Amazon (AMZN) founder and one of the world’s richest men – Jeff Bezos – recently sounded the recession alarm, tweeting in agreement with Goldman Sachs (GS) CEO David Solomon that there is a good chance of recession in 2022-2023:
Yep, the probabilities in this economy tell you to batten down the hatches.
In this article, we will discuss the implications of his warning on the S&P 500 (NYSEARCA:SPY) and also share our approach in the current environment.
S&P 500 Implications
Year-to-date, the SPY has taken a beating, as – despite a strong run over the past few days – the index is still down by nearly a fifth:
Of course, big tech (QQQ) and high growth tech (ARKK) have gotten hit even harder:
However, while anemic economic performance year-to-date is surely at least a partial contributor to the lousy market performance, it is not the main driver of lower stock prices. Rather, they have largely been the product of (1) rising interest rates and (2) a much-needed correction in market valuations.
Year-to-date, the long-term US interest rate has more than doubled, though it is still in a lowish range at just 3.67%:
This increase has been driven in part by the Federal Funds rate, which has soared from near zero to 3.25%, with more hikes expected in the coming months and possibly even in 2023:
Why is this such a bad deal for the stock market? Well, there are several reasons. First and foremost, perhaps no one put it better than the Oracle of Omaha – Warren Buffett of Berkshire Hathaway (BRK.A)(BRK.B) – himself when he said:
The most important item over time in valuation is obviously interest rates. Any investment is worth all the cash you’re going to get out between now and judgment day discounted back. If interest rates are destined to be at very low levels … it makes any stream of earnings from investments worth more money.
As a result, in the short-term, stocks are taking a pretty heavy beating thus far this year since higher discount rates are being applied to valuation models to account for the current higher interest rate as well as the expectation by some that interest rates are going to move far higher still.
Another reason why higher interest rates are negatively impacting the economy is because it is causing the US dollar to strengthen against foreign currencies (since the higher risk-free return on dollars makes them more attractive as a store of value). This in turn makes US products more expensive overseas and also reduces the US dollar denominated profits that companies earn overseas, weakening their bottom lines when they report results to US shareholders.
A third reason higher interest rates are bringing down the stock market is simply that they incentivize individuals to save and pay off debt rather than borrow and spend money, thereby sucking money out of circulation and slowing the economy down. This inevitably weighs on corporate profits as well.
Despite the meaningful rise in interest rates so far in 2022, US jobs data remains very strong, with the economy adding 263,000 jobs last month and the unemployment rate falling to 3.5%. Given that the Federal Reserve’s mandate is to maximize employment while also minimizing inflation, it appears to continue to have some leverage that it can deploy by further pressing the labor market in an attempt to bring still-high inflation under control. This means that interest rates are highly likely to continue increasing for the foreseeable future. As a result, the stock market continues to flood in the doldrums.
The second main reason for a poor market performance this year is simply that stocks had gotten ahead of themselves. Despite an immense loss of true wealth in the form of produced goods and services during the COVID-19 lockdowns, the stock market quickly recovered from its initial plunge and actually soared to new highs all the way through 2021. This was largely due to the Federal Reserve printing a historic amount of money and bringing interest rates to historic lows.
On top of that, the US government handed out money at an historic level as well, resulting in a huge bubble in financial markets and the housing markets. By late 2021 this inflationary bubble began to spread into consumer goods as the economy became fully reopened and consumer behaviors began to normalize, while supply chains remained clogged, and production had not yet caught up to rapidly normalizing demand.
Further compounding the problem were that the Federal Reserve hesitated to respond – overconfidently dismissing the inflation as “transitory” instead – and then Russia and Ukraine went to war, placing a severe strain on global food and energy supplies, further exacerbating the inflation issues.
What this all brought to light was that the initial illusion of wealth creation thanks to the massive influx of cash and artificially low interest rates in the wake of COVID-19 was not real wealth. As a result, the stock market realized that its bloated valuation levels were not justified, and it had to correct. Even now, after the major pullback seen in markets this year, the Yield Curve model implies the stock market is overvalued while the Buffett indicator, PE Ratio, Interest Rates, and S&P 500 Mean Reversion models all imply that the stock market is fairly valued. Clearly, a correction was needed to get the markets back on a more stable valuation footing.
While the high inflation, rising interest rate, and bloated valuation environment have certainly done a number on the SPY this year, we are seeing some green shoots that indicate that it could be time to more confidently invest.
There is increasing talk that the Federal Reserve may temper some of its expected future interest rate hikes as the risks of a severe recession continue to grow. This is evidenced by the fact that – despite the persistently low unemployment rate – major corporations are beginning to lay off employees, including Intel (INTC), Meta (META), Tesla (TSLA), Coinbase (COIN), Spotify (SPOT), and Platoon (PTON). Microsoft (MSFT), JPMorgan (JPM), and Alphabet (GOOG) (GOOGL) have also indicated that they are adopting a more cautious approach moving forward in anticipation of an economic slowdown. Furthermore, these layoffs imply that the unemployment rate may be poised to rise meaningfully in the coming months, which would indicate that the Federal Reserve’s efforts to create a better balance between employment and inflation are having their desired effect.
Furthermore, housing has slowed down at a record-setting pace, with sales plummeting and prices beginning to fall too. The Federal Reserve had previously cited housing affordability as something that needed to improve as well before it could ease its tightening, so this is a major positive for stocks.
When you combine these green shoots with the fact that the economy still remains overall in decent shape – at least on the surface – and that stocks are in general in a fair value range on average, it looks like right now is not a bad time to dollar cost average into stocks for those with a long-term time horizon. Bottoms are impossible to time, and the valuations have fallen to a level that is close enough to fair value according to many of these models that over the long-term, investments made today are likely to generate solid total returns.
For those who have been members of High Yield Investor for a while, you probably already know how we react to market volatility. We don’t shy away from it. In fact, we embrace it because it provides us with compelling bargains, and the lower prices go, the more shares we will buy because we (that is, those of us who run the Core and International Portfolios) have a long-term (5 + year) time horizon on our investments and a decent tolerance for risk. As Warren Buffett says:
if you don’t feel comfortable owning a stock for 10 years, you shouldn’t own it for 10 minutes
He also has told investors in the past that:
There is simply no telling how far stocks can fall in a short period…The light at any time can go from green to red without pausing at yellow.
Over the course of its illustrious history under Warren Buffett, Berkshire has seen its stock plunge five separate times:
- down 59% in 1973-1975
- down 37% in 1987
- down 49% in 1998-2000
- down 51% in 2008-2009
- down 26% in 2020
Yet, over time, those who held through the dips have reaped incredible rewards in the form of market-crushing total returns alongside Buffett during his journey to becoming one of the wealthiest men in history.
It is thanks to this simple philosophy that we earned huge returns in 2020 and 2021 as the market recovered, and today’s sell-off is just another opportunity for us to profit in the coming years.
It is easy to feel like today’s uncertainty is unprecedented and that, therefore, this time must be different. But in reality, we have actually been through much worse and always made it to the other side. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; the resignation of a disgraced president; a global pandemic; and much greater inflation than today. Yet, the Dow rose from 66 to over 30,000.
As Warren Buffett told Berkshire shareholders:
Never bet against America.
In that sense, we are actually glad that the market is crashing again. Seeing red in our portfolio never feels pleasant in the moment, but looking back, we have always made our largest gains coming out of bear markets.
The market is at its most inefficient when it is volatile and that is really when active investing is the most rewarding.
Of course, we don’t have a crystal ball and cannot know for sure how the stock market will perform in the short run, but historically, those who have had the courage to buy stocks when they were temporarily discounted have always been richly rewarded in the following years.
As a result, our approach moving forward will continue to be the same as what it has been: instead of fretting about short-term performance, we will keep our focus on the passive income that our portfolio is generating in the short-term as well as a five-year time horizon for total return generation. With this mindset, we are able to sleep soundly at night, stay calm during the day, think rationally, take advantage of bargains that the market indiscriminately throws at us by making consistent small additions to our portfolio whenever capital becomes available (from a combination of dividends, opportunistic capital recycling, and additional cash flow from external investments to our portfolios), and ultimately build our passive income stream.
SPY has already had a rough year and billionaire businessmen like Jeff Bezos of mega cap AMZN are piling on, warning us to “batten down the hatches.” While we certainly understand the risks – and are positioning our portfolio accordingly – we also do not believe that now is the time to run for the hills in a panic.
We believe the SPY is fairly valued after the sell-off and that there are numerous highly opportunistic investments in the high yield space, which is where we specialize at High Yield Investor.
Over the long-term, we look forward to the outperformance that will be generated by our investments made today that we purchased from others who are panic selling. As Warren Buffett once said:
Games are won by players who focus on the field, not the ones looking at the scoreboard.
Instead of focusing on the stock prices being thrown at us each day, let’s keep our focus on the true intrinsic value that our businesses are compounding for us.