It’s been a brutal run for stocks for 2022 so far, with inflation-adjusted returns among the worst ever. We’ve also seen stocks and bonds decline in tandem. That’s unusual. Bond returns too are approaching the worst in recent history for the first half of 2022. Though it is worth noting that bonds have performed relatively better than stocks, even if both assets have lost money.
Unfortunately, valuation is less supportive of equity markets than you might imagine. Yes, stocks are certainly cheaper than they were in late 2021. However, valuations before this bear market were historically elevated. Valuations remain relatively high compared to history, even now.
Currently, the P/E ratio on the S&P 500 stands at just under 20x. If you look at a Shiller P/E which smooths 10-years of historic earnings, then market valuations are higher still at 30x. This is not cheap. Both of these valuation levels are above the long-term historic average, which is in the range of 14x-16x.
Part of the recent justification for high stock prices was relatively low interest rates, making stocks relatively more attractive. Now that’s changing. The Fed has hiked rates, with further increases expected. Earnings growth may be at risk too depending on if a recession emerges.
Improving Return Prospects
We can have some optimism that stocks and bonds will now deliver reasonable performance on a long-term view, which is something we couldn’t necessarily say in 2021. For example, Research Affiliates currently estimate that on a 10-year view a U.S.-based 60/40 stock/bond portfolio will deliver an estimated return of 5% on a nominal basis (before the impact of inflation) and a little more if you add in international exposure where valuations are perhaps a little more attractive. That’s lower than a lot of historical returns and recent history, but better than many recent forecasts prior to this bear market.
However, valuation is seldom that useful to predict short-term market swings. That means that longer term prospects for investors are now a little more favorable, over the next decade, but that shouldn’t necessarily inform our view on whether a shorter term rally in stocks is on the cards for the next few months.
In fact, Research Affiliates still forecast valuations to decline slightly over the coming years, dragging on investment performance, but overall positive returns are expected given higher yields after asset prices have declined.
The Fed raising rates, has in part prompted a bear market in stocks. However, the Fed is also reacting to unusually high inflation. Also, the Fed see a limited trade-off in raising rates because of low unemployment, so as of their last meeting, they aren’t too concerned about weak jobs market.
That may be changing as recession prospects loom, with even a chance a recession is here already. Ironically, this could prove to be a slight positive for markets. The chance of a recession, especially if it’s a shallow and temporary recession, may cause the Fed to back away from aggressive plans for rate hikes.
However, the Fed is also very concerned about inflation and may continue to raise rates if inflation appears out of control. Here again there may be some good news in that inflation may have peaked, recent declines in longer term Treasury bond yields after peaking in mid-June, suggest that could be the case, but it’s early days. Incoming data will may be closely watched. Also even lower inflation may not be enough for the Fed if it’s substantially above their 2% target.
Buying The Dip
Ultimately buying the dip is market timing. There’s a reason there are virtually no long-term investors who have consistently get aggregate market timing right. It’s fiendishly difficult.
It appears true that valuations are more attractive than they were, and inflation could have peaked. Also, even if a recession occurs, it may be somewhat priced in after current market movements. That said, valuations are still not cheap from a historical standpoint.
All we can be sure of, is that long-term returns are now a little more attractive than they were last year. It’s worth noting that investors can certainly harm their performance at times of market turmoil. Evidence suggests that changing course, from what would otherwise be a robust long-term investment strategy, due to fear caused by market declines, has often historically harmed performance of individual investors.
Often consistent monthly saving in the stock market, for money that you don’t need for many years, can prove a robust approach compared to looking for the perfect entry and exit points for the market.