Markets are in turmoil, what should we do?
Attention investors: fasten your seatbelts, because we’re in for some turbulence.
I wrote recently that the yield curve inverted, portending a possible economic recession within the next 24 months. Turns out, recession might already be upon us. In Q1 of 2022, the U.S. GDP surprisingly declined by 1.4%. A recession is defined as a fall in GDP for two successive quarters, so if GDP growth declines again in Q2, the U.S. economy will indeed enter a recession.
There’s doom and gloom everywhere you look. COVID persists, and while life seems to be back to normal in many parts of the world, China is actually intensifying draconian COVID-related lockdowns in a stringent (and unrealistic) zero-COVID policy. China is the world’s second largest economy, but is the #1 exporter of good and services, surpassing even the United States in total exports. This has caused significant economic disruptions and shortages of Chinese exports worldwide.
Russian’s invasion of Ukraine is ongoing. Shortages of many other consumer goods continues. There’s a deepening nationwide shortage of baby formula of all things, leaving many anxious parents scrambling. The Ukraine war is also threatening to cause a global food crisis. Shortages of toilet paper and PlayStations are one thing, but food and baby formula? I can’t even imagine the panic on the streets if we face significant food supply disruption.
Consumer goods aren’t the only supplies affected. Those in the medical field may be aware that there’s a nationwide shortage of IV contrast for imaging studies. As it turns out, most of our IV contrast comes from China. The hospital system that I work at is implementing dramatic steps to conserve IV contrast for medical emergencies, as are many other hospitals across the nation.
Inflation remains as hot as ever, with the prior 12-month Consumer Price Index (CPI) hitting 8.3% as of April 2022. This is despite the Federal Reserve raising interest rates significantly (most recently by 0.5%, or 50 basis points), meaning that further rate hikes are highly likely.
The stock market is the ultimate barometer of public sentiment. Unsurprisingly, that sentiment is pessimistic. One year ago, the S&P 500 broke the 4,000 milestone for the first time. Now, almost exactly one year later, the S&P 500 has dipped back under 4,000 again, wiping out an entire year’s worth of market gains (excluding dividends). Stock markets are forward-looking, and investors are not seeing a rosy future in the short-term.
The S&P 500 broke the 4,000 milestone on April 1, 2021. One year later, the index has fallen below 4,000 again. As of May 12, 2022. Graph from Federal Reserve Economic Data.
We probably haven’t hit the bottom yet
As bleak as things look now, the bad news is that things may get even worse before they get better. While we can’t predict the future, the market probably hasn’t bottomed out yet.
In prior economic recessions, stock market peak to trough losses were staggering. For example, during the 2007 to 2009 global financial crisis, the S&P 500 suffered a peak to trough loss of over 55%. To put that in context, a similar drop in the S&P 500 in 2022 would put the index value at about 2,000, or back to year 2014 index values!
| S&P 500 peak to trough declines during recent recessions | |||
|---|---|---|---|
| Peak price & date | Trough price & date | Peak to trough decline | |
| 2000's recession | 1527.46, (Mar 24, 2000) | 776.76, (Oct 9, 2002) | -49.1% |
| 2007 - 2009 crisis | 1565.15, (Oct 9, 2007) | 676.53, (Mar 9, 2009) | -56.8% |
| COVID-19 recession | 3386.15, (Feb 19, 2020) | 2237.40, (Mar 23, 2020) | -33.9% |
| Current market* | 4796.56, (Jan 3, 2022) | 3930.08, (May 12, 2022) | -18.1% |
| *S&P 500 trough as of May 12, 2022. | |||
Note that these values reflect S&P 500 index prices only, without accounting for dividend reinvestment, which softens the blow somewhat.
So, when viewed through the lens of history, the current stock market turmoil is relatively mild. As of May 12, 2022, the S&P 500 is “only” down 18.06%. We’re not yet in bear market territory, defined as a 20% or greater decline, which accompanied all three prior recessions. If we do enter a recession, the market has potential to fall much, much further.
I would be remiss if I didn’t point out, however, that the S&P 500 had approximately 10% compounded annualized returns in the long-term, even with these market downturns.
Speculative assets have crashed
While the overall stock market downturn is pretty tame so far, more speculative assets have already cratered. This is often the case during economic downturns, as euphoria quickly turns into panic, and riskier assets see disproportionate outflows as investors flee to safety. These assets are usually rich in hype but poor in fundamentals, and are the first to be panic sold.
For example, the NASDAQ-100 index of mostly technology stocks has fared much worse than the S&P 500. Whereas the S&P 500 is down 18% in 2022, the NASDAQ has shed over 27%. Similarly, cryptocurrencies, which are some of the most volatile assets in existence, have fallen further. Bitcoin, the oldest cryptocurrency and the benchmark for the entire crypto market, is down over 37% for 2022, and down over 55% from it’s all time high of $69,000 from November 2021.
2022 year to date performance of S&P 500, NASDAQ, and Bitcoin. While the S&P 500 is down 18%, other assets have fallen much further. Chart from tradingview.com.
The “fear gauge” has not yet peaked
The Chicago Board of Options Exchange (CBOE) publishes a volatility index, known by the ticker VIX. VIX is a computed index based on S&P 500 options expiring 30 days in the future. It represents a projection of expected market volatility over the next 30 days. It is frequently referred to as the stock market’s “fear gauge”.
VIX usually stays between 10 and 20, but rises above 20 during periods of market turmoil. During more severe market downturns, VIX undergoes extreme spikes to multiple standard deviations above its mean. During the COVID-19 recession, VIX peaked at over 80. Similarly, during the 2007 - 2009 global financial crisis, VIX stayed above 50 for weeks, with multiple peaks above 70 and 80.
VIX spiked above 80 during the 2008 and 2020 recessions.
Currently, VIX is at 32.56 as of May 12, 2022, with a recent peak at 36.45 on March 7, 2022. While VIX is elevated during the current market turbulence, many observers believe that VIX has not peaked, and therefore believe that the market has not bottomed out yet.
What should we do?
The good news is that the U.S. economy and stock market have never failed to recover from a recession. This downturn is likely temporary, like every previous one. Given enough time, investors can wait out any downturn. However, this is little consolation to people who are watching their portfolios evaporate before their eyes.
Unfortunately, there is no universal advice for what investors should do during this, or any other market downturn, because everyone’s financial situation is different. But here are some general guidelines to consider:
First and foremost, don’t panic! Now is not the time to make rash or impulsive decisions out of fear or greed. For most investors, the best thing to do is simply to stay the course and stick to your existing plans.
Have enough cash. No asset feels safe right now, and even bond funds are down for the year. Holding cash feels bad because inflation remains at 40-year highs, but it is important to have an adequate emergency fund if the economic downturn worsens. This is especially true if your cashflow is not consistent or if your job is highly susceptible to economic recessions. While it is tempting to buy the dip every time the market hits a new low, never do it with your emergency fund. You might catch a falling knife instead.
Match your behavior to your time horizon. Your overall investing horizon is very important. If you are investing for ten years or more, consistently investing in the stock market even through a downturn is probably the best bet. In fact, for long-term, buy and hold investors, market downturns represent opportunities to buy assets at a discount, and stocks are still the best assets for long-term growth. If you are making consistent contributions to investments and retirement accounts every month, you should probably just continue to do so. On the other hand, if your time horizon is shorter than this, then shifting your assets for capital preservation may be warranted.
Asset allocation. Similarly, make sure your asset allocation matches your time horizon and risk tolerance. During times of economic and market turbulence, risky and speculative assets suffer disproportionate losses as people flee to safety. Speculative bubbles may collapse completely. For example, if your portfolio consists of S&P 500 index funds, you’ll probably be okay in the long-run, because the fundamentals of the S&P 500 companies are sound. The same cannot be said of more speculative assets, such as meme stocks and cryptocurrencies. I am loathe to tell anyone to sell assets during a downturn. However, the advice to keep investing as usual only applies to traditional assets. If most of your portfolio is highly speculative, it might be time to cut your losses and run, because assets without solid fundamentals may not recover.
Rebalance if needed. Market downturns also represent opportunities to rebalance your portfolio. Selling one asset to buy another can incur significant tax costs from realizing capital gains, unless the rebalancing is done in a tax-advantaged account. However, during market downturns, selling an asset at a loss can provide a tax break instead. This is known as tax loss harvesting, and can be used to offset capital gains from other parts of your portfolio.
Don’t leverage. I’ve written extensively about leverage in other articles, specifically regarding leveraged ETFs. During sustained bull markets, such as the last decade or so, leveraged portfolios can greatly outperform non-leveraged ones. Nonetheless, it bears repeating that leverage of any kind is dangerous, especially during periods of heightened volatility. If you’re employing significant leverage in your portfolio, it’s probably time to reconsider. Sudden, unexpected market movements can totally wipe out leveraged investors.
Don’t try to time the market. There are several ways to profit in a declining market, with the most accessible being inverse ETFs, short selling, and put options. During the COVID-19 pandemic in 2020, I explored some of these methods. It was not worth the effort, and I quickly learned that there’s no way to know where the market’s bottom is. Alternatively, even traditional long investors might try to time the market by waiting for the bottom before going “all-in”. Either way, it is tempting to time the bottom of the market, but this is all but impossible. As a reminder, during the recent COVID-19 recession, the market bottomed out on March 23, 2020 (after just 4 weeks), whereas many people were predicting that lockdowns would persist through summer and that the economy would not recover for years.
Conclusion
We live in uncertain times, and it is hard to find optimism in midst of current world events. As a result, the stock market has taken quite a tumble in 2022. During these turbulent times, it’s more important than ever to take stock (haha) of your overall financial situation and your investing strategy. Don’t make impulsive decisions out of fear. Stick to your long-term plans instead. Remember that everyone looked like a genius during the recent bull market, when a rising tide lifted all boats. Warren Buffet famously said, however, that only when the tide goes out do you discover who's been swimming naked. Adhere to tried to and true investing principles, and you won’t get caught swimming naked in a recession. Thanks for reading, and happy investing!
Another year in the books