You would be excused if you thought the global economy was going into economic meltdown from recent media headlines that are plagued with phrases such as ‘bear markets and ‘stagflation’ and threat of a ‘recession’.
The stock market is said to have entered a bear market once the respective index declines by 20% or more from its peak. The US technology index, NASDAQ 100, was the first notable index to enter bear territory in April, and was followed by the broader US index, the S&P 500, in June. To date, the Australian ASX200 index has not fallen into a bear market, having come close in June after a 15% decline from peak to trough. However, certain sectors within the Australian index have certainly entered bear territory, such as the Information Technology sector, with names such as Xero and Altium leading the way.
What is a bear market?
A bear market is the opposite of a bull market, which is defined as a market that rises over time without falling more than 20% from its peak during the period. As the global economy emerged from the Global Financial Crisis (GFC) of 2007-08, stock markets globally entered into the longest bull market in stock market history. Assisted by a sustained period of declining interest rates, bulls managed to keep the bears down for the better part of a decade. However, recent economic developments have given bears some ammunition, such as rising interest rates, persistently high inflation, geopolitical tension, yield curve inversions, and supply chain issues.
While the economy is facing and will likely continue to face challenging conditions in the near-term. When looking back at global financial markets, times exactly like these present the greatest opportunities to create long-term, lasting wealth. The old Warren Buffet saying could not be more relevant in today’s markets “Be fearful when others are greedy, and greedy when others are fearful.”
Why is the Stock Market Falling?
Following the Global Financial Crisis (GFC) of 2007-08, the global economy experienced a sustained period of interest rates going lower and lower. Take the Reserve Bank of Australia’s (RBA) targeted cash rate for example, the rate that domestic commercial banks derive their own lending rates from.
Financial markets globally grew accustomed to these historically low interest rates creating a beneficial environment for ‘risky’ assets: cheap credit, low returns on alternative asset classes, higher valuations. These easy monetary conditions were fantastic for equity markets across the globe, giving rise to the longest bull market in the history of the stock market.
Interest Rates & Inflation
Interest rates were kept low for so long because these conditions are used as a tool to stimulate economic growth. When rates are low, households and businesses are more likely to borrow and are less likely to save – lifting the level of aggregate demand in the economy. However, due to the unprecedented amount of money injected into the economy throughout the pandemic, inflation across the world started increasing materially for the first time in a decade as an increasing amount of money chased a relatively fixed amount of goods and services.
Central banks across the world classified the rise in prices as transitory, noting that the drivers behind the inflation were temporary, and will imminently subside. Basically, the institutions responsible for keeping inflation within a reasonable range decided not to raise interest rates to combat inflation as they thought the risk of pre-emptively dampening economic demand outweighed the risk that inflation was here to stay.
As 2021 progressed, supply chain issues dominated the global economy. The economy is now simultaneously battling heightened demand because of the high levels of stimulus that flooded the economy, as well as supply chain issues that were causing the prices of inputs and ultimately most end-products to rise. When demand outstrips supply, prices rise. The cherry on the top of this demand-supply imbalance was Russia’s invasion of Ukraine in February 2022. Russia and Ukraine are home to some key commodities, putting even more pressure on supply chains, particularly oil.
As evidenced within the below graph of the United States’ inflation rate, in 2022 it became evident to investors and central bankers alike that inflation wasn’t so transitory and interest rates had to rise to help combat rising prices.
Oil prices led the rally in prices across the globe, hitting US$120 a barrel in June 2022. Historically, any time oil has risen as much as it has as quickly as it has, the economy has entered a recession in the periods following. At the same time, interest rates were entering a new period of tightening for the first time in over a decade. As interest rates rise, economic demand decreases as a result of less borrowing activity, higher interest rate repayments, higher rates of saving, etc. These factors were occurring at the same time as Russia was invading Ukraine, and just months prior the bond yield inverted, which has historically been an accurate indicator preceding a recession, because it signals that the bond market is unwilling to accept a lower yield for short term bonds compared to long term bonds, citing higher risk in the near term. Therefore, the combination of these factors led to market commentators and investors focusing on the fear of what is known as stagflation.
Stagflation occurs when an economy faces stagnant demand and persistent high inflation simultaneously. These two conditions do not typically occur together, however are most likely to occur when oil is the primary driver in inflation, particularly due to a supply chain issue – which is what is happening now.
How does this link to stocks?
In two ways, both through valuations and earnings. When interest rates rise, the rate at which future cash flows are discounted increases, making the present value of those cash flows worth less. This translates to lower market values for stocks. Additionally, as businesses endure high rates of inflation and potentially weakened consumer demand, profits fall, also leading to lower market values for stocks.
How should investors react?
Cash shouldn’t be invested into stocks if the cash is likely to be needed within the next 3-5 years. Therefore, if this advice was heeded upon entering into the stock market, investors don’t have to worry about permanently losing capital if they are invested in a high quality, diversified portfolio of companies. Remember, losses and gains aren’t realised until shares are sold.
Our recommendation to investors
We believe the best thing investors can do during these times is gradually invest regular amounts of cash into high quality equities, at regular intervals. Trying to time the market on a consistent basis is a fool’s game, and over time is impossible to successfully do time and time again. Another recommendation for investors can do is turn off their brokerage accounts and hold their stocks. And the worst thing an investor can do is panic sell. Sure, if the reason you entered into a company is no longer intact, then a sell might be warranted. However, selling out of a position purely due to the price going down makes no logical sense. This strategy can be likened to selling a brand-new water-side apartment just because someone has left an offer in the mailbox for 20% less than you bought it for.
For investors, occasional stock market ‘crashes’ are the best thing that can happen to them if they are greedy while others are fearful. These periods provide an opportunity to buy into high quality businesses at a discount. It’s as simple as this: the lower the price you pay, the higher the future return, and vice versa.
For younger investors in particular, low prices are their best friend. For example, if you had invested just before the GFC on October 31, 2007, you would have achieved a compounded annual return of 8.4% before dividends by 31 December 2021. However, if you had invested after the market had fallen 47% on January 30, 2009, you would have achieved a compounded annual return of 15.7% before dividends, over the same period.
Only in hindsight can we clearly see the immense opportunity that these stock market declines provide. Almost everyone is hesitant to deploy capital into markets due to the belief that the market has not bottomed yet and has further to fall. However, as displayed in the above example, even if you timed it horrendously and bought the peak, you still did very well over the long term. You would do even better if you had bought consistently over the decline.
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