Tips to Keep Your Head About You

May 2022 | Victoria Bogner, CFP®, CFA, AIF®

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After a 34% market drop in 2020 (but ultimately a positive calendar year) followed by a positive 2021, volatility has shown up to the 2022 party. The S&P 500 is down -18% from its January 3rd peak, while a sell-off in tech stocks has the Nasdaq down -29% from its November 19th high. And if that weren’t enough, US aggregate bonds that typically act as volatility hedges are down 10% for the year.

What’s causing the spike in the stock market’s heart rate monitor? The war in Ukraine is making surging commodity prices worse, COVID lockdowns in China are weakening already strained supply chains, and 40-year-high inflation has prompted the Fed to start raising rates and tightening monetary policy. It’s enough to prompt many commentators to insist that recession is nearly inevitable at this point.

But are we headed into a recession in 2022? When we look at the data, here’s our objective (albeit human and probably imperfect) opinion: First, let’s define a recession. Let’s define a recession and then talk about how close we are to the edge.

The most common definition of a recession is two consecutive quarters of negative GDP growth, but the National Bureau of Economic Research (NBER), the official scorekeepers for recessions and expansions, define a recession as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months…these include real personal income less transfers, nonfarm payroll employment, real personal consumption expenditures, wholesale-retail sales adjusted for price changes, employment as measured by the household survey, and industrial production”.

Great. We can use that expanded list to see where we stand:

  1. Monthly nonfarm payroll growth has averaged over 550K in the past 6 months, signaling very strong demand for labor and a robust job market.
  2. Real personal income excluding transfers fell 0.3% month over month in March but is 1.9% higher relative to a year ago and 1.2% higher relative to the pre-pandemic peak.
  3. Real consumer spending expanded 0.2% month over month in March as consumers continue to shift from buying goods to paying for services.
  4. Industrial production rose 1.1% in April, aided by a 0.8% increase in manufacturing output.

When you look at the data and cut out the sensationalist noise, it’s pretty clear: the economy is still firing on all cylinders and we are not in a recession. When we look at an even bigger heatmap of lots of economic variables across corporate profits, labor, and activity, the data shows that the US economy is still expanding, albeit at a slower pace after roaring out of the pandemic. And bonus, if we start to see inflation come down from the high numbers we saw in March and April, that will calm down the Federal Reserve and allow growth to continue at a more normalized pace.

While the US economy is showing signs that the huge boon of economic stimulus is starting to wane, we don’t see signs of a 2022 recession. It’s true that stocks are near correction territory, consumer sentiment has soured to levels last seen in 2011, geopolitical tensions are elevated, and prices are higher everywhere. It’s hard to turn on the TV and hear good news. But on the other side of the teeter totter, consumer spending is still strong, unemployment is low, and earnings are still double digits. In fact, with the drop in equities, the S&P 500 is now undervalued in our opinion.

That said, I’m not Pollyanna over here. Recession risks are rising as we look ahead to 2023: inflation could remain stubbornly high, pushing the Federal Reserve to overtighten policy; the fiscal drag this year is likely to slow economic momentum, and a lack of labor supply will also weigh on growth. The far future is hazy, and that unknown is what keeps folks awake at night.

So with everything happening out there, how do you keep a level head? Here are a few important thoughts:

Volatility is normal. Did you know that the S&P 500 falls -14% on average each year? And calendar returns have been positive in 32 out of the last 42 years with the biggest cluster of those years being gains of over 20%.

Diversification supports portfolios through market downturns. If you had invested in the equity market at its October 2007 peak, it would have taken you until March 2012 to recover your initial investment. However, if you had invested in a 60/40 stock/bond portfolio instead, your portfolio would have recovered in October 2010 – a year and a half earlier. Diversification captures returns on the upside and protects on the downside to deliver better risk-adjusted returns.

It’s about time in the markets, NOT timing the markets. Being invested in the equity market for any one calendar year since 1950 could have yielded a 47% return or a -39% return. However, over longer time horizons the range of outcomes is much tighter and overwhelmingly skews to the positive side. A 50/50 diversified stock/bond portfolio didn’t experience a period of negative returns over the rolling 5, 10, or 20-year calendar periods since 1950.

Think about this: if you sell after the market has dropped, you’ll likely buy back in at a higher price. When an investor tells me they’re nervous enough to sell, they usually also say they’d be willing to step back into the market when “things look better.” Well, things look better after the market has already recovered. Therefore, the problem with that mentality is thonly reason to sell in a down market is to roll the dice in the hopes to buy back in at an even lower point. Otherwise, it’s a net loss. Since research has shown that timing the market successfully is driven by luck, the best formula is to stay invested in your proper risk tolerance and stop trying to dodge unrealized losses. It usually results in falling further behind in the long run.

To that point, stay invested when you feel the worst. Sentiment is a terrible guide for investor behavior. Looking at the peaks and troughs of consumer sentiment since 1970, average one-year equity returns following peaks in consumer sentiment were 4.1%, but average returns following the bottoms in sentiment were 24.9%!

One more crucial point: through multiple wars, recessions, pandemics, and crises, the S&P 500 has never failed to regain a prior peak— and then surpass it. The best strategy during volatile times is to maintain composure and stick to your investment plan. Turn off the news, don’t play the “what-ifs” in your mind. No one knows for sure what’s going to happen. Take 2020 as a prime example! So take a deep breath, enjoy each day as it comes, and let the market work itself out as it has every other time in history.

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