Our Best Bear Market Advice from the First Half of 2022

by James Parkyn

The first six months of 2022 were brutal for investors around the world.

Runaway inflation prompted central banks to hike interest rates and that led to worries the economy would be thrown into recession. At the same time, China’s harsh response to COVID outbreaks and the war in Ukraine compounded supply chain disruptions and economic uncertainty.

Markets around the world dropped in response. And it wasn’t just stocks. The bond market, which is supposed to be a safe harbour when the stock market turns stormy, also fell sharply in response to rapidly rising rates. 

Personal finance author Ben Carlson described the first half of 2022 as one of the worst six-month periods ever for stocks and bonds. According to Carlson, returns from a portfolio composed of 60% U.S. stocks and 40% bonds were in the bottom 2% of rolling six-months returns going back to 1926.

And those losses were mild compared to the crash in formerly high-flying speculative assets such as cryptocurrencies, non-fungible tokens and special purpose acquisition companies (SPACs). 

Over the last six months, I’ve written a series of blogs that brings together our best advice for coping with a bear market. Before we recap the highlights of those articles, let’s take a quick look at some key numbers from the fist half.

To June 30, Canadian short-term bonds were down 4.35% and the total bond market, which is the most widely followed benchmark for bonds in Canada, was down by a shocking 12.19%. It’s rare to see such negative numbers in the bond market. The last time a drop of this magnitude happened was in 1994.

Earlier in the year, Canadian stocks outperformed other international markets, thanks to the rocketing price of crude oil and other commodities. However, the Canadian market has been losing ground in recent months and ended the first half down 9.87%.  

One bright spot was large and mid-cap value stocks, which we tilt portfolios towards. In Canada, they had a year-to-date performance of 0.78% versus -20.38% for growth stocks. Small cap stocks have, however, followed the trend downward, they were -13.2%.

In the U.S., we are in bear market territory with the total market is down to June 30 by 21.1% in U.S. dollar terms and 19.4% in Canadian dollars. Here again, large and mid-cap value stocks outperformed growth at -11.01% year to date versus -26.55% for growth stocks.

It’s at times like these that it’s crucial to go back to the fundamental principles of good investing. Here are some of the core concepts I discussed in blogs in recent months that are especially relevant in the midst of a bear market.  

1. Don’t let anxiety drive your investment decisions—The illusion you can time the ups and downs of the market leads many investors to commit wealth-destroying errors. Consider what happens if you sell to avoid more losses. First, you will have to grapple with the notoriously difficult challenge of deciding when it’s safe to get back into the market and second you will risk missing out on strong returns while you’re sitting on the sidelines. Tune out the short-term noise from the media and accept that no one can forecast when the market will go up or down.

• Cultivate a long-term investor mindset—Bear markets are when investors learn their true tolerance for risk. The emotional pressure to decide and act can feel overwhelming at times. But panic almost always leads to a permanent loss of capital. That’s why it’s crucial to be mentally prepared and stick to a plan based on scientific principles. It should include broad diversification across assets and geographies and periodic rebalancing back to target allocations to position yourself to reap future returns. Louis Simpson, who managed the investment portfolio for Berkshire Hathaway’s insurance company GEICO, once said: “We do a lot of thinking and not a lot of acting. A lot of investors do a lot of acting and not a lot of thinking.” 

• Short-term pain in the bond market will lead to long-term gain—Losing money in what supposed to be your portfolio’s safe bucket is unpleasant. However, higher interest rates will lead to better bond returns in the long run. Investors, who have suffered through years of rock bottom bond returns, should want rates to rise, even if it means some capital losses in the short-term.

• Diversification is still your best strategy–It has often seemed in recent years that when trouble strikes, the markets tend to move down together. This raises the question: Does diversification still do the job it’s supposed to do: increase expected returns while reducing risk? The Credit Suisse Global Investment Returns Yearbook is a guide to historical returns for all major asset classes in 35 countries, dating back in most cases to 1900. The 2022 edition includes an examination of diversification across stocks, countries and asset classes. Among the authors conclusions is that “globalization has increased the extent to which markets move together, but the potential risk reduction benefits from international diversification remain meaningful.” They also note that international diversification is particularly important in small markets like Canada and highlight studies showing that most investors are woefully under-diversified.

A wise man once said: Expect the unexpected and you won’t be disappointed. It hasn’t been an easy time, but market history shows that the best way to ride it out is to tune out the noise, develop a long-term investor mindset and keep your focus on the fundamentals.

Be sure to check out our Capital Topics website where you will find all our podcasts and blogs to help you become a better investor.

The Bear Market in Bonds: Short-Term Pain, Long-Term Gain

By James Parkyn

Most readers will be aware that Canada and the rest of the world have an inflation problem. You’ve no doubt noticed on your trips to the grocery store, your local restaurant, or Canadian Tire that prices are up for all sorts of things.

You also probably know that central banks are fighting inflation by increasing interest rates to cool down the economy. The other day, the Bank of Canada increased its benchmark rate by 0.5%, the largest one-time increase in over 20 years. It’s a safe bet the U.S. Federal Reserve will raise its rate at its next meeting in May. And both banks are expected to announce several more hikes in the months ahead.

What you may be less aware of is the extraordinary effect rising interest rates are having in the bond market. They’ve created a bear market like nothing we’ve seen since the mid-1990s.

You can be forgiven if you don’t follow twists and turns in the bond market. It’s usually quite staid compared to its flamboyant cousin, the stock market.

The stock market’s ups and downs are driven by investor emotions and that naturally draws the attention of the media and the public. By contrast, movements in bond prices are much more driven by boring, old math.

Bond yields—the current interest rate paid by bonds—move in the opposite direction to bond prices, meaning rising interest rates cause falling bond prices. This is because investors who wish to sell bonds have to accept lower prices since the purchasers of those bonds now expect to earn the new higher interest rates.

This effect has meant a steep decline in bond prices this year in response to higher rates. The FTSE Canada Universe Bond Index—the benchmark for bond ETFs held by many Canadians—is down 8.5% (excluding interest payments) year to date and 10.8% since hitting its high mark of the last 12 months in August 2021.

A decline of that size would be bad enough in the stock market; in the normally less volatile bond market it’s an epic debacle. In fact, there have only been two other bear markets on this scale in the Canadian bond market since 1980 – in 1980-81 and in 1994. The one in 1994, which also occurred in the U.S. was dubbed by our southern neighbors the Great Bond Massacre!

This year’s decline will be unsettling for investors, especially because the bond portion of their portfolios is supposed to be the “safe” bucket. However, there a couple of mitigating factors to keep in mind when thinking about this bear market.

The first point is that the decline in bond prices is more pronounced when you hold bonds with longer maturities. The longer a bond’s duration, measured in years, the more sensitive its price is to changes in interest rates.

Short-term bonds, as measured by FTSE Canada Short Term Bond Index, have lost 3.3% (again excluding interest payments) this year and 5.8% since hitting its high of the last twelve months in April 2021. This is still a significant drop, but a lot less severe than the one for longer dated bonds.

In our client portfolios, we prefer short-term bonds with maturities ranging from one to five years. The ETFs we use have a duration of roughly 2.7 years which compares to 7.9 years for the FTSE Canada Universe Bond Index.

Besides being less sensitive to interest rate increases, short-term bonds also provide better protection against rising interest rates in response to higher inflation and are less volatile than longer maturity bonds.

They offer better protection against rising interest rates because with shorter maturities, the portfolio turns over more rapidly, and the bonds can be reinvested at higher rates more quickly. In this context, it’s important to keep in mind that high inflation is a greater risk than rising interest rates because it eats into the value of your savings.

The second point to remember is that higher interest rates lead to better bond returns in the long run. Long-term investors, who have suffered through years of rock bottom interest rates, should want rates to rise, even if it means some capital losses in the short-term.

This is one clear case where short-term pain will produce long-term gain.

Should you be worried about high inflation?

by James Parkyn

If you follow the business news, you know there’s been a lot of speculation lately about whether we’re heading into a period of persistent high inflation.

The trigger for these concerns has been a spike in prices that saw May headline inflation hit 3.6% in Canada and 5% in the U.S.

Some economists are concerned that long-term inflation is being stoked by massive monetary and fiscal stimulus to fight the pandemic recession, combined with pent-up demand from consumers and supply chain bottlenecks as the global economy reopens.

Should we be worried? While we don’t make forecasts about where the economy or the markets are heading, there are signs inflation fears may be overblown.

Both the Bank of Canada and the U.S. Federal Reserve insist the current inflation surge is transitory and there remains a lot of slack in the economy. Although disagreement has emerged recently within the Federal Reserve leadership over the seriousness of the inflation threat.

More importantly, the bond market is not signalling high inflation expectations. If the millions of investors who make up the bond market foresaw a sustained bout of higher inflation on the horizon, they would bid up interest rates. In fact, rates did move sharply higher earlier this year, but since mid-May, they have dropped by .10% in Canada and .25% the U.S.

Looking at the longer term, many observers believe high consumer and public debt and an aging populations are secular trends that will keep a lid on inflation. Economist David Rosenberg believes once things settle down towards the end of the year, the focus will shift back to deflation as the real threat.

Certainly, the stock market hasn’t shown any negative effects so far from the upswing in inflation. It remains at or near all-time highs in Canada and the U.S.

While the stagflation period of the 1970s produced terrible equity returns, inflation has historically been good for stock prices when it’s accompanied by economic growth.

The Credit Suisse Global Investment Returns Yearbook looks at the impact of inflation on global stock and bond returns from 1900 and 2020. It shows that real returns turned negative only in the worst 20% of inflation occurrences. It also found that long-term bonds were hit far worse than stocks during bouts of high, sustained inflation.

So, how should investors think about the today’s cross-currents of information and opinion about inflation?

Your first reaction should be to tune out the day-to-day noise in the media. Nobel Prize winning economist Eugene Fama noted in a recent webinar that future inflation movements are even harder to forecast than interest rate and stock movements, which is to say they are impossible to predict.

Nevertheless, we know inflation is an important variable in financial planning and a risk to be considered. To manage it and other risks, it’s critical to have a financial plan and to be disciplined in sticking with it through market volatility.

To protect against inflation, choose high-quality, short duration bonds for the “safe” portion of your portfolio. Shorter duration bonds turn over more quickly and thus avoid the heavier losses that longer-term issues suffer when inflation and interest rates rise.

Allocate the rest of your portfolio to stocks and higher yielding income securities, ensuring you are globally diversified because inflation might not hit all countries at the same time.

Ignoring the noise and focusing on the fundamentals of prudent investing are the best ways to grow your wealth and keep your peace of mind, no matter what happens in the economy and markets.

To learn more about good investing practices, get a free copy of our new eBook, the Seven Deadly Sins of Investing.

Investment returns are expected to be lower in the future—get used to it

by James Parkyn

Readers who are familiar with PWL Capital’s philosophy will know we don’t make predictions about where the markets are headed in the coming months or years.

We believe no one can predict the markets, despite all the time and money spent by active fund managers, analysts and media commentators trying to do just that.

Look no further than 2020 for the proof of the futility of forecasting market movements. No one predicted the COVID crash or the remarkable rally that followed.

Nevertheless, financial planning requires investors to consider not only personal factors such as their time horizon and tolerance for risk, but also to make assumptions about future rates of return.

What mix of stocks and bonds might provide you with the level of growth you need to achieve your retirement income goals? How bumpy might the ride be? To answer these questions, financial planners use expected rates of return and risk levels for different asset classes.

At PWL, Research Director Raymond Kerzérho provides us with his best estimate of stock and bond returns over the next 30 to 40 years. His projections are based on current asset prices and their return history. The methodology Raymond uses is explained in this paper.

In his latest report, his analysis produced an expected real return (not including inflation) of 4.7% for global equities, or a nominal return of 6.0%, if you factor in 1.3% inflation going forward. Of course, these are averages; there will be lots of ups and downs along the way.

Following a segment on expected returns in a recent episode of our Capital Topics podcast, a listener wrote in to ask why equity returns are expected to be so low in coming years.

The first observation is that they are not that low by historical standards. Over the last 121 years, global equities provided an annualized real return of 5.2%, according to Credit Suisse’s Global Investment Returns Yearbook. Over the last 20 years, global equity markets generated a similar real return of 5.0% per year.

However, strong returns over the last decade might be colouring investor perceptions of how much they should be earning from stock market. Recall that in 2011, the stock market was starting to recover from the financial crisis and stock prices, especially in the U.S., were much lower than they are today. Since then, global equities have generated an annualized return of almost 11%.

Today, it’s a different story. The Shiller-CAPE price-to-earnings ratio has risen to 35 from 21 in 2011 for the U.S. market. The price appreciation has been less dramatic in Europe, but stocks are still much higher than a decade ago.

This is a key reason why equity returns are expected to be lower in the future. Combining lower equity and bonds returns, we conclude a portfolio composed of 60% equities and 40% bonds has an expected return of just 4.34% annually. This is almost two percentage point lower than 6.15% that markets actually returned over the past 20 years.

What does it mean for investors? First, it’s a strong signal to temper your own expectations. In a low-return environment, investors are often tempted to take undue risk in an effort to beat the market.

Egged on by the financial media, they fall prey to recency bias, chasing the latest hot investment idea and ending up getting burned. Last year, they might have decided to load up on high-flying growth stocks. But markets can turn around quickly and without warning. So far this year, value stocks are outperforming growth by a wide margin.

The second conclusion investors should draw from lower future returns is that it’s critical to capture every bit of return that is available. That’s why at PWL we put so much importance on portfolio diversification, tax efficiency and rebalancing.

Building wealth over the long term requires you to make decisions based on the best available evidence and then patiently stick with your plan through good times and bad. A realistic view of future returns is an important part of the equation.