Stocks reached the unenviable milestone of entering a bear market this quarter. A bear market is when the market declines 20% or more from its peak. The S&P 500 reached its high in early January and has sold off 23.5% at its lows in June. 2022 marks the worst start to a year since 1970. There have been worse six months periods for stocks over the last 50+ years, but this is an attention-grabbing headline nonetheless. Usually, you can look to the bonds markets for safety, but they did not offer much help. Bonds continued to sell off as interest rates moved higher. This continues to be a record-breaking year for the bond market, posting its worst six-month return in the index's history. The sell off across all asset classes is a function of investors repricing assets based on slower growth, high inflation, and higher interest rates.

With the price action seen this quarter, there are not many positive things to highlight. Large cap companies saw less of a sell off than smaller companies which is expected in a bear market. Value stocks outperformed growth stocks in the quarter by about 10%. This was the first quarter since March 2020 where no sectors had a positive performance. Sectors that have defensive characteristics held up better in the quarter. Consumer staples (-4.9%), utilities (-5.8%) and healthcare (-6.4%) posted modest declines relative to the market. Technology (-20.0%), communication services (-21.1%), and consumer discretionary (-25.7%) were the biggest decliners. All three sectors started the quarter with above-market valuations and are expected to see earnings growth decline over the next 12 months.

Investment Strategy

The two most frequently asked questions we are getting from clients are, how long will this bear market last and what is our plan when the market turns around. We’ll cover the first part in our outlook below and our strategy here.

After our June Investment Committee Meeting, we will maintain our neutral investment strategy in your stock, bond, and money market allocation. We are keeping our conservative stock strategies in place for the time being. We are overweight value stocks and, more importantly, low volatility stocks. This quarter, these stock factors have held up better than the broader market and growth stocks.

We will shift away from our conservative holdings in our stock allocation as we get more confident that markets are close to a bottom or stock valuations become more attractive. Our first step will be to reduce our low volatility holdings and move into small cap stocks. When markets bottom, small cap stocks outperform larger companies by a wide margin in the first month, quarter, and six months of a new bull market. This happened in the past because smaller companies are more economically sensitive and see strong earnings growth early in an economic cycle. Small companies tend to sell off more in a bear market. Low volatility is an excellent strategy for the current market conditions, but when stocks rally, this asset group tends to lag.

Bonds are now offering more attractive expected returns at current yields. There could be modest additional downside, but we are optimistic that the worst of the declines in the bond markets are behind us as interest rates start to stabilize.

Outlook

It would be imprudent to say we have clarity on what will happen with stocks or bonds over the next 12 months. Here is what we do know. Bear markets since World War Two, on average last about 12 months and see a decline of around 33%. In a recession, stocks tend to sell off more and bear markets last longer than 12 months. This bear market for the S&P 500 started in January 2022, while the Nasdaq and Small Cap indexes peaked last fall. There is likely still more time and further sell-offs to come but if the averages serve as any guide we are closer to the end than the start.

In the past, when stocks sold off, the Federal Reserve (Fed) could step in to support the financial markets with monetary policy moves or offer support through their messaging. The Fed’s job is difficult because they need to squash inflation while trying to avoid tipping the economy into a recession. The Fed’s tool to cool inflation is to raise interest rates, but this is a blunt instrument to accomplish this because it does not just target inflation it impacts the entire economy. The move in interest rates this year in the markets has been a response to expectations. The Fed has already raised rates by 1.5% and is projected to rise by another 1.5% to 2.0% throughout the year. Much of this is already priced into current bond prices.

Recession risks in the next year are elevated, but a recession is not a certainty. Current economic data is showing mixed messages. For instance, consumers are spending at record levels and have reduced their savings levels. This is typically a sign of an optimistic consumer, but consumer confidence surveys are showing the most pessimistic readings, according to the recent University of Michigan Survey. High inflation and stock market weakness influence individuals’ perceptions of the future. Unemployment is near all time lows and there has never been a recession with unemployment at current levels.

It will be hard to predict precisely when stocks will bottom. We have created a checklist to help navigate when we should shift from our conservative equity allocation. In previous bear markets where inflation has been high, bear markets did not end until investors were confident that inflation had peaked. This alone was not enough to kick off a new bull market. There also needs to be an additional catalyst. We think we’ll need one of these four in addition to inflation peaking.

Valuations get cheap: The S&P 500 is trading at about 15.3x for the next 12 months’ earnings. The 25-year average is around 16.8x. Prices have come down, but the earning revisions have not yet occurred. Valuations are interesting but still are not cheap enough.
Interest rates start to decline: 10-year bond rates have started to drop since their peak in mid-June. If rates stabilize or fall over a period of a few weeks, this could serve as a signal.
The Fed changes its stance: The Fed is focused on slowing inflation by using restrictive policy. If the Fed’s messaging moves from restrictive to more accommodative this could be a catalyst.
The economy starts to recover: We will monitor leading economic indicators like purchasing manager index (PMI) to see when the data stops getting worse. Financial data like the unemployment rate and GDP are more backward-looking and not as helpful in looking for market bottoms.

Bear markets are never enjoyable. To see your investment values decline week after week is tough, but we encourage you to stay the course. The markets generally find a bottom well in advance of the economic data. JP Morgan gathered the information below that shows stocks have strong rallies before economic growth picks up, so waiting for the data to improve will leave you behind the curve. Bear markets eventually end and this one will as well.

US Market Viewpoints - Q2 2022