The U.S. stock market is very likely in a bear market that anticipates a recession will start later this year. This means the time is now to shift portfolios from risk-on mode to risk-off before the losses get even worse. But what worked in the past when hedging against a bear market may not work now, given the ever-changing economic dynamics. It’s also important not to fall for some old myths.
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In many ways, the economy is in uncharted waters. The pandemic spawned disruptions in global supply chains as frictions in the reopening of economies stoked inflation. The war in Ukraine has sired additional price pressures that have left the Federal Reserve well behind the curve in fighting inflation and with its credibility severely strained. So the central bank is playing catch-up, and is considering multiple increases in its federal funds policy rate of 50 or even 75 basis points. That and the recent bond markets yield-curve inversion, falling real wages as well as declining consumer confidence and real household spending, rising mortgage rates and excessive inventories almost guarantee a recession.
Then there’s the dramatic shift in Fed policy, from quantitative easing to quantitative tightening. The central bank went from pumping $140 billion into the financial system every month, to winding down those purchases to nothing, to soon letting its balance sheet assets shrink – a big shock to equity holders who were accustomed to more-than-ample liquidity. So as the bear market deepens, here are some thoughts:
—Long the U.S. dollar against other major currencies. As the recession spreads globally and equity markets swoon, the greenback’s haven status will become more even desirable. British sterling, the euro and the Japanese yen have been especially weak and will probably continue to be so.
—Treasury bonds. The recent dramatic leap in yields may have fully discounted the Fed’s credit-tightening campaign. Also, as in the past, once the central bank realizes it has done the recessionary deed, it will reverse gears and ease credit. It’s normal for the Fed to cut the fed funds rate even before the onset of recession, and Treasury bonds rally at that point.
—Stocks are a long way from the bottom if the recession and bear market unfold as I predict. The S&P 500 is down 13.3% this year but has the potential to drop a further 32% given current valuations. Speculative stocks are especially vulnerable. The long bull market since 2008 (with the exception of the early days if the pandemic in March 2020) and virtually free money has fueled highly-leveraged positions that will only be revealed when those securities crumble. Robinhood Market Inc.’s collapse may be the harbinger of more to come.
—Growth stocks can be disasters when their prospects fail to meet investor expectations, as was recently the case with Netflix Inc. The stock fell 35% on April 11, dragging down other streaming stocks. Users flocked to Netflix in the early months of the pandemic while at home but easing lockdowns and competition from other streaming services in the past year have been brutal.
Netflix and other so-called FANG stocks depend on big earnings growth in future years, so they are extremely sensitive to interest rates that discount those earnings to determine present stock prices. Ten dollars in earnings 10 years hence is discounted to $9.05 today at 1% interest rates, but to $5.58 at 6%. The NYSE FANG+ Index is down 34% from its November 2021 peak, and as the Fed raises rates and they fail to meet rosy projections, downward pressure will likely persist. The Barron’s Big Money poll found 59% believe equities are the most attractive asset class, only 6% like cash and bonds weren’t even listed as an option. Stocks reach their bottom when the last bulls capitulate.
—Homebuilder stocks have dropped, but probably still have further to fall. Weakness in single-family housing demand is coming as mortgage rates rise, the pandemic-era bailout funds are spent and the pandemic-driven flight to homes in the suburbs and rural areas is completed. New home sales in March fell 8.6% from February and 12% from a year earlier. At the same time, homebuilders have finally regained their confidence after the subprime mortgage collapse, and inventories of new homes are climbing.
—Covid variants persist. They aren’t as lethal as earlier, but they are very disruptive to global economic activity. China is facing renewed lockdowns in major cities, especially Shanghai, and the International Monetary Fund slashed its growth forecast for China this year to 4.4%, well below Beijing’s 5.5% target. Gone are the days of double-digit growth in China, the world’s second-largest economy.
—Cash. As the bear market unfolds, cash will continue to go from trash to king. Cash and short-term securities such as 3-month Treasury bills don’t return much and have negative inflation-adjusted returns but will provide much better returns than plunging stocks.
Many believe that spending on essentials such as utilities, consumer staples and health care is relatively immune from weakness in recessions. Therefore, their corporate earnings and stock prices should hold up. History says no. This chart lists the price changes in the S&P 500 and its components in the last four recessions. The only non-negative was the 24.2% rise in consumer staples in the 2000-2002 bear market. As shown in the last column, the averages of all 10 fell by double digits.
Read the full article here by Gary Shilling, Advisor Perspectives.
