Investors are on pace for their worst year in history, declared strategists at one U.S. bank this past week. Their reasoning? Stocks and bonds are off to terrible starts, while consumer prices have roared. Extrapolate all of that bad news through to the end of the year—never mind that we’re barely halfway through spring—and diversified investors could lose nearly half their stash after inflation.
It’s possible, of course, but consider a less-dire view. Big stock downturns are normal. Since 1950, the S&P 500 index has fallen more than 20% from its high on 10 different occasions. If we lump in five cases where it came within a fraction of that mark, America seems to go through as many bear markets as presidents.
What is remarkable about the current decline isn’t its severity—the index is down 18% from its early-January high. It’s that bulls, with unprecedented help from the Federal Reserve, had it so good for so long. The average bear market during Warren Buffett’s career has taken about two years to get back to even, and a few have taken more than four years. But since today’s 35-year-olds graduated from college, no bounceback has taken longer than six months. The tech-heavy Nasdaq 100 Index has had a positive return every year since 2008.
Time to reset expectations. What follows are some new guidelines on investing, which many savers will recognize as the old ones. Momentum chasers sitting on fallen meme stocks and cryptocurrencies should resist the temptation to double down, or even hang on. On the other hand, seasoned investors who have given in to extreme bearishness should start shopping. There are plenty of good deals to be found among companies with sturdy cash flows, healthy growth, and even decent dividends.
Don’t flee stocks. They tend to outperform other asset classes over long periods, and not just because the Ibbotson chart on your financial advisor’s wall says so. Stocks represent businesses, whereas bonds are financing and commodities are stuff. If businesses couldn’t reliably turn financing and stuff into something more valuable, there wouldn’t be so many big ones hanging around.
The problem is that the people who buy stocks can’t decide between rapture and panic, so short-term returns are anyone’s guess. Vanguard recently calculated that, since 1935, U.S. stocks have lost ground to inflation during 31% of one-year time periods, but only 11% of 10-year ones.
Cash-heavy investors should begin buying. It isn’t that things can’t get much worse; they can. The S&P 500 index is already down from over 21 times earnings at the end of last year to 17 times, but it could revert to its longer-run average of closer to 15 times, or overshoot to the downside. A prolonged market slump could create a negative wealth effect, sapping spending and company earnings and sending share prices lower still.
But trying to time the bottom is futile, and stocks can make even buyers who overpay a bit look wiser as time goes on. The average annual return for the S&P 500 since 1988 is 10.6%. Buyers who put money in when the index was trading at 17 times earnings, and held for 10 years, averaged mid- to high-single-digit returns.
Troubled 10: There have been 10 S&P 500 bear markets—defined as declines of 20% or more—since 1956.
|Start and End Date||% Price Decline From Peak to Trough||Length in Days|
|7/15/57 – 10/22/57||20.7%||99|
|12/12/61 – 6/26/62||28.0||196|
|2/9/66 – 10/7/66||22.2||240|
|11/29/68 – 5/26/70||36.1||543|
|1/11/73 – 10/3/74||48.2||630|
|11/28/80 – 8/12/82||27.1||622|
|8/25/87 – 12/4/87||33.5||101|
|3/24/00 – 10/9/02||49.1||929|
|10/9/07 – 3/9/09||56.8||517|
|2/19/20 – 3/23/20||33.9||33|
Sources: Ned Davis Research; Yardeni Research; Bloomberg
That won’t sound overly generous compared with this past week’s report of 8.3% inflation. But that figure is backward-looking, and the Federal Reserve has powerful tools to bring it lower. The relationship between yields on nominal and inflation-adjusted Treasuries implies an average inflation rate of 2.9% over the next five years, and 2.6% over the following five. Strong medicine for inflation could set off a recession. If so, it will pass. For now, jobs are abundant, wages are rising, and household and corporate balance sheets look strong.
Bullishness during downturns can seem naive. There is a tempting intellectualism to the newsletter permabears. But their long-term results are lousy. By all means, worry about war, disease, deficits, and democracy, and blame the left, the right, the lazy, the greedy—even stock market reporters if you must. But try to maintain a long-term investment mix of 60% optimism and 40% humility.
The house view at Morgan Stanley is that the S&P 500 has a smidgen more to fall. But Lisa Shalett, chief investment officer of the firm’s wealth management division, says some parts of the market are priced for upside surprises, including financials, energy, healthcare, industrials, and consumer services, as well as companies linked to transportation and infrastructure.
“You need very high quality and reliable cash flows,” she says. “You tend to find that in companies that have a really good track record of growing their dividends.”
An exchange-traded fund called Pacer US Cash Cows 100 (ticker: COWZ), whose top holdings include Valero Energy (VLO), McKesson (MCK), Dow (DOW), and Bristol Myers Squibb (BMY), is flat for this year. One called SPDR Portfolio S&P 500 High Dividend (SPYD) has some of the same names but yields a much higher 3.7% and has returned 3% this year.
The S&P 500 might not have breached bear-market territory, but half its constituents are down more than 25% from their highs. A glance through some of the hardest-hit names turned up Boeing (BA), which has been laid low by design mishaps and a travel downturn, but whose product cycles are measured in decades, and which can still generate more than $10 billion in free cash during good years. Two years ago, it was valued at more than $200 billion, but now it goes for $73 billion.
Stanley Black & Decker ( SWK
) has been hit by inflation and supply-chain kinks, but demand is healthy, and the valuation has been cut in half, to 12 times earnings. BlackRock (BLK), which owns iShares ETFs and is the world’s most successful asset gatherer, is down this year from 20 times forward earnings to 15 times. Even Netflix (NFLX) is tempting—almost—at 2.2 times forward revenue, down from an average of seven times over the past three years. Some free cash flow there would punch up the script nicely.
There are more sophisticated approaches than looking through the scratch-and-dent bin. Keith Parker, head of U.S. equity strategy at UBS, sees upside for stocks. In the early 2000s, he points out, valuations took two to three years to fall from stretched levels to reasonable ones. This time around, they have done that in a matter of weeks. His team recently used a machine-learning computer model to predict which investment attributes bode best under current conditions, such as when the purchasing managers index, or PMI, is falling from peak levels.
They came up with a mix of measures for things like profitability, financial strength, and efficiency, which they collectively label quality. They then screened the market for high and improving quality, plus decent sales growth and free-cash-flow yields. Names included Alphabet (GOOGL), Coca-Cola (KO), Chevron (CVS), U.S. Bancorp (USB), Pfizer (PFE), and Waste Management (WM).
Don’t skimp on small companies like those in the iShares Russell 2000 ETF (IWM). Their price/earnings ratios are 20% lower than their historical average, and 30% lower than those of big companies, according to BofA Securities.
The same goes for international stocks, despite higher exposure in Europe to the war in Ukraine. The MSCI All Country World ex-US index recently traded at 12.2 times forward earnings. That puts it in the 22nd percentile going back 20 years, which is to say, at statistically low levels. The U.S. market is in the 82nd percentile. The dollar recently hit a 20-year high against a basket of currencies from major trading partners, which Shalett at Morgan Stanley Wealth Management says makes overseas shares an even better deal. “If you have invested in Europe, you get stock appreciation plus a potential rebound in the euro,” she says. “Same thing with the yen.”
UBS says these companies stand out for improving quality, sales growth, and free-cash-flow yieldds.
|Company / Ticker||Recent Price||YTD Change||Market Value (bil)||2022E P/E||2022E FCF Yield||Dividend Yield|
|Alphabet / GOOGL||$2,256.88||-22.1%||$1,488||18.3||5.1%||None|
|Chevron / CVX||164.71||40.4||324||10.7||9.9||3.4%|
|Coca-Cola / KO||64.51||9.0||280||26.1||3.9||2.7|
|Pfizer / PFE||50.39||-14.7||283||7.4||11.9||3.2|
|U.S. Bancorp / USB||48.59||-13.5||72||11.1||N/A||3.8|
|Waste Management / WM||155.48||-6.8||65||27.7||3.3||1.7|
Note: E=estimate; FCF=free-cash-flow; N/A=not available
Bonds have hit less punitive levels, too. The 10-year Treasury yield has hovered around 3%. It tends to peak close to where the fed-funds rate will end up during hiking cycles, which this time around Morgan Stanley expects to be near 3%, give or take. “You may not get the timing perfect here, but the big bulk of the move in bonds, we think, has already taken place,” says Shalett.
Investors can step up to a yield of 4.7% on a benchmark of high-grade corporate bonds, and 7.4% on junk. Stick with quality. The main purpose of bonds is to defend, not delight. Vanguard calculates that a 60/40 mix of stocks and bonds is much less likely than an all-stock one to lag behind inflation over five years, and slightly less likely to do so over 10.
Age isn’t the factor that determines how much to invest in bonds. Go by how soon the investor might need the money. A nonagenarian billionaire can afford to live dangerously. A 28-year-old sole breadwinner with children, a mortgage, and $30,000 in savings should park it in something dull and low risk and focus on maximizing a hidden bonanza—the present value of future pay.
Not everything that’s down a lot has become a better deal. Cash-burning companies will face tighter capital markets. If their path to profitability is long, and chances of a takeover are low, look out. Likewise, there isn’t a long performance record for meme-ability as an investment factor amid rising rates and a falling PMI, but maybe hold off on buying the dip on GameStop (GME) and AMC Entertainment (AMC) just the same.
Crypto lacks cash flows, underlying asset values, and other fundamental value pegs, having only recent price momentum to recommend it. That makes it the rare example of an asset that becomes less attractive, not more, as prices fall. Put differently, there’s no such thing as a crypto value. Buy a smidgen for fun if you like, but the ideal portfolio allocation is zero.
Crypto fans might view this skepticism as fuddy-duddy finance. As an olive branch, we circle back to a fintech innovation that has been even more transformative than the blockchain. Four centuries ago, periodic cash payments to investors were the breakthrough that allowed joint ventures to begin operating in perpetuity rather than splitting the profits after each trip, which led to more stakes changing hands, and the creation of a market for that purpose. In other words, dividends gave birth to stocks, not the other way around.
Since 1936, dividends have contributed 36% of total returns, but since 2010, they have provided 15%. The S&P 500 dividend yield, barely 1.5%, sits at its fourth percentile going back to 1956. The good news is that BofA expects payments to grow 13% this year, as companies that sit on $7 trillion in cash look for sweeteners to offer shareholders. The sooner the better.