“When the [credit] delusion breaks, people all with one impulse hoard their money, banks all with one impulse hoard credit, and debt becomes debt again, as it always was. Credit is ruined.”
– Garet Garrett, 1932, A Bubble that Broke the World
Down, Down, Down
As we close out the third quarter of 2022, it’s a fitting time to reflect on the state of the markets and money to better understand their future trajectory. The U.S. stock markets are currently engaged in a fierce struggle between bullish and bearish forces. Throughout much of this year, bears have dominated, landing heavy punches, but bulls have shown resilience. Let’s take a quick look at the performance of the three major U.S. indexes.
After reaching its peak on January 4, 2022, at 4,814.62, the S&P 500 faced a significant decline of 24.46%, dipping to an interim low of 3,636.87 on June 17, 2022. The Dow Jones Industrial Average (DJIA) also suffered, falling approximately 19.71% during the same span.
The NASDAQ’s decline began earlier on November 22, 2021, starting from a peak of 16,212.23 and plummeting to an interim low of 10,565.14 on June 16, 2022, marking a staggering decline of 34.83%.
While the indexes saw a brief rally through mid-August, leading many investors to believe the bear market had concluded, the reality soon set in: September proved to be a harsh month for the markets.
On August 16, the S&P 500 reached an interim closing high of 4,305.22. However, since then, it has experienced a drop of 15.44%. Similarly, the DJIA hit an interim high of 34,152.01 on that date, only to fall 14.42% subsequently. The NASDAQ closed at an interim high of 13,128.05 on August 15, suffering an 18.21% decline since.
This tumult has only just begun. Despite a fleeting rise following the Bank of England’s announcement to intervene in the government bond market in response to escalating interest rates, the downward trend remains intact.
The stock market appears to be on a continued descent.
Sucker’s Rally
As the third quarter of 2022 concludes, it’s essential to assess where we stand. Writing this after Thursday’s market close, the figures reflect almost a complete three quarters. For now, let’s examine the current status.
Year-to-date, the S&P 500 has declined by 24.10%, the DJIA by 20.12%, and the NASDAQ has plummeted by 32.18%. These are alarming figures, suggesting the possibility of further declines ahead.
Analyzing historical data, the eight previous bear markets for the S&P 500 since 1973 have averaged 13.7 months from peak to trough, with average losses of 38%. For instance, the 1973 bear market lasted 21 months, resulting in a 48% decline. In contrast, the 2000-03 bear market, which followed the dot-com bubble, persisted for 31 months with a 49% drop. The 2007-09 bear market lasted 17 months, causing an astonishing 57% decline. In comparison, we are only entering the tenth month of this current bear market, with the S&P 500 down just over 24%. We might not even be nearing the bottom yet.
Given these statistics, it’s improbable that the bear market has reached its conclusion. The rally witnessed from mid-June to mid-August appears to have fizzled out. Considering the durations of historical bear markets, we may be facing another year or two of declining stocks before things stabilize.
What exacerbates this situation is a unique factor in this bear market…
Double Whammy
One major issue is that, unlike previous bear markets, Treasury notes are also declining alongside stocks. This erosion of value means that the traditional 60/40 allocation of stocks to bonds is failing to protect against losses in equities. It’s important to note that bond prices have an inverse relationship with bond yields.
Currently, bonds are moving in tandem with stocks, a phenomenon unfamiliar to most investors. As a result, they are experiencing significant losses.
Investment advisors and pension consultants have long emphasized diversification, encouraging clients to hold a mix of stocks, bonds, and real estate. Some suggest a small cash reserve and even alternative assets like art and cryptocurrencies. However, very few apprise their clients on the merits of holding gold, a traditionally stable asset that represents distrust in the financial system—one reason to consider including it in an investment portfolio.
The 60/40 stock-to-bond strategy has generally served investors well in prior bear markets over the last four and a half decades. Non-correlated bond investments typically cushioned losses from equities. For example, during the S&P 500’s 37% drop in 2008, bonds (as per the Bloomberg Aggregate Bond Index) rose by 5.2%, limiting the overall portfolio’s decline to 20.12%. Similarly, during the 2002 dip of 22.1% in the S&P 500, bonds gained 10.3%, resulting in a mere 9.14% drop for a balanced portfolio.
This year, however, the S&P 500 is down 24.10%, while bonds have also plummeted by 14.77%. Thus, a conventional 60/40 portfolio is facing a decline of 20.37%. This dispels the notion of diversification as a safe guard.
What is going on?
Why Bonds Are Behaving Like Risky Assets
Historically, there have been eight instances since 1976 when the S&P 500 fell, and in each case, bonds provided a buffer against those downturns. However, the situation has drastically changed this year. Throughout the first nine months of 2022, bonds and stocks have declined simultaneously. Compounding this issue, as stock prices have dropped, Fed Chair Powell has opted to raise interest rates.
Even more surprising, Treasury bonds, typically the epitome of risk-free assets, are faring poorly. Year-to-date, the iShares 7-10 Year Treasury Bond ETF (IEF) has lost 17.69%, coinciding with the S&P 500’s 24.10% decline. This is an uncharacteristically tumultuous bear market.
Adding to the erosion of wealth is the issue of declining purchasing power, driven by rising inflation. A hypothetical 60/40 portfolio, comprised of the S&P 500 and the iShares 7-10 Year Treasury Bond ETF, has lost 21.54% in nominal terms within 2022. When factoring in an annualized inflation rate of 8.3%, investors face real, inflation-adjusted losses nearing 29.84%.
In summary, the current landscape exhibits the following dynamics:
- Bond yields had been artificially suppressed to near zero by central planners.
- Borrowers, including government entities, took on excessive debt under these conditions.
- As inflation surged, the Fed shifted its strategy, raising interest rates.
These dramatic market interventions have caused traditionally “safe” bonds to perform like risky assets, becoming closely correlated with stock investments within a standard portfolio.
Has your financial advisor discussed this shift with you? What other essential information may have been omitted?
[Editor’s note: Conventional strategies have left American investors vulnerable. Thus, innovative investment approaches are crucial. Learn how to safeguard your wealth and financial privacy by exploring the Financial First Aid Kit.]
Sincerely,
MN Gordon
for Economic Prism
Return from Why Bonds Are Behaving Like Risky Assets to Economic Prism
