Global markets pulled back again last week following the Fed's announcement that it would tighten by another 75 basis points and keep rates higher for longer. Major indices are back to their June bear market lows with the S&P 500 falling 23% year-to-date and the Nasdaq down 31%. Bonds have also struggled as all interest rates across the inverted yield curve have jumped, with the 2-year Treasury yield rising to 4.2% and the 10-year to 3.7% - the highest levels since 2007 and 2010, respectively. Investors have been navigating this challenging market all year and, for many, it may feel as if there is no relief in sight. How can investors see beyond recent market swings and short-term headlines in order to achieve their long-term financial goals?
In times like these, staying the course can be difficult but history shows that it is ultimately rewarded. Nearly all investors understand that markets naturally swing on a regular basis and that the economy tends to operate in cycles. Still, this knowledge doesn't make it any easier to avoid overreacting to large market moves. This is why, despite the importance of having an understanding of investment analysis, financial planning and portfolio construction, it's often our own behavior that has the biggest impact on achieving financial objectives. Investors understandably prefer to wait for the "perfect" time to invest, which often translates into waiting until it feels safe and comfortable to do so.
The average investor has never been more bearish
The reality is that no market environment is ever perfect, whether it's the challenging period following the 2008 financial crisis, in 2020 during the pandemic, or in the early 1980s when the Fed was last battling inflation. Waiting until investing feels comfortable tends to backfire. When viewed with perspective, how investors feel often turns out to be a contrarian indicator since investors are most confident when markets are at their peak, and most uneasy when markets have already bottomed. As the Warren Buffet quote goes, having the fortitude to "be fearful when others are greedy, and greedy when others are fearful" is what rewards investors over long periods of time. Investing when others are bearish may feel uncomfortable, but this is when prices and valuations are the most attractive.
As the chart above shows, investor sentiment today is at historic lows due to fears of the Fed pushing the economy into a recession. Not only have these concerns been driving markets all year but they are also widely understood. Experienced investors know that boom and bust cycles are a natural and unavoidable part of both the stock market and the economy. Today, the economy is not dealing with shocks from a once-in-a-century pandemic or a 2000-style tech bubble. Instead, it is in the process of restoring the balance between economic growth and inflation. This takes time and there can be stumbles along the way as markets adjust to a new period of more sensible interest rates.
Bull and bear markets behave very differently
Eventually, all recessions and bear markets across history stabilized, paving the way for economic expansions and bull markets. These phases of the economic and market cycle are not created equal. The history of modern market and economic cycles suggests that while downturns may be sudden and deep, the subsequent expansions more than make up the difference. As the chart above shows, bear markets since World War II have lasted anywhere from 6 months to two-and-a-half years. During these periods, the U.S. stock market has fallen anywhere from 22% (1957) to 57% (the 2008 financial crisis) at their worst points.
In contrast, bull markets have lasted from about 2 years to over a decade in length, with the two longest cycles occurring during the past 30 years. These cycles have seen the stock market multiply in value many times over. The eleven-year bull market that ran from 2009 to 2020 experienced a price return of 401% and close to 530% with reinvested dividends. If seasons behaved like the bear and bull markets of recent decades, there would be beautiful weather 11 months out of the year. While preparing for winters is important, focusing on them at the expense of springs and summers is counterproductive.
Overreacting to pullbacks can lead investors to miss rebounds
Of course, past performance is no guarantee of future results, and the point is not that bear markets are insignificant or inconsequential. Instead, it's a reminder to stay invested and diversified in order to benefit from all parts of the market cycle. The chart above highlights the fact that it can take two years for the market to fully recover from the typical bear market. However, the most important point is not when the market fully recovers, but when it begins to turn around. This rebound can happen suddenly even as most investors remain skeptical. Being patient and not focusing on each and every market headline allows investors to avoid their own worst behavior.
The bottom line? It may take time for markets to adjust to this new economic period of higher interest rates and tighter Fed policy. History shows that periods like these may be uncomfortable, but investors who can stay the course will be better positioned to achieve their financial goals.