Look Past the Rocky Present

After a 17.7% rise between June 16 and August 16, the S&P 500 is now down -7.3% since then after Tuesday’s drop.^[i] Is the resumed negativity a brief blip along the way to recovery? The start of a W-shaped bear market (typically a prolonged decline worse than -20% with a fundamental cause) low instead of the V-shaped variety? Or the resumption of a longer bear market following a temporary rally? Unfortunately, the answer is probably the last thing you want to hear: “unknowable.” Short-term movements are always unpredictable, regardless of direction—and regardless of whether they occur during a bull or bear market. In our view, the best thing investors can do right now is focus on their long-term goals and avoid the temptation to react to day-to-day swings.

As last Thursday’s commentary discussed, whether the summertime rally was the recovery’s start or a bear market correction is impossible to glean from patterns and comparisons with historical market movement. For example, we have seen much discussion of the fact that the 17.7% rise erased over half of the bear market’s decline, as if getting past the halfway point eliminates the possibility of retracement. We have seen this rally overlaid with the “typical” bear market recovery, as if visual resemblance is enough to declare it for-real. Problem is, it is also common for a bear market rally—or bear market correction, if that term is more intuitive for you—to recoup over half the decline from the prior bull market’s peak to the rally’s starting point, only for the relief to prove temporary as stocks eventually sink to new, worse lows. Patterns are no help.

Fundamental analysis is more meaningful, in our view, and while it won’t confirm whether the upturn is a new bull market, we think it points to a recovery being close. Stocks move on the gap between sentiment and reality, and sentiment hasn’t much improved since June. People still dwell on rate hikes, dissecting every Fed person’s comments and every inflation report for hints at how monetary policy will evolve. Europe’s energy woes continue fueling recession fears. US economic sentiment continues hovering around its summertime lows, and good economic news continues attracting “yah, but” objections. China’s rolling blackouts, COVID restrictions and property woes continue generating fearful headlines globally. Food and fertilizer shortages spark talk of global hunger. Surveys of fund managers and individual investors alike give little indication that expectations rose alongside stocks over the summer. While fund flows don’t show huge capitulation, we wouldn’t necessarily expect them to in this environment, considering there isn’t exactly anywhere for investors to go—not when bonds are also down, inflation is eating cash alive, crypto is crashing and gold is sinking. There is nowhere for fearful investors to flee—all the alternatives would be equally scary-looking.

Meanwhile, from our vantage point, the likelihood that things go worse than the awful conditions that people broadly expect is low. Some monthly US economic indicators are rolling over in a manner that would be consistent with the onset of a shallow recession, but bear markets normally precede recessions, and the peak-to-trough movement to date would be consistent with that. All the Fed chatter ignores the fact deposit rates are far below prime lending and mortgage rates, keeping banks’ net interest margins healthy and giving them plenty of incentive to continue lending. EU natural gas reserves are filling well ahead of schedule, giving a better-than-expected buffer if Russia keeps restricting gas flows this winter. Conservation efforts are bearing fruit, which may abate the temptation for outright rationing. China is bailing out property developers, which should keep construction going, and running coal mines flat-out, which should prevent a repeat of last autumn’s severe factory outages. The country may slow or even stagnate, but global markets overcame Japan—the China of the 1980s and early 1990s—doing the same after its bubble popped in 1990. Elsewhere in developing markets, currency problems seem confined to tiny, less-developed nations with little global economic significance—far from a repeat of the crisis that engulfed major Emerging Asian nations in 1997 (which didn’t even cause a global bear market). No, none of this looks consistent with a rip-roaring global economic expansion. But with expectations so dreary, we think mild recessions in some nations and slow growth in others would likely qualify as positive surprise. Meanwhile, on the political front, gridlock across the developed world should reduce the risk of sweeping legislation creating winners and losers, with US midterms turbocharging it.

So a recovery is what we think is likely, and we think it will probably arrive sooner rather than later. But we don’t think it is possible to pinpoint a when any more precisely than that. Stocks are just too fickle in the short term, and sentiment swings are too big a factor, particularly at present, given the bear market’s largely sentiment-driven nature.

The impossibility of predicting short-term sentiment swings is why we regularly encourage readers to focus on their long-term goals and remember how markets work. As Ben Graham said, while stocks are a voting machine in the near term, over longer stretches they are a weighing machine, sizing up fundamentals. In time, stocks will resume rising on earnings growth expectations further into the 3 – 30 month window they typically look to, as they always have following bear markets. Capturing those returns, regardless of when they begin, is crucial to getting the compound growth long-term investors seek to fund retirement. Even if stocks have further to fall in the very short run, new bull markets typically erase it quickly—said differently, near-term drops hurt you only if you sell. That is what crystalizes temporary declines into actual losses. Steeling your nerves and waiting for the recovery is the best way we know to avoid that.

So take a deep breath. Volatility is painful as it happens, but enduring it is part and parcel of reaping stocks’ long-term returns. Taking the bad with the good doesn’t always feel good, but it has long been the most beneficial approach for stock investors at this juncture.