Most people who have called themselves bears over the last couple of years had a pretty simple equation to justify their bearishness – High Present Valuations = Low Future Returns. And today’s valuations – the valuations of two years ago – were so high that future returns would be very low and probably, possibly, at some point, negative. The argument was that stock prices were too high to justify the risk of owning a normal allocation, say 60% of the portfolio for the typical moderate risk investor. I made that valuation argument myself in one of these weekly missives in the middle of 2013 so I’ve taken even more flak than the average bear. It has not been a pleasant two years for the bears to say the least.
If you define a bear market by the size of the decline, what we’ve seen so far does not qualify. Indeed, what the stock market has done this year, as volatile as it has been, only briefly qualified as a correction, a drop of 10%, and now doesn’t even do that term justice. Of course, these things are not confined by the calendar and if you measure from the peak last May the S&P 500 is down just over 10%. As you move away from the US blue chips the damage gets larger; the equal weight version of the S&P 500 is down over 13%. The Russell 2000 small cap index is in full blow bear territory, down just over 20% since peaking last June. The EAFE international index is almost there, down 18% since last May and about the same since it first peaked in June of 2014.
The definition of a correction as down 10% and a bear market as down 20% though are just arbitrary numbers agreed upon by no one and everyone. And those thresholds, despite recent history, are met quite frequently. 10% corrections come around every couple of years and most of them are over before most investors get a statement that might scare them into doing something stupid. 20% bear markets are also pretty routine, coming along roughly 1 year out of 4. Corrections and bear markets are generally over pretty quickly, even the ones that turn into financial crises. The 2008 bear market, from peak to trough, lasted 17 months; it only felt like a lifetime.
The real enemy of investors is not these fairly routine 10 or 20% downturns. The real enemy is the bear market that is associated with a recession or crisis, the one that knocks your equity block down by 40 or 50%. And actually it isn’t even the depth that is the real enemy. For most investors the enemy is time. Whether you are a younger investor still accumulating assets or a pre-retiree about to depend on your nest egg for income or a retiree already doing so, bear markets eat up your most precious commodity – time. Recovering from large drawdowns when you are young is obviously easier – if you stick to a plan and don’t get laid off in the recession that caused it. But if you are about to retire, a bear market may mean you have to keep working for a few more years, putting a little tarnish on your golden years. If you are already retired it may mean something even more devastating – running out of money before you run out of years.
It would obviously be ideal to be able to just sell all your stocks right at the top and avoid these big drawdowns, preserving your capital for the next bull market. Unfortunately, ideal is not available in the investment world and we have to accept something less than perfection. High valuations, such as have existed in the US stock market the last few years, are one way we identify markets where the risk/reward ratio is starting to get out of kilter. The valuation bears, who have taken so much abuse the last two years, were, in retrospect, generally right. Future returns have not been anywhere near what they would need to be to justify a full allocation to stocks. At its low last week the bear market in the small cap Russell 2000 had wiped out all the price gains since the spring of 2013. That doesn’t mean you shouldn’t have owned any since then; there were 30% gains from there to the top. But you certainly could have owned less than you normally would, less than your normal allocation and hopefully rebalanced along the way, selling some at those high prices. Those were high risk gains and owning less would have still produced a good, risk adjusted return. For some reason it is hard for some investors to grasp that investing is not an all or nothing endeavor.
The S&P 500 at its low last week had given up all price gains since December 2013. And the gains from those late 2013 levels to the peak were only 17% and I would argue obtained only at very high risk to your capital. What should be learned from this episode is that valuation tells you about risk but it doesn’t tell you an awful lot about immediate reward; valuation is a lousy timing tool. Stocks that are overvalued can and do become even more overvalued. But ultimately, valuation matters and either fundamentals have to grow into the stock price or the stock price has to fall to the fundamentals. Reality, or the perception of it, can only be distorted by monetary policy, not actually altered.
So, is this already a bear market? If we are measuring it for the S&P 500 in terms of price the answer is no. But in terms of time? I think, for a lot of people, we’re already there. For most people it’s been two years of no gains and for some more adventurous investors, a lot worse. Investors who have had any exposure to oil or commodities, whether through the stocks of their producers or directly, are doing a lot worse than the S&P 500. Any investor who had the temerity to diversify their portfolio with small caps, international stocks, commodities or junk bonds, their reward was lower returns, greater risk realized. Heck even for those who managed to confine themselves to the S&P 500, they’ve now gone over 18 months only picking up a paltry dividend. In short, the trend has changed, the inflection point between trending higher and trending lower is long gone. If you’re still looking for it, I’m sorry to be the one to tell you but you missed it.
As to whether this will turn into recession and another big, bad, bear, that is something that can’t be said with a high degree of confidence right now. Certainly the odds of it are rising as the shale industry continues its slow motion train wreck. The only thing booming in the oil patch are oil and gas bankruptcy firms. Credit spreads are blowing out all over the place from investment grade to the junkiest of junk. The HY spread moved over 8 last week which is nearly as high as the European crisis of 2011 and higher than the onset of recession in late 2007 and early 2001. Baa spreads, the lowest of investment grade, also continue to move wider, worse than 2011 now and a lot worse than late 2007. Make no mistake, credit leads the business cycle just as George Soros’ theory of reflexivity predicts. It is not that economic conditions deteriorate pushing spreads wider; it is that spreads move wider causing economic conditions to deteriorate. So, as spreads widen, the odds of recession rise.
It would be easy to just say that these things are sufficient and recession is inevitable but that isn’t how this works. There are no immutable laws in this business. Things that haven’t happened before do happen; things that haven’t happened in a long time, do happen again. Baa spreads got this high in 2012 without a recession; so did junk bond spreads. And I have to say, there are some situations that are starting to get very interesting from an investment standpoint. We may have seen the low in crude oil last week when we touched the mid-20s. Not for sure yet but that may have been the first stab at finding a bottom. Prices in the 20s or 30s don’t just make shale unprofitable, it makes large swaths of the planet’s known reserves unprofitable to extract. It will take a while to work down inventories but it sure seems likely that there will be some money made on the long side of oil or oil stocks somewhere down the pike.
For now, though I think it is still time for investors to maintain a conservative stance. Momentum indicators – short, intermediate and long term – are all still pointing lower. As I pointed out last week, sentiment is negative enough to produce a bounce so last week’s start may continue in the coming week. But turning those long term momentum indicators around will take time or a heroic rally that seems unlikely. Whether it is a bear market in price or just one that needs more time, it doesn’t appear to be over yet.
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