With several hundred years of combined investment experience, we at Ancora have seen our share of bear markets and, simply stated, each one is unpleasant. Last Friday’s Consumer Price Index report confirmed the inflation problem facing the economy and the markets. To be specific, the S&P 500 is now down over 20% from its early January peak, thus, it has officially entered bear market territory. While stocks get most of the headlines, the bond market has experienced its own version of a bear market for at least two years. In short, there have been very few places to hide.
The often-asked questions, including in this down market, are if the decline is over yet and when will stocks and bonds go higher again. No one knows for sure, yet there are plenty of Wall Street strategists who offer their perspective daily. We read the few we place value in, but devote more time to the merits of the asset allocation and security decisions we make in portfolios. That said, we will offer up a few of our own perspectives for navigating bear markets:
- We are likely in a regime change of higher inflation for the next 2-3 years. The significant monetary stimulus combined with excess fiscal spending, first delivered a sugar high, which we are now paying for. Inflation is the byproduct of past sins. Demand destruction and gradual supply chain improvements will be the path out of inflation jail.
- Stocks that tend to perform best in bear markets have the characteristics of higher dividend yields, discounted valuations, sustainable cash flow, dividend growth and, importantly, strong balance sheets. In other words, quality endures.
- The companies which have suffered the most, had unrealistic growth expectations and were priced for perfection. Investors are once again being introduced to the Ben Graham concept of margin of safety.
- Alternative strategy focused return streams which do not correlate directly with the stock or bond markets, and especially those that hedge, can be advantageous when included as part of a diversified portfolio.
- According to Guggenheim Partners, the average 20-40% bear market takes 10.6 months to find a bottom and 13.8 months to recover. So, roundtrip, a 20-40% correction takes about two years on average to fully recover.
- Periods of market volatility are frequently followed by periods of outsized positive returns.
Regarding our prior comment about expected future returns for stocks, longer-term forecasts, which usually cover ten years, can be too long for the average investor. Much can happen in a ten-year period. In turn, one-year forecasts typically have a poor batting average. A three to five-year perspective allows for setting the right framework for asset allocation and, importantly, security selection.
As for some perspective on a three to five-year view on the markets, please see the following two exhibits. The first simply demonstrates that, even if you had terrible timing, stocks still can generate attractive cumulative returns, even while enduring poor timing and market volatility.
S&P 500 Index vs. T-Bill Returns
Purchased Just Prior to Market Declines
Source: Bloomberg
The following illustration provides a view of what stocks might be capable of returning over the next 5-years by looking at free cash flow yield. Free cash flow is defined as the positive cash flow a company generates, less the capital required to maintain its assets. It has its foundation in what valuations are today and how that has a respectable forecast to 5-year expected returns. Specifically, valuation using free cash flow yields implies a five-year annualized return of 7.5% – 8.0% for U.S. stocks. While below the long-term average of 10% for stocks, it nevertheless offers favorable capital appreciation potential for stocks.
Free Cash Flow Yield vs. Forward 5-Year Annualized Returns
*Free Cash Flow Yield = Free Cash Flow / Market Capitalization. Source: Strategas Research Partners, since 12/31/99 through 4/30/22.
In short, bear markets happen for a variety of reasons and none are pleasant. They test investor’s resilience and can feel like bungee jumping, from an uncertainty standpoint. You expect that rope to catch, but each time you wonder if it will fail.
The reality is, every bear market finds its bottom where the ominous headlines of the day give way to fundamental analysis of real businesses with enduring cash flows, strong balance sheets and solid reinvestment opportunities and the fear cycle turns to greed. These characteristics, when held in a portfolio of carefully selected individual stocks or funds, are precisely what give equities their long-term staying power and positive skew. We encourage all investors to focus on this aspect of equity ownership to increase your odds of not merely surviving through bear markets, but emerging stronger from them.