now enter the most challenging part of the bear market: The tedious middle.” This portion of the market cycle is challenging because prices have already declined and investors are beginning to hear the siren calls of market timing, compounded by pundits with loud predictions about what comes next.

Over the past few weeks, we have seen numerous historical analogies that purport to know where and when to buy: Prior market action during inflationary cycles, performance in the 2nd year of the presidential cycles, average pullback during Fed rate hiking cycles, etc. The reality is that each cycle is different, and the current landscape of an ongoing global pandemic, while the Fed increases rates, does not have a perfect historical analog. Despite the difficulty of sitting still during a period of short-term price decline, the historically optimal approach has been to avoid radical changes and regularly rebalance portfolios back to their target allocation.

With the benefit of hindsight, few tasks look easier than pointing out a market peak and saying, “Here is where to sell stocks.” Unfortunately, no indicators can consistently predict market inflection points and trying to time the market has been proven to produce lower returns. In 2021, Bank of America quantified the potential impact and downside of attempting to time the market. Dating back to 1930, missing the 10 best days each decade would bring a return of 28% versus the 17,715% return that would have been had if the person had stayed invested.³ That is an extreme example, but the underlying message is true: sticking to your strategy, even during the tedious middle of a bear market, will deliver more consistent returns and growth over time, and therefore greater financial security and flexibility.

The counterintuitive part about the current stage of a bear market is that there is actually less risk for investors. Broad market indices are trading at lower prices, meaning investors can buy shares of high-quality businesses that are currently on sale during a temporary period of fear.

Warren Buffett, the legendary investor and financial folk hero, emphasized this phenomenon recently by sharing that he first started buying stocks in 1942 during the turmoil of World War II. He cited developments over the decades from major wars, atomic weapons, massive inflation, and periods of political turmoil as various reasons other people gave to avoid the markets. If an investor remained on the sidelines because of these macro concerns, they would have missed out on significant portfolio growth. We can learn from Mr. Buffett’s track record that staying invested in spite of tumultuous headlines – and even looking for buying opportunities if you have excess liquidity – is the surest way to achieve long-term wealth creation.

Recessions are a normal part of the business cycle and trying to predict them, trying to stop them, and trying to time the bottom of the market are all misguided pursuits for long-term investors. At North Berkeley, we have found that the more successful, and significantly less stressful, approach is designing investment strategies with the expectation that recessions and price declines will be landmarks on the journey to financial security and opportunity.

We are grateful to our clients for their continued trust and engagement with our North Berkeley Team, and we welcome all questions and conversations as we move further into 2022 and an ever-changing landscape.

Resources

¹ S&P Sector and Industry Indices S&P Global

² Bear Markets and Recessions Happen More Often Than You Think The New York Times

³ This chart shows why investors should never try to time the stock market CNBC