What a long and strange journey the third trimester turned out to be.
The Morningstar U.S. Market Index took a dizzying round trip rising 13% from July 1 to August 16 before giving back those gains and more, falling nearly 17% from then to the end of the quarter. For the year, the index is down 24.9%.
As of Sept. 30, the optimism that kicked off a months-long summer rally from the June 16 low on hopes that inflation had peaked and the Federal Reserve would begin to slow the pace of interest rate hikes was a distant memory. Exuberance gave way to deep pessimism, driven by weakening corporate earnings, concerns about slowing consumer demand and the potential for recession as the Fed redoubled its commitment to lower inflation. Stocks hit new lows in the closing days of the quarter.
Inflation has remained stubbornly high. Far from pivoting, the Fed went ahead and raised rates by 0.75 percentage points for the third consecutive time in late September, and the central bank pledged to continue. The ongoing war in Ukraine continued to wreak havoc on global supply chains and energy supplies. China, which accounts for nearly 19% of global gross domestic product, is grappling with a sharp economic downturn. Earnings warnings from top companies such as FedEx (FDX) and Ford (F), among other things, spooked investors. And the US dollar continues to appreciate against other currencies, putting pressure on corporate earnings but also raising concerns about the possibility of a liquidity crisis.
There are lessons to be learned from recent investment momentum and volatility, many old saws worth repeating but refreshed with insights specific to today’s times. Chief among them:
“Don’t fight the Fed”
It’s one of the most common market ideas you’ll hear, but there’s a reason: it’s true. And investors ignore it at their peril.
“Don’t fight the Fed – it works up and it works down,” says Steve Sosnick, chief strategist at Interactive Brokers. “Fed liquidity is like the market tide. If the tide is rising, that drives stocks up…and if the tide goes out, that direction drives stocks down, and you don’t want to fight that either.
Right now, the tide is definitely shifting in the form of multiple aggressive interest rate hikes and messages from Fed Chairman Jerome Powell that the central bank will not back down until price stability continues. will not be reached.
“Trust what the Fed says and what it does,” says Andy Kapyrin, co-chief investment officer at RegentAtlantic, a registered investment adviser based in Morristown, New Jersey, with $6 billion under management.
“The biggest lesson we’ve learned: the Fed really cares about getting inflation under control,” Kapyrin said. “They were unequivocal about reducing inflation. The bond market has been damaged by rising rates, and they are comfortable with that. There’s been some damage to the housing market, and they’re comfortable with that. There is damage to the stock market, and they are comfortable with that. Don’t expect them to subside until the weak economy demands action. It is too early to talk about easing.
So forget that “V” bounce
Years of interest rate easing – first in response to the 2007-2009 financial crisis, then following lockdowns related to the COVID-19 pandemic—and near-zero interest rates led investors to assume that the Fed would continue to come to the rescue at the slightest sign of trouble in the markets. This has led investors to become accustomed to “V” bounces in the stock market (supposedly due to their appearance on a chart).
This time around, it didn’t help that initially the Fed said it believed inflation would be “transient,” but that was before Russia’s war on Ukraine.
Yet investors continued to expect them to pull back. Among the reasons for the rebound in equities was the belief that the Fed would be quick to pause or significantly slow the pace of interest rate hikes, especially with the stock market down more than 20%.
“The Fed is not going to pivot on market reaction,” says Jim Masturzo, partner and chief investment officer of multi-asset strategies at Research Affiliates, based in Newport Beach, Calif. “They have a goal and they are going for it.”
That doesn’t mean the stock market won’t experience more rallies in the coming months, but as long as the Fed remains in aggressive tightening mode, investors should be mindful that the bear market may persist.
“One of the lessons of the third quarter is that the Fed isn’t coming to the rescue of the stock market,” Sosnick agrees. “And another lesson is that bear market rallies are short, sharp and fierce.”
Against this backdrop, Sosnick warns that “buying the dips” will be a treacherous short-term strategy. “When there’s not that flow of money (from the Fed and other central banks) coming into the market, buying the dips becomes a lot trickier.”
Stay invested and stay diversified
It’s easy for investors to become disillusioned when the markets make a big dent in a financial plan.
This is especially the case in a year like this when most asset classes have suffered setbacks, making it difficult to find cover anywhere. In particular, bond investments have failed in their traditional role of providing a safe haven in the face of a stock market downturn. In fact, during the third quarter, many parts of the bond market posted larger declines than stocks.
But by maintaining a diversified portfolio of different asset classes, sectors, regions and style characteristics, investors can mitigate their losses and position themselves to benefit from changing conditions.
“Diversification continues to be important,” says Kapyrin of RegentAtlantic.
And now is definitely not the time to pull out of the market. Just be sure to consider your investment strategy, time horizon, and market conditions.
“Trust the fundamental value of your investments and look beyond the volatility,” says Scott Clemons, chief investment strategist for the private banking division of Brown Brothers Harriman. “If you’re comfortable with your strategic asset allocation, then buckle up and go for it. For long-term investors, buying low makes sense.
With that in mind, many market strategists see value for long-term investors in the bond market, even though they might be vulnerable to short-term losses.
Now that 10-year Treasury yields are approaching 4%, “long bonds are something every investor should start thinking about,” says Research Affiliate’s Masturzo.
RegentAtlantic’s Kapyrin also focuses on the fixed income market.
“For the first time in a generation, the rate of return on fixed income products is very good,” he says. “Investors have options.”
At the same time, the experience of the last three months shows that sometimes the rules of thumb in the market—as bonds will move in the opposite direction of equities—is a sign that for some portfolios, a broader definition of diversification may be needed.
The diversification lesson of this period, says Masturzo, comes with a twist.
“US stock and bond portfolios are not enough diversification,” he says. Investors, he suggests, should add commodities, inflation-protected Treasuries, real estate and non-US assets.
