As stocks staggered mercifully to an arbitrary finish line in late June, market statisticians watched attentively to see if the results would represent the worst first half for equities since either 1962 or 1970. That’s how scores are measured in bear markets.
Speaking at Financial Advisor’s Invest In Women conference in Atlanta on June 22, Schwab’s chief investment strategist Liz Ann Sonders expressed gratitude that she had never in a 30-year career been asked to come up with a precise target on where the stock market would sit at 4:00 p.m. on December 31 of any given year. The exercise is a fool’s errand, in her view. “What the markets do during the year is a lot more important” than where it sits at any particular point in time, she said.
As of late June, the average U.S. stock was down almost 30%, and many foreign markets fared worse. But after a 13-year bull market with only a few brief interruptions before 2022, investors have yet to capitulate to the current bear market, Sonders told attendees. She actually used a more descriptive synonym for capitulate—a four-letter word that begins with “p” and ends with “e”—to describe what is often viewed as the final phase of a bear market. That hasn’t happened.
By her reckoning, bear markets come in a wide variety of styles and flavors. Even though the current climate is characterized by a number of unusual factors, including inflation reaching a 41-year high, a once-in-a-century pandemic and a war in Europe, Sonders cited a number of characteristics of today’s market conditions common to those of other Fed interest-rate hiking cycles.
These include a combination of growth and inflation overheating while the Fed attempts to tighten monetary policy to cool economic activity off. What markets may be about to see in July is a shift in phases to a lower trajectory for corporate earnings and profit margins. The Fed may have a dual mandate of maintaining price stability and healthy levels of employment, but with unemployment at 3.7%, circumstances require the central bank to focus almost solely on runaway inflation.
Sonders told attendees that there is “even more pain [in the markets] under the surface of the indexes.” The upshot is that “we haven’t gotten to the point” of capitulation.
She said she didn’t expect volatility to diminish. Instead, she told advisors to be on the lookout for “a full market washout,” even though it may never come.
Asked to compare the current wave of inflation to either the 1970s or the 1940s, Sonders said the price behavior in the post-World War II era is a more accurate parallel. That’s because “a lot of the drivers are somewhat similar to what we experienced post-lockdown.”
The wave of stimulus during the Covid-19 pandemic “put a tremendous amount of money in the hands of individuals and businesses.” Initially, most of it went to the “good side of the economy,” partly because people had “no access” to spend money on frivolous activities.
The 1970s had a “lot of dissimilar drivers,” in her view. Chief among them were deteriorating labor-market conditions. In the 1970s, tens of millions of baby boomers entered the market, a sharp contrast to today when those same folks are retiring.
Instead, it’s the supply-chain shocks of the 1940s that offer the most glaring similarities to today’s economic landscape. But there were demographic differences between the post-World War II period and today, and disparate structural conditions as well—the unionization movement back then was far more ubiquitous than a few Apple and Starbucks outlets.
Unfortunately, a recession is a higher probability than a soft landing, by Sonders’ estimates. In any Fed tightening cycle, “the needle always points more towards a recession than a soft landing.”
This time, there are a confluence of factors. The central bank is not only tightening; it’s also trying to shrink a $9 trillion balance sheet. “It’s possible we are already in a recession,” Sonders said.
Of the 13 Fed tightening cycles after World War II, only three have ended with a soft landing, Sonders noted. The first occurred in the mid-1960s, when the aggressive fiscal policy behind the Great Society programs and the Vietnam War helped propel the economy. Ultimately, these twin drivers helped spawn the inflation of the 1970s.
Sonders also noted that the soft landing in the mid-1980s occurred after a nasty double-dip recession, which began in 1970 and ended in 1982, expunged many excesses from the economy. Finally, the 1994 landing coincided with the advent of the internet, which allowed businesses to slash costs even as it produced the high-tech stock bubble that burst in 2000. Like the 2009-2020 bull market in stocks, the dot-com era did not generate a significant inflation in goods and services—only in financial assets.
Optimists point to the buoyant labor market as a possible signal that the economy can sidestep a recession. However, Sonders noted that unemployment claims are already ticking up—and that the jobless rate is a lagging indicator.
She urged advisors to focus on signals like hiring freezes, reductions in job openings and layoffs as “initial feeders” to a recession. A real key could be a letup in both supply chain bottlenecks and the labor market. Conceivably, that could prompt the Fed “to take their foot off the brake,” she said, as it would free up bottlenecks in the economy.
Sonders suspects, however, this could be wishful thinking. “If we are in a recession, the labor market will deteriorate,” she predicted. Moreover, there has never been “this big a drawdown in the equity market without a recession,” she declared.
In the 21 months from late March 2020 through late 2021, the Standard & Poor’s 500 and other stock market indexes doubled. Historical incidents of equity price appreciation at this rate are few.
Asked if this signals that markets were in a bubble last year, Sonders responded that many sectors of the stock market and other investment vehicles exhibited “micro bubbles.” She pointed to crypto currencies, “SPACs, heavily shorted stocks and meme stocks” as clear-cut examples of this phenomenon.
As market strategist for the nation’s largest discount broker, Sonders has been an avid student of investor sentiment. The outlook for equities, when measured by the University of Michigan consumer survey, is at an all-time low.
Sonders warned advisors that investor sentiment was hardly “a perfect timing indicator.” However, if investors remain increasingly negative, it ultimately could have a positive effect on stock prices. After all, consumers and the public at large have often despised stocks at the start of many extended bull markets.
At the same time, this isn’t 2009.
Sonders told attendees how she received one of the great buy signals of her life at a dinner party in March 2009. On the Friday night before March 9 of that year, she and her husband attended a party filled with gloomy Wall Streeters.
A 30-year investment banking veteran showed her some pity, saying, “Liz Ann, I don’t envy your position. I don’t think the market will ever come back to prior highs.” He expressed doubt that the retail investor would “ever come back,” adding that he didn’t know “how a firm like Schwab could possibly survive.”
As she and her husband got in their car, he looked at her and said, “Did you hear it?” They realized that the proverbial bell, the one that rarely rings at the bottom of bear markets, had just clanged.
The market dislocations experienced today bear little resemblance to that era, when stocks had fallen more than 50%, unemployment was 10%, and many home mortgage loans exceeded the value of the underlying properties. But Sonders believes there will be opportunities for investors.
The sprawling complex of index and factor funds inevitably creates imbalances and dislocations. “Utilities live in the value indexes, but they are more expensive than the S&P 500,” she said.
Even within technology, investors who looked for high-quality companies within the value sector last year have found some of this year’s leaders. “You can find opportunity within all 11 [S&P] sectors,” she said.
At the same time, she warned that advisors and investors can “fall into traps” by simply dividing the market into growth and value and “investing passively.” Changes in market leadership trigger a reclassification of companies in and out of different indexes, asset classes and style factors. Netflix and Meta Platforms, for example, are winding up in some value indexes.
The next cycle is unlikely to enjoy the same powerful tailwinds the last one did. From 2014 on, asset management complexes like JP Morgan, AQR and GMO steadily predicted U.S. equities would generate low single-digit real returns or worse for the next five or 10 years. Sonders wasn’t among them back then.
Most of those estimates were based on current valuations and past performance, which conventional wisdom maintained borrowed current returns from the future. Sonders told advisors the best indicator of future returns is actually the level of U.S. household equity ownership, data that the Fed tracks.
Now models using this data set predicts low single-digit returns, Sonders said, or about 3%. That’s something, but not much, to get bullish about.