Update: Market Narratives

June 13, 2022

Face your fears. That’s what my father always used to say to me. I think it was less about “being tough” and more about understanding them at a deeper level. Once demystified, much of the fear and uncertainty naturally melts away.

No doubt there are many things to be uncertain or fearful of in today’s world – and by extension, in the economy. As humans, we have been hard wired from the dawn of humankind with a fight or flight reflex. It has kept us out of the jaws of predators and ensured our ongoing survival. As investors, that reflex may do more harm than good. Facing our fears is a way to short circuit the desire to either be reactive (fight), or worse yet, run and hide (flight).

So, let’s get brave, peek from under the covers and face the boogeymen in the room.

Fear #1: Recession

Rated (R) for stock market volatility and graphic scenes of traders holding their heads in disgust.

  • Recession definition: Two consecutive quarters of negative GDP growth. Officially, the National Bureau of Economic Research (NBER) does not necessarily need to see two quarters to “declare” a recession.
  • Recessions are always declared in arrears. Most of the time, the forward-looking stock market is already moving higher by the time they are made official
  • The U.S. just had one quarter of negative GDP growth, but next quarter is estimated to be up ~2% per the Conference Board Economic Forecast. There seems to be room for the economy to undershoot the 2% estimate and remain above 0%.
  • Recessions have happened, on average, approximately every six years since 1945. It just so happens that the U.S. has not experienced a prolonged downturn in over 13 years.
  • Recessions have a function. Zombie companies generally go out of business and capital is redirected to more productive ventures – paving the way to a more heathy, fundamentally sound period of growth. The resultant slowing growth typically takes excesses out of financial markets and restores a sense of prudence.
  • If the pandemic years of 2019/2020 taught us anything, it is that the stock market is NOT the economy. Suppose the market believes that a recession will provoke the Fed to remain accommodative, or that stocks have overreacted to the prospects of a macro-economic slowdown, in that case it is quite feasible that the market can go up while GDP growth languishes.
  • Recessions are usually brought about by one of three things: mistakes by central bankers, a faltering consumer base or a weak financial system. To that end, our current economic situation differs from past recessionary episodes in the following ways:
    • Unlike 2007, our banking system is well capitalized, and lending standards have been high for the most part.
    • Unlike in the 80’s, current inflation is not entrenched like the Volker days.
    • Unlike in past recessions, the current economy seems to be on firm footing: consumer spending is strong, consumer debt is contained, and employment is very strong.
  • The average recession lasts 1.5 years. The average stock market decline around a recession from peak to trough is -29%, the median decline is -24%. As of this writing the S&P 500 is down ~18% from its peak last year. Per the chart below, it is important to remember that in almost every case, 1 year later, the market is UP – clocking an average return of 40%.

Yahoo Finance

Fear #2: Stagflation

(NR) not yet rated because most people don’t quite understand what it is.

  • Stagflation is an investment term that brings shivers down the spine of even the bravest investment manager. However, it is often confused with a depression or worse, a period where no investments work.
  • Stagflation definition: Stagflation is a broad term that defines a period of concurrent slow economic growth, high unemployment, and high inflation.
  • The World Bank recently called out stagflation as a possibility for much of the globe.
  • Here in the U.S., we believe we could see a short period of this, but it’s important to point out that slowing growth is still growth, and that inflation can still be high, but trending lower. It is the second derivative moves (or direction and rate of change) that the market focuses most upon.
  • Typically, there are strategies that work in a stagflationary environment. Value tends to do better than growth, real assets do well and, of course, diversification pays dividends during these periods.
  • We have not had any bouts of stagflation since the 1970s. Back then, they were largely brought on by price controls and the oil crisis of 1973. With any luck, the folks on Capitol Hill will back down on their current price control rhetoric and in terms of oil, the U.S. is in a very different place now than the 70s. The U.S. is now the world’s largest producer and a net exporter of oil.

Fear #3: Housing Market Collapse

Rated (PG) for brief scenes of houses selling drastically over list price and mild to severe language from those missing out on homes.

  • After rising a record 16.9% in 2021, home prices do look like they will slow down in 2022. For many, rising mortgage rates are making homes less affordable. Cash buyers are still active but make up a minority of buyers across the country.
  • Mortgage applications are down 40% from the recent peak.
  • Builder sentiment is dropping, and commercial property sales were down year over year in April, as higher rates are making returns harder to generate.
  • Home prices in the U.S. and around the world have been driven by ultra-low interest rates. A pause in the frenetic pace of appreciation is welcome. We are nowhere near a 2007/2008 housing collapse scenario. Real estate experts are predicting a period over the next few years of more normal, low to mid-single digit price appreciation.
  • Supply is still very low relative to demand and many current homeowners are going to have a difficult time letting go of their current 3% mortgage to get into a new 5%+ mortgage – so supply may continue to be constrained.

Before being drawn into scary market narratives, we urge you to take a step back and dive into the facts. In that regard, BSW is always here to help keep things in perspective.

As it pertains to your long-term financial success, we’ve attempted to factor in most all scenarios – ranging from recessions to bear markets to rising rates – into our financial modeling.

I grew up near the ocean but unfortunately always suffered with sea sickness. The best remedy when in choppy waters was to focus on the distant, still horizon. It never failed to work. The same can be said with investing. The markets can be choppy – as they are now. However, if you focus beyond the white caps to your financial future on the still horizon, the queasiness goes away, and peace of mind will hopefully be restored.

Thanks for reading.

Craig Seidler

Director of Public Investments.