During bear markets, it is not uncommon for market participants to be focused on if there could be another 10-15% downside, regardless of the fact that the market is far cheaper than it has been in several years when they were willing to invest aggressively. Bear markets bring out the biggest pessimists, peddling the most horrible potential scenarios. Keeping an even keel through both bull and bear markets is imperative to lasting investment success. Today the Nasdaq dropped 3% as Consumer Confidence numbers continue to be some of the lowest on record, as the impacts of inflation hits. Thus far we have held up far better than the overall market and I believe our positions are as undervalued as they have ever been relative to intrinsic value. When you have these attractive valuations and intrinsic values that are likely to grow via strong earnings, accretive stock buybacks, etc., that is a recipe for very robust future returns regardless of whether the overall market pulls back a bit more or not in the short-term. Our large positions are having strong years financially, even if we are indeed in a recession, but the prices reflect financial outcomes that just aren’t what we are seeing in the real world. That disconnect is what creates the enormous opportunities that we are finding right now, and is why I’m putting all the free cash I can into my investment accounts.
The S&P 500 has posted negative returns ten out of the last twelve weeks, and is now down over 20% to start the year once again after a short rally last week, with the Nasdaq down nearly 30%. This is the 2nd worst start to the year in history, although I will note that in most years where the S&P started the year with big losses, the remainder of the year has been positive, but of course anything can happen. Bonds have provided no protection with the U.S. bond market on pace for its worst year in history, with a loss of 11.5% YTD. A 60/40 stocks and bonds portfolio is now down 18% YTD, which is just shy of the -20% return of 2008, which was the worst year since 1977. These data points tell you what we have already endured, not what will happen in the future. Stock valuation multiples have come down dramatically and bond yields have risen exponentially, making both asset classes quite a bit more attractive than they have been. Real estate is the one asset class that tends to take a little longer to reprice so we’ll see if the sharp rise in mortgage rates will have an outsized impact or not. I personally wouldn’t want to be leveraged to real estate as prices are already starting to get lowered and demand is slowing down in once hot markets. Real estate tends to lag equities by about 12 months, but I certainly don’t expect anything like 2008, as supply is way lower, and underwriting has been far better.
Bitcoin dropped more than 30% two weeks ago, putting its returns as being down 74% from its highs. Other cryptocurrencies have seen far worse outcomes, including several blowups in the supposedly Stable coin sector, where I’d suggest being very careful. The Crypto space is unsurprisingly proving fertile grounds for fraud and deception, so just make sure you know what you own there as with any other asset class as well. Since the market high on January 3rd 2022, $9.3 trillion has been lost in the S&P 500, which is more than the $8.1 trillion that was lost from the Lehman crisis. Another $2 trillion has been lost in crypto, and many trillions more in fixed income.
Really the only sector that has worked well this year has been energy stocks, but you have to be careful there as well. On June 6th, CNBC commentator Jim Cramer recommended that investors buy the dip in oil stocks and stay away from everything else. Since he said that, the XOP energy index is down over 20%. Many market participants chased that recent outperformance only to be clubbed even harder on the selloff. If we do indeed get a recession, it’s very possible we could see energy prices fall more quickly than most would anticipate, as we’ve seen in 2008, 2015-2016, and 2020. Quite a few commodities are dropping substantially, which at least augurs well for future inflation, but is likely not a great indicator for the economy.
It’s an interesting economy because you have very low unemployment but raging inflation that is pressuring consumers. More money is being spent, but many consumers are having to choose between goods and services, if they are lucky, while others less fortunate are just trying to afford food on the table and gas in their automobiles. I was in Las Vegas a couple weeks back and it was as busy as I’ve ever seen it. Every restaurant seemed busy, but the economy is only now starting to see major layoffs being announced, so we’ll see how long this continues. It’s not impossible that we are in a recession now, as defined by two consecutive quarters of negative GDP growth, as we already saw that in Q1. Supply chain issues continue to be a major impediment as there is a major disruption between goods that people want at the times that they want them, versus what actually is possible. Look at your local auto dealer floorplans and it is very likely you’ll see sparse supply. We are about two weeks away from earnings season starting again for the 2nd quarter, which I think could be very helpful in providing guidance for the remainder of the year. Many pessimistic scenarios are being priced into the market at current prices, and while things can get worse, I also see a lot of opportunity for things to improve.
The current bear market is very severe for an economy that doesn’t go into a recession. It is about average for an economy that does go into a recession, while it is still mild for a major recession such as 1932, or 2008. The reality is that it is virtually impossible to pick the bottom. You prepare for bear markets with your strategy before the bear market actually occurs and I believe we’ve done that with our deep value stocks, cash-secured puts and covered call strategies These businesses are extremely cheap, paying good dividends, and our options should provide more and more protection as the year progresses, as they get closer to expiration. The biggest permanent losses occur when people panic sell, thinking they will magically be able to get back in again, but usually we see the biggest rallies when things look the bleakest. If you miss those, it becomes very hard to produce good returns, as you’ve basically realized the losses at the lows, only to try to get back in at way higher levels.
There is a major election coming up in November where both sides will be trying to make their case. Perhaps we can see a negotiated peace deal in the Russia/Ukraine conflict. Oil prices have started to come down, as have other commodities, which could potentially ease the inflation burden. Higher interest rates will be helping banks and insurance companies make materially more money, which is not reflected in their valuations creating great opportunity. Stay focused on the medium to long-term and I’m confident we will be fine. By the time our major options positions expire in late January, the full extent of the protection will be realized, and I think we should see quite robust returns as things develop.