There’s no two ways about it. It’s been a tough year for investors. And in a somewhat unusual (but not unprecedented) move, both stocks and bonds have been taking it on the chin. Since the start of the year, the Canadian bond index has plunged by around 16 per cent, while the S&P 500 stock index has dropped close to 25 per cent, from a high of 4,766 on New Year’s Eve in 2021 to 3,583 on October 14, 2022.
As with every bear market, the question now becomes exactly how long we’ll have to wait before this decline starts to turn itself around. As usual, most of the financial news is filled with catastrophic predictions that the current bear market will go on virtually forever. But this kind of doom-casting is really just a reflection of an innate cognitive bias we all share as human beings which leads us to assume that whatever is happening in the present, will also keep on happening well into the future.
When times are good, for example, we tend to become overly optimistic, confidently ploughing our money into questionable investments like NFTs (non-fungible tokens) and SPACs (special purpose acquisition companies). Unfortunately, when the markets inevitably turn around and investor confidence goes south, those speculative investments are usually the first to come crashing back down to Earth. As the great Warren Buffet says, it’s only when the tide goes out that you learn who has been swimming naked.
When times are tough like they are right now, that same cognitive bias leads us to become extremely cautious – especially if we’re being fed a steady diet of headlines promising that the pain has only just begun. Market drops mean that many high-quality investments suddenly go on sale. But many investors refuse to take advantage of those fire-sale prices because of their instinctive expectation that, since this year was so bad, the next one will almost certainly be the same or worse.
Within these two extremes of confidence lie both the root cause of nearly every market decline, as well as the seeds of their inevitable recoveries. This most recent bear market, for instance, was sparked by a surprisingly dramatic resurgence of inflation. As a result, central bankers across the globe have been racing to put the inflation beast back in its cave by raising interest rates at a pace not seen since the early 1980s. This one-two punch of rising inflation and higher interest rates has hit both bond and stock markets hard.
Bonds that were issued at low coupon rates suddenly no longer seemed quite so attractive, and anyone who wanted to get rid of the ones they had were forced to sell at a steep discount. Stocks, which represent a share in the future earnings of public corporations, were similarly hit hard when rising interest rates decreased the expected valuations of those future earnings. The farther into the future the earnings, the harder the stock was hit.
Given what we’ve been through over the past 12 months, what will it take to make the markets change direction, and head back towards bull territory again? The most likely answer is a combination of lower inflation followed by lower interest rates. But perhaps the question that’s more on the minds of investors today is, exactly when will that start to happen?
If you’ve been following the dire forecasts we’re being bombarded with on a daily basis, you could be forgiven for thinking the answer is never. But cognitive biases aside, there are already some signs peering over the horizon, which suggest that the current state of peak pessimism may be unwarranted.
Consider the price of gasoline. As I write these words, gas is down almost 17 per cent from its peak in June. No surprise, as crude oil has dropped close to 30 per cent from its peak in March. And that semiconductor chip shortage that was threatening to stifle supply chains a few months ago? It’s already shifted from shortage to surplus. Shipping, another bottleneck, has also opened up – the cost of loading and transporting a shipping container has declined by 75 per cent from just a year ago.
Food is another big one. Everyone is concerned about the effect that supply chain issues and the conflict in Ukraine are having on food prices. But in spite of those fears, the price of wheat today is actually 40 per cent lower than it was when the conflict first broke out.
What does all this mean? In basic terms, it means that many of the core commodities that tend to drive inflation are starting to come down. The lag between cost declines in those underlying commodities and finished consumer goods means that we’re still seeing high prices at the grocery store or gas pump. But to paraphrase Sherlock Holmes, change is already very much afoot.
More importantly for investors, the markets seem to agree. Over just the past few weeks, the S&P 500 has gone from 3,583 to 3,963. That’s still a long way off its peak. But it’s a 10 per cent increase in a pretty short timeframe.
Of course, in the short term, movements in the market are always random. And when it comes to investing, no one has a crystal ball. Any number of factors could wipe out the recent increases in the index just as quickly as they appeared. But if inflation is what really has investors worried, it’s worth considering just how much has already changed for the better.
This article is supplied by Alan MacDonald, an investment advisor with RBC Dominion Securities Inc. Member–Canadian Investor Protection Fund.