I don't think I have read as many negative articles on the stock market as I have in the last two months. The soothsayers who loved the markets 20% higher, now predict an ongoing bear market. Many learned analysts opine that interest rates will march upwards and high levels of inflation will prevail. But what if they are as wrong today as they were two months ago?
I see numerous factors that indicate that both the stock markets and the bond markets have already priced in a recession (in fact we may already be in a recession):
Container rates for overseas shipping have fallen 50%. Rates are still high relative to pre-COVID but moving in a more manageable direction
The price of copper has dropped 25%. Copper is the canary in the coal mine when it comes to predicting economic change
Natural Gas has corrected downwards 30% in the last month. Still high by historic standards
Oil is down from $122 (WTI Crude, AUG 22) to $108. Still painful at the pumps, weighing on consumer sentiment. It seems that only a negotiated settlement in Ukraine will result in better affordability
The S&P 500 is down 20.6% so far in 2022. This is an abnormally fast drop, in fact, the worst first six-month period in 70 years
The yield on the two-year Treasury Note (as Barrons notes "the maturity most attuned to future Fed moves") dropped 22 points this week or 7%. What if interest rates have already peaked?
Although hard to price the real estate market, local prices appear to have fallen 15% to 20% over the past two months in greater Toronto.
You could look at this data and reflect that the future looks bleak or you could see light at the end of the tunnel.
For my own portfolio, I am not planning any changes. I was positioned before this slump in a 55% equity / 45% fixed income allocation. It has been a difficult year as my fixed income, rather than acting as a positive offset to equity declines, has also fallen in value. I would argue that at current valuations the outlook for a balanced portfolio is positive looking forward.
Fixed income now has attractive yields north of 5% for diversified holdings. This very well could produce pre-tax returns annually for the next several years above 5%. Private debt pools continue yielding 6% to 8% with stable asset pricing.
Equities, as represented by the S&P 500, are in line with past valuations. I read an insightful report this past week that examined the S&P 500 over the past 12 recessions.
Based on past data, the outlook is encouraging as we look at various time periods:
For the six months before a recession, the historical worst return was -18.75% (S&P is currently down over 20%). The best six months was in 1980 when the market appreciated 13% before the recession.
During the recessionary period, the worst market drop occurred in 2007 (the Great Financial Crisis...no comparison in my view with today's economy). The drop was -35%. The best return in a recession occurred in 1981 with the S&P 500 returning 14%.
What about returns one year after the recession ended? Worst one-year return -16%. Best one-year return 46%.
If I step out to three years post-recession (perhaps a more relevant period), the lowest return was a positive 8.4%, with the top return being 93%. The average return over eleven post-recession periods is approximately 49% or close to 16% per year.
I continue to focus on allocating the majority of my equity holdings to high dividend Canadian ETFs and to the S&P 500 (arguably the most dynamic global index).
Based on current equity valuations, bond yields and historic return history, the future looks bright.
Thoughts, agreement/disagreement? email me at tim@mortonir.com
Tim Morton, CFA is a recently retired portfolio manager with 45 years of experience working with private clients and is the editor of mortonir.com
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