The S&P 500 is now down 25% YTD, which puts it in the top 10 worst selloffs historically. What is particularly unique about this bear market is that bonds have offered no help whatsoever, generating massive losses as well. Even conservative investment grade bonds are down by 22% YTD, when the previous biggest loss on record was just 3.8%. Records weren’t as good in the late 70’s early 80’s, but these are by far the biggest losses in 40 years. Zero coupon bonds are down an astounding 53% YTD.
Bear markets are a frustrating thing to go through. It is psychologically unnerving as our balances take a mark to market hit. During the Covid-19 lockdown bear market of 2020, the global economy stopped functioning in a way that was truly unique to history, making many companies completely reliant on government stimulus to survive, after being shutdown from operating by the same government. This current crisis is very different in that you have high inflation for the first time in 40 years, overlapped with an extremely worrisome war in Eastern Europe, with major Western countries as backers against an aggressive nuclear power.
The fundamental economy is functioning normally unlike in 2020, and most businesses are making solid profits. Bond markets are stressed as though we are in an environment similar to a 2008, or maximum stress in 2020, but the economic situation at this time does not seem to warrant such extreme pessimism. I believe the stock and bond markets have overshot on the downside, which is why current opportunities are so good, especially for investors that can look out 3,5, and 10 years. With that said, the housing market is likely to really struggle with 30-year fixed mortgage rates above 7%, combined with the appreciation of the last few years. This is a combination for pricing pressure and we are starting to see clear signs of that. Underwriting has been much better and of course banks are much more firmly capitalized, so we should avoid systemic breakdowns, but housing tends to lag other asset classes such as equities and commodities, which have already dropped severely.
For over a decade I’ve been a critic of how most advisors use Monte Carlo portfolio simulation to show hypothetical returns in the typical cookie-cutter asset allocation models that are so common. Those models base future projected performance on historical performance, which might be okay if we hadn’t just been through a 40-year period of generally declining interest rates, to the point where we had tens of trillions of bonds that had negative yields. It was mathematically impossible for us to see similar returns from bonds over the next 40 years, but that didn’t stop advisors from modeling them to the detriment of their clients. Many market participants kept plowing into bonds at those outrageous prices, and now it will take many years for them to get back to even.
Using our cash-secured put strategy on value stocks, our worst case scenario is owning deeply discounted stocks at an even better price than was available if we tried to purchase outright at the same time. We’ve avoided many 50-75% stock drops that so many securities have seen, and if we get exercised we could easily see some doubles and triples over the next few years as things recover. This strategy generates attractive income streams, or creates strong long-term appreciation potential when we end up owning these stocks. If we do get exercised on many of these stocks, our portfolios’ will be filled with stocks yielding 5-8%, with well over 50-100% of upside potential as valuations finally normalized once again.
Many of our key positions trade at P/E multiples of 4-5, with some even less than that, despite solid prospects to remain robustly profitable even if we experience a recession of substance. In about 3 weeks earnings for the banks will start coming out and I think you’ll see verification of what I’m saying in that they will report billions of dollars of income each, despite many of them trading at discounts to liquidation value. That is very different than previous recessions. The increase in interest rates has added billions of dollars of net interest income growth to their bottom lines, which will make up for most of the other headwinds facing the sector. Mr. Market is shooting first now however, marking stocks down to absurd levels and making us feel poorer, which is not fun. Being able to discern when a situation changes and what is simply a short-term mark to market fluctuation is a huge differentiator between successful and unsuccessful investors. A year ago, almost everyone would say they would be buyers of stock if the market plummeted by 25% and well over 30% for the Nasdaq. However, now, many market participants and pundits get frozen by fear, or panic sell.
There is a lot of bad news out there. The war in Ukraine has been disastrous on so many levels. The recent sabotage of two of the Nordstream pipelines sadly will likely perpetuate the engagement, as it escalates things and makes it harder for Europe to come together once again to serve each others mutual benefits. This is scary when nuclear powers are involved. Interest rates and the U.S. dollar have been rocketing higher with unprecedented volatility. This puts tremendous pressure on markets and economies. At some point, hopefully sooner than later, the Fed will ease up the hawkish rhetoric, as the balancing act of doing too much damage outweighs the inflation risk. Nobody knows when, but it could happen anytime, and it would not surprise me if the market bottoms before we get to that point. This is not a mild bear market. 60/40 portfolios are getting killed in a way they never had before. We’ve held up much better, but this has been a terrible month for everything and fear is close to peak levels. It almost always has been the right move buying stocks during 25% market declines if one has any reasonable time horizon. I believe we will be richly rewarded coming out on the other side so that payoff should be there for our patience, discipline, and fundamental principles. This negativity and volatility won’t last forever and we are most likely far closer to the end than the beginning, as this has already been quite a long bear market.