"May you live in interesting times" is an English expression which purports to be a translation of a traditional Chinese curse. While seemingly a blessing, the expression is normally used ironically; life is better in "uninteresting times" of peace and tranquility than in "interesting" ones, which are usually times of trouble. (Wikipedia)
There can be little doubt that we are living in interesting times. Nobody knows how long or how bad the pandemic will become before it eventually peaks and begins to recede.
Nobody knows how long this bear market will last. And nobody knows how long this recession will last. It’s not just the numbers that have people concerned about the future, it’s the uncertainty of it all. Few of us like uncertainty, and investors abhor it. This is why I believe that we haven’t yet reached the bottom of our current bear market.
I’ve been calling for 2000 as the bottom for the S&P 500 since the beginning of this year. Am I too pessimistic? Too optimistic? Nobody knows, but I base my forecast on the two bedrocks of my work - history and probability.
Here are the facts from bear market history
- We're now 37 days into the 2020 bear market
- The typical bear market lasts about 2 years
- To date, we're down 25% from the top on February 19th
- The typical bear market is down 40%
- A 40% market drawdown would take the S&P 500 to 2032
- The typical bear market takes 2.9 years to recover
- That 2.9 year average excludes 1929, which lasted 25 years.
The market is likely to get worse before it finally stabilizes
There is so much uncertainty out there that forecasts from the financial media and money managers are essentially useless. That's why I'm drawing on history to at least set some kind of realistic parameters.
In these interesting times, even skilled and experienced investors are falling into the emotion trap. I implore you not to go down that road, because you will look back at today and regret the decisions you made that were based on fear and panic.
The speed and depth of this bear market is unprecedented. I can't find another example where the market dropped by 34% in a single month. This is the fastest bear market in history. (If you know of a faster example, please share it in the comments below.)
The historic 11 year bull run is dead, so now what?
Many of my clients had the foresight (with a little nudge from me) to write a Plan B for just this type of market event. If you have one, just follow the steps as you laid them out.
If you don't have a Plan B yet, it's not too late to write one. If you haven't sold anything, you're behind the curve but you can still do things that will help you stop the bleeding. For example, you can review your holdings and jettison any positions that you don't understand, or that are causing you extreme anxiety.
Then you can reap the benefits of any capital losses and redeploy the money into names that you still have confidence in by adding to them at lower prices. I had a client recently who sold his small cap tech stocks and bought the bigger, more stable names like MSFT, IBM, AAPL, and GOOGL. That was a smart move, because the big players in tech are much more likely to return to their former glory than younger, negative-cash-flow companies who may not survive.
You can do the same with energy stocks, retailers, travel & leisure, and other pockets of the economy that have been especially hard-hit. Go from smaller companies who may not survive to bigger ones that will be there tomorrow and beyond.
Recession
A new recession is virtually guaranteed at this point, but how long it will last is an open question. Much will depend on the effectiveness of the stimulus measures just passed. After the pandemic passes and people start returning to work, what will the economy look like? And how long will the recession last?
According to history and probability, the recession should last about 11 months. If we assume that it began in March 2020, it could be over in February 2021. The stock market tends to bottom out about 4 months before the recession ends, which means that the market could find a bottom as soon as October 2020.
This is purely an estimate, but I have high confidence in my models and what they are saying.
The Elephant in the Room
The unprecedented steps taken by the FED and Congress to mitigate the economic effects of the pandemic can be seen on this chart. Our national debt is on track to match the entire output of our economy - $20 trillion dollars. This is the chart that keeps Warren Buffet up at night.
Who is going to pay for this debt? U.S. taxpayers. How will the U.S. government extricate itself from this debt? They will do what all previous governments have done throughout history - inflate it away. Inflation is coming.
Asset classes for inflationary times
In the Vietnam War era the government’s rapid increase of the federal deficit began the inflation cycle that peaked in the late ’70s. The latest projections from a government budget watchdog forecasts that the annual deficit will double from what was expected just three years ago ($600 billion), to $1.2 trillion in 2020, due to the tax cuts and just-approved spending package.
It’s worth remembering that the worst stock performance of the 1970s came not when inflation peaked but when it first spiked rapidly. From 1972 to 1973, inflation doubled to more than 6 percent. By 1974 it was 11 percent. In those two years, the S&P 500 declined by a combined 40 percent.
Inflation was higher in 1979 and 1980, topping out at 13.5 percent, by which time the S&P 500 had long returned to positive performance, though on an inflation-adjusted base. It was a lost decade for stocks.
The Fidelity Study
In 2012, Fidelity back-tested nine assets against inflation on a year-to-year basis between 1973 and 2012. While no single asset beat inflation 100% of the time, certain assets performed better than others. The following list sheds light on the behaviors of nine different assets, during inflationary periods.
Gold
Based on the study, gold only beats inflation only 54% of the time. If you're interested in securing broad exposure to gold in the future, consider SPDR Gold Shares, which tracks the price of gold bullion. I use gold in investor portfolios but I rarely go higher than a 5% allocation. This market might warrant a 10% allocation.
Commodities
Commodities is a broad category, that includes grain, precious metals, oil, beef, orange juice, and natural gas, as well as foreign currencies, emissions credits, and certain financial instruments. Fortunately, it's possible to broadly invest in commodities via ETFs. And considering that commodities beat inflation 66% of the time, iShares S&P GSCI Commodity-Indexed Trust is a worth a look.
When a currency is having problems—as it does when inflation climbs and decreases its buying power—investors might also turn to tangible assets.
For centuries, the leading haven has been gold—and, to a lesser extent, other precious metals. Investors tend to go for the gold during inflationary times, causing its price to rise on global markets. Gold can also be purchased directly or indirectly. You can put a box of bullion or coins under your bed if a direct purchase suits your fancy, or you can invest in the stock of a company involved in the gold mining business. You can also opt to invest in a mutual fund or exchange-traded fund (ETF) that specializes in gold.
Commodities include items like oil, cotton, soybeans, and orange juice. Like gold, the price of oil moves with inflation. This cost increase flows through to the price of gasoline and then to the price of every consumer good transported by or produced. Agricultural produce and raw materials are affected as well as automobiles. Since modern society cannot function without fuel to move vehicles, oil has a strong appeal to investors when prices are rising.
Other commodities also tend to increase in price when inflation rises. For most investors, it is difficult to invest directly and store barrels of oil, sacks of soybean, of bales of cotton. It is far more convenient to invest in an ETF that specializes in agricultural commodities or businesses. Some more advanced investors may wish to trade in commodities futures. However, all investors may gain exposure through a publicly traded partnership (PTP) that gains exposure to commodities through the use of futures contracts and swaps.
REITs
Real estate equity/real estate investment trusts also beat inflation 69% of the time. If you seek broad exposure to real estate to go along with a low expense ratio, consider the Vanguard REIT ETF.
Real estate is a popular choice not only because rising prices increase the resale value of the property over time, but because real estate can also be used to generate rental income. Just as the value of the property rises with inflation, the amount tenants pay in rent can increase over time. These increases let the owner generate income through an investment property and helps them keep pace with the general rise in prices across the economy. Real estate investment includes direct ownership of property and indirect investment in securities, like a real estate investment trust (REIT).
Bonds
Investing in bonds may seem counter-intuitive as Inflation is deadly to any fixed-income instrument because it often causes interest rates to rise. However, to overcome this obstacle, investors can purchase inflation-indexed bonds. In the United States, Treasury Inflation Protected Securities (TIPS) are a popular option. pegged to the Consumer Price Index. When the CPI rises, so does the value of a TIPS investment. Not only does the base value increase but, since the interest paid is based on the base value, the amount of the interest payments rises with the base value increase. Other varieties of inflation-indexed bonds are also available, including those issued by other countries.
The Barclays Aggregate Bond Index beats inflation 75% of the time. So if you want exposure, consider iShares Core U.S. Aggregate Bond ETF, which tracks the index.
Inflation-indexed bonds can be accessed in a variety of ways. Direct investment in TIPS, for instance, can be made through the U.S. Treasury or via a brokerage account. They are also held in some mutual funds and exchange-traded funds.
Treasury inflation-protected securities (TIPS), are indexed to inflation in order to explicitly protect investors. Consequently, TIPS beat inflation 80% of the time, making it best of breed in this category. If you favor using an ETF as your vehicle, the three choices below might appeal to you. The first two track the Barclays U.S. Treasury Inflation Protected Securities Index, while the last tracks the iBoxx 3-Year Target Duration TIPS Index.
For a more aggressive play, consider junk bonds. High-yield debt—as it's officially known—tends to gain in value when inflation rises, as investors turn to the higher returns offered by this risker-than-average fixed-income investment.
Stocks
Stocks have a reasonable chance of keeping pace with inflation—but when it comes to doing so, not all equities are created equal. For example, high-dividend-paying stocks tend to get hammered—like fixed-rate bonds—in inflationary times. Investors should focus on companies that can pass their rising product costs to customers, such as those in the consumer staples sector.
Stocks offer the most upside potential. Interestingly, if you pull up a max chart comparison for VNQ and the S&P 500, you will discover that they trade nearly in tandem, with the S&P 500 marginally leading the way, most of the time. This makes sense, given that the S&P 500 beats inflation 70% of the time, which is slightly better than VNQ. If you wish to invest in the S&P 500, or if you favor an ETF that tracks it for your watch list, look into SPDR S&P 500 ETF.
Loans/Debt Obligations
Leveraged loans are potential inflation hedges as well. They are a floating-rate instrument, meaning the banks or other lenders can raise the interest rate charged so that the return on investment (ROI) keeps pace with inflation.
Leveraged loans outpace inflation 79% of the time. If interested in this approach at some point down the road, consider PowerShares Senior Loan ETF.
Mortgage-backed securities (MBS) and collateralized debt obligations (CDOs)—structured pools of mortgages and consumer loans—respectively, are also an option. Investors do not own the debts themselves but invest in securities whose underlying asset are the loans.
Source: Investopedia; Fidelity
Final thoughts
I've painted a rather dark picture for the market in this article, so why am I saying that you should calm down? That's a fair question.
We're down 25% as I write this, and I think we're closer to the bottom than we are to the top. I think 2000 will hold for the S&P 500. There are many unknowns out there, so this forecast can change as the situation unfolds. I suggest that you stay tuned to this article series and watch for updates.
Erik is very experienced and has a lot of knowledge, but neither Erik or anyone else knows when the market will bottom and start back up. The average this or usual that in months is meaningless. Only the market knows and will tell you if you watch what it is doing. The market will begin to move sideways. Up and down and up and down. But if the downs are not too far down from the last down this is part of the bottoming process. There will be rallies. If the highs are not to far from the previous highs this is part of the bottoming process too. There are fewer and fewer sellers because a lot of the panic sellers have sold. The professionals with millions of dollars to invest use a little of their millions to buy on the downs. On the ups they stop and let the fewer and fewer panic sellers get out and wait for another down to buy more. Go with the professionals. Buy a little when they buy. At some point all the panic sellers will be out and the market will start a steady rise. You will have got in at the bottom and a year or two later will consider yourself a genius as you see you big profits.
Watch the market it will tell you when to get in.