The S&P 500 Index officially entered bear market territory last week, driven by concerns of slowing economic growth, persistently high inflation, and the Federal Reserve’s (Fed’s) determination to get it under control.

Following the higher-than-expected May Consumer Price Index (CPI) reading and an increase in long-term inflation expectations, the Fed raised short-term interest rates by 0.75% on Wednesday and stated their intention to continue aggressively raising rates until inflation recedes. This stated aggressive path of interest rate hikes raises the probability of recession with stocks now indicating slower growth.

What Are Stocks Reflecting?

The S&P 500 declined by 24% to a recent low of 3,667 from its all-time high on January 3rd. Since 1950, there have been 11 previous bear market episodes. After entering a bear market, the index typically fell for an additional 1-2 months before reaching a trough. The median peak-to-trough decline during these bear markets equaled -34%. In the 4 bear market episodes that were not followed by a recession within the subsequent 12 months, the median 6-month return after falling into bear market territory was +16%. In the remaining 7 episodes that were followed by a recession, the median 6-month return for the index was -7%.

This historical data speaks to a wide range of potential outcomes and highlights the inherent risk of stocks— a property that has also enabled them to outperform bonds, cash, and inflation over long periods of time.

What About Valuation?

The recent decline in the S&P 500 has reduced its forward price-to-earnings ratio to about 15 from 21 at the start of the year and below the 25-year average of 17. Since 1948, S&P 500 earnings have dropped from peak to trough around recessions by a median of 13%. This suggests that stocks are reflecting an economic slowdown, but not a significant recession.

What Could Go Right?

The pandemic caused a major shift to goods demand over services and resulted in significant supply-chain problems that are still being resolved. This resulted in significant goods price inflation that is now receding as demand for services normalized with the fading pandemic. Labor force participation which has been improving could see further gains to pre-pandemic levels as the pandemic fades. The Fed expected these factors to help alleviate inflation pressures this year and they ultimately still could. This would allow the Fed to ease off their current aggressive hiking campaign and reduce the odds of recession.

Importantly, consumers and businesses are healthy today with pent-up demand. There are key differences compared to the last major recession in 2008. Back then, consumers and banks had too much debt and the needed deleveraging took years to accomplish. Today, consumers and banks are much healthier. While high mortgage rates are now slowing housing, inventories remain tight with estimates showing a need for 3 million to 6 million more new homes. This is very different from 2008 when there was significant excess inventory that acted as an economic drag for years. Meanwhile, new vehicle production is constrained by supply-chain problems while pent-up demand builds. This suggests healthy economic underpinnings.

What Could Cause Further Volatility?

High food and energy prices have been significant contributors to persistently high inflation. However, nothing cures high commodity prices like high prices. High grain prices are the signal for farmers to plant more acreage which will ultimately normalize agricultural prices.

While we anticipate energy supply/demand conditions to remain tight, we note several major differences to previous oil price spikes. The U.S. economy is much less energy intensive today and critically is now energy independent. Shale drilling technology gives U.S. energy producers the ability to rapidly increase activity and is enabling significant wealth to remain in the U.S. and ultimately support the economy. This is very different from previous oil spikes where significant wealth was transferred overseas.

In summary, while there is significant uncertainty today, we continue to recommend investors stick with their long-term investment plan which includes proper exposure to stocks.

 


 

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