Believe it or not, it’s getting calmer on Wall Street as the bear market drags on toward its end and investor sentiment finally resolves all the excesses of the last few years and achieves something like a sustainable balance between irrational exuberance and apocalyptic panic.
We’ve experienced the exuberance. When already-gigantic stocks like Apple (AAPL) and Amazon (AMZN) surge 80-100% in any given year like they did in 2020, the bulls are out of control . . . drunk on zero interest rates that amount to free money.
It’s unsustainable and seasoned investors find it hard to take it seriously. But then again, we’ve also watched end-of-the-world scenarios like the COVID crash hit their own wall of probability. As it turns out, the pandemic didn’t actually destroy the economy. The world didn’t end.
And when investors realized that, stocks priced for the end of the world suddenly looked cheap again. The only thing unsustainable then was the gloom. Now, here we are. The free money is going away. A recession is either imminent or already underway.
But we’ve weathered recessions before. Not even 2008 was the end of the world. Most of the time, the market swings between the extremes and investors keep a running score across the rollercoaster ride.
That score averages out to about 8-11% a year for the S&P 500 as a whole. That’s realistic. It’s “normal.” And while it’s a long way from the 80-100% surges of a truly giddy year, it’s still pretty good. I think the market can give us that kind of return in 2023 and beyond.
After the year we’ve had, a positive return of 8-11% will feel incredible. But maybe you’re wondering why I think a weary market can give us that kind of performance in the new year.
Start With The Numbers
A combination of factors argue that the bear is already living on borrowed time. Statistically, a downturn of this scale can drag on about 9-10 months. Anything more starts pushing the limits of history.
And the market tends to respect history. Extreme moves in either direction don’t last long without a strong material justification. Nothing about the current economic situation is unprecedented or extreme, which means a reversion to “normal” is a lot more likely than a lot of people think.
Interest rates are higher than they have been in over a decade, but Wall Street has survived with much, much more restrictive policy in the past. The world didn’t end in 1995 when the Fed Funds rate got above 6%, let alone the 10-20% rates investors gritted through in the early 1980s.
Recessions come and go. They ultimately push interest rates down. If we’re in a recession now, don’t tell me interest rates will remain a drag on the market. And if you see interest rates as the threat, you need the economy to cool in order to get the Fed to relent.
Pick your poison. But neither stagnation nor interest rates has been fatal to the stock market in the long term. Even the combination of stagnation and inflation can be survived. It hurts. It’s lousy. But it’s not inherently toxic.
Here we are, 11 months into a bear market. Odds are good the cycle will turn in the next few months. The extended stagflationary downswings of the mid-1970s and early 1980s played out in 20-21 months, which means that even if this one pushes that historical limit things should look a lot brighter a year from now.
After all, inflation is finally softening. The Fed’s tough medicine is showing results. And because inflation is calculated on a year-over-year basis, we’ll get a natural headwind early next year when the impact of the Ukraine war rolls off the comparisons.
At that point, the absence of Russian oil from western energy markets will be the new normal. Consumers will have found new sources of supply. One way or another, prices will plateau. Inflation goes down. All the Fed needs to do is keep prices from climbing much beyond their current levels . . . and they can declare victory.
Not Out Of The Woods Yet
We’ve already held on for 11 months, leaning harder on short-term trading strategies to keep the cash flowing while buy-and-hold investors remain deeply underwater. Those strategies can sustain themselves as long as needed.
I think they’ll need at least another month or two before the bulls come roaring back. There just isn’t a lot of constructive good news out there . . . we’re still in the phase of the cycle where investors cheer hints that the bad news will end soon.
That’s not greed or hope. That’s relief. Relief is transient. It can evaporate fast. We’ve seen that happen again and again in this Fed cycle: investors start feeling pretty good and then the Fed knocks the market down again.
Right now I see the market about 1-3% from the point where it needs to watch its back. The Fed has been indulgent so far, but we’ve already heard rumblings about rates climbing well beyond Wall Street’s comfort zone.
I don’t see substantial downside here, admittedly. A lot of doomsday scenarios have already been digested and now investors basically assume the gloom will last indefinitely. They’ve given up.
That means stocks are at worst trading at roughly fair value. There’s no hype or hope built into the calculations. At best, they’re priced for doomsday . . . and as you know, doomsday has yet to hit Wall Street in all the generations Americans have traded stocks.
The Dow is still a little higher than it was before the pandemic. Someone who bought the pre-COVID peak and held on would be up about 14% today . . . nearly three years later. While that’s an unusually depressed three-year return, we can all agree it’s been a wild and fractious three years of stress, shock and strain.
But through that three-year period, the Dow has made money. Not much, but a positive return nonetheless. The S&P 500 has done a tiny bit better, up around 16% in the COVID era. The NASDAQ has done a tiny bit worse.
That’s progress. And if the market can make any amount of progress across pandemics, lockdowns, recession, inflation and spiking interest rates, that only proves how resilient the market really is.
How bad could things get in the future? Well, for one thing, I don’t think we need to worry about universal lockdowns from here.
Earnings are tracking at their slowest growth rate since the depths of the pandemic. There just isn’t a lot of dynamism in the market as a whole right now. And stocks don’t look extremely cheap.
But think back to 2019. Three years ago, we had already swallowed three quarters in a row of negative earnings growth . . . a verifiable earnings recession.
The yield curve was inverted. The Fed had to pivot fast from a tentative tightening posture to provide a little support for a fragile economy.
Remember, this was before the pandemic. These were the final days of the “old” normal world. It was business as usual.
And yet stocks supported a 17.6X multiple. The market looked a little rich, but not so rich that it strained statistical reality too much.
Here we are now, with positive earnings growth and the S&P 500 is trading at 17.2X . . . a little cheaper than 2019, with significantly stronger fundamentals on its side.
Granted, some companies are warning that their numbers will be worse than expected. Others are raising their guidance. All in all, the environment there isn’t any worse than it was in 2019. It’s better.
Corporate management today is a little more hopeful about the future than they were before the pandemic. Wall Street’s targets are a little lower, setting up at least a few upside surprises ahead.
If your expectations are reasonable, I think you’ll be rewarded in the coming year. There isn’t a lot of urgency . . . you can be patient and wait for the market to work out its remaining angst before buying in.
But when the boom comes, it will come fast. Be ready.