By: Thomas Steffanci, PhD, Senior Portfolio Manager
Let’s cut through the ongoing cross currents of Wall Street and other pundits’ chatter about supply chains, the pandemic, the Federal Reserve (the “Fed”), and market volatility to concentrate on the proven drivers of stock market investing.
History attests to the maxim that if you don’t expect a recession nearby, stay invested in stocks. That sounds like a haughty claim, but it turns out to be true. The catch is when do we know a recession is around the corner.
Stock investors have underestimated the role of the business cycle in driving corporate earnings. There is a close and consistent relationship between business cycle indicators and the path of earnings and revenues, and these in turn drive stock prices. The empirical relationships are often dismissed as unnecessary noise to stock pickers until the business cycle spoils their investment plans.
Stock prices usually peak about six to nine months before the onset of a recession; so, if you think the economy is going to stay out of recession for the next 12-18 months, stay invested. In fact, over the past half century, except for the 1987 market crash, there has never been a decline in the S&P 5001 of more than 20% outside of a recession.
Without recounting the economic and financial imbalances, and errant Fed policy, which led to previous recessions, suffice it to say this: Over-extended housing, capital spending, oil supply restrictions, along with strongly rising inflation expectations sow the seeds of recessions.
We do not believe that is the business cycle environment today. Much of today’s inflation is a function of unconventional supply-chain disruptions, which should ease as the pandemic fades, and the effects of prior fiscal stimulus will also diminish.
Monetary policy tightening cannot address those issues, which is why the Fed will likely take a far more measured approach in this environment, despite consensus handspringing about six or seven rounds of interest rate increases. Consumer survey-based three-year inflation expectations have only risen to 3.5% despite a year-to-year CPI at 7.5%.2 There is also no glut of housing or capital spending weighing down economic growth. In our opinion, the seeds of recession have not appeared.
What we do have is a surfeit of liquidity no longer needed to foster economic expansion, and large Federal deficits that risk tax hikes that transfer private wealth to an already bloated government. Rising interest rates are the result. But absent runaway inflation, real rates are likely to remain subdued.
Market timing easily plays on our emotions in a way that overrides even the most well thought out plans. But if you stay calm, you’ll find that the likelihood of a positive return grows higher the longer you stay invested. Having a long-term plan, one that can work through market volatility, is one of the best ways to pursue your long-term goals and bolster your financial situation for years to come. While staying invested is the preferred overall strategy, careful asset class and security selection is required.
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