There’s no greater time than the present to discuss where we are in this difficult market. Many feel as challenged running their portfolio as what they experienced during the '08 Great Recession. What’s happening, why are we and everyone else struggling?

Let’s start with where we are. We know that the Federal Reserve has fought to be in charge of this market ever since Covid-19 ravaged us and President Joe Biden put through the rescue plan — which created more jobs than people to fill them. The overstimulated economy flashed troubling signs of inflation over a year ago, but Fed chief Jerome Powell, being fearful of the unpredictability of Covid (rightfully so), opted to keep rates low and continue to buy tens of billions of bonds. Powell perhaps did not want to repeat his 2018 error of too many rate hikes at once. In retrospect, he should have started the flight on inflation way sooner (perhaps in the Fall). The good news is that he’s been at it long enough that we may be further along in the process of slowing inflation than what the headline data shows. The bad news is that everything - the entire economy - is slowing with it.

Right now we are in a classic Fed-orchestrated slowdown with the hope of a soft landing (the economy has been flying so high, it needs to be brought down, but preferably with a soft landing, not a hard landing). Last week, Powell switched to solely fighting inflation, not the promotion of jobs while punishing inflation. It didn’t work, as the market made fresh lows afterwards. 

The market is closer to the bottom now

Our judgment is to put almost maximum cash to work because we think that we are a lot closer to the bottom. 

First is the time. The average bear market since World War Two lasts a little more than 180 days. We are in the 190-day range. That matters. 

Second, we have a lot of single digit price-to-earnings valuations. Now we know from history that you get those valuations not because stocks are cheap, but because they are expensive. You see, the reason why we are getting lower forward P/E multiple, in addition to the impact of rising rates (which we discussed here), is because the market thinks the earnings part of the P/E ratio will come down. We are about to start an earnings season we all expect to be brutal, which will force analysts to bring down forward earnings estimates for 2023. If the E declines faster than expected, one could argue stocks are actually "expensive." 

The conundrum will be that even after we get the estimate cuts, these stocks will prove to be inexpensive versus the current 15 times multiple for the S&P 500 index. That conundrum is made even more difficult because of the phenomenon of price targets that were set during more halcyon days. Hardly a day goes past when price targets aren’t cut. And each time they send stocks down. But they have not led to downgrades — yet. I suspect those are next.

You would think that they couldn’t go down more. However, when the stock of Toll Brothers (TOL), a very good homebuilder, received a downgrade last week, it still fell — even as it was down 40% for the year. That’s a cautionary tale vis-à-vis the 180-day-average bear market. What it says to me is that we need to have price target cuts as well as downgrades. And we need to see stocks NOT go down, before we say that's the bottom. Given the length of time and the coming rate increases that seems impossible. 

Can stocks really bottom before the recession that we all know will happen? 

Ironically, history says they most certainly do. Consider these statistics, put together by a great market historian/statistician Larry Williams. Stocks fell 3% on average twelve months before a recession, 2% six months before a recession. During the recession, we average 1% down. We’ve obviously blown through those levels, but directionally we are following the course.

Now here’s where it gets intriguing. Six months after a recession, stocks are up 7%. After one year, up 16% and after two years up 20%. If we are indeed in a recession, as so many think we are, then we are closer to a long-term increase in stock prices than we have been any time in the last year.

We have set our portfolio up for that rebound with ~70% of the portfolio in stocks that do well with a growing economy, which always come after a recession, but hedged with a defensive stature of stocks that do well in the slowdown or recession — mostly healthcare and some consumer staples. 

We also are hedging against the possibility of continued inflation, namely in energy. Why put ~5% of the fund in oil? Because oil represents the most visible portion of inflation. We need that hedge. Last week, the hedge worked against us, with oil plummetting and energy stocks posted worst week since March 2020 (Covid). We discussed hedging with oil here.

This is a market that easily goes to extremes, with the downside most evident right now. Going back to those statistics about how long the pain should go on, we would be fools to bail out now with so much pain already taken.

What needs to happen for stocks to go up?

We have been consistent about three things that has been choking the market: a Fed that is willing to do everything, including creating a recession, in order to bring inflation under control; an enemy of the West, Russia, holding us hostage and causing higher energy and food prices; and a Chinese public health disaster.

Now the Fed is at last on the right course. I believe that come winter, Europe might begin pressuring Ukrainian President Volodymyr Zelensky to make some sort of a deal with Russia, and the Chinese may come to embrace the miracle of Western-made vaccines that has made our economy stronger than most others. 

We had thought that the Russians were irrational, but the rise of the ruble, the chief determinant of the Russian economy, tells us otherwise and gives leader Vladimir Putin a tremendous upper hand come cold weather. The market would be an accurate predictor of a compromise come six months if it bottomed now. The mystery of the impossible path taking by China’s Xi Jinping continues to baffle and he has much of our tech stocks and international commerce waylaid. 

We do not deny the possibilities that we just keep stumbling lower and that the decline so far from the top means nothing. In investing, it doesn’t matter where stocks are coming from, it’s where they are going. It’s the toughest market since the '08 recession. Our portfolio has managed not to blow up, like many crypto and "disruptive technology" hedge funds which are down greater than 60%. I think it's time we get less defensive and start to be constructive about the market.