October 4, 2022

If one only looked at the returns on the major stock market indices for the third quarter (the TSX was -2.2% and the S&P 500 was –5.3%), one might think it was a relatively uneventful three months. Quite the contrary. Stocks staged an impressive rally to start off the third quarter, with the S&P 500 Index rising as much as 14% by mid-August. All of those gains and more, however, were given up by the end of September.

While the S&P 500 Index is at roughly the same level it was at in mid-June, the rollercoaster ride has left some investors’ stomachs feeling queasy. (Unfortunately, investors often feel the pain of declines more than the pleasure of an equivalent rally.)

Squashing Inflation

Financial markets are apprehensive regarding persistent inflation and the actions that central banks are taking to squash it. In August, consumer prices rose at a faster-than-expected pace of 8.3%. This prompted the U.S. central bank to raise its benchmark interest rate by another 0.75% to a range of 3%-3.25%, with the promise of more hikes to come. Going from 0% to the new forecast of 4.40% by the end of 2022 is the bank’s fastest rate increase since the early ‘80s.

Stocks are impacted by such interest rate increases in two primary ways. First, after years of ultralow bond yields, now that 2-year government Treasuries are yielding above 3.7% in Canada and 4.0% in the US, some investors are selling stocks in favour of bonds. Secondly, many fear that higher interest rates will slow the global economy and, thus, hurt corporate profits.

This comes against a backdrop of other headwinds to corporate earnings: raw material inflation, labour shortages, supply chain disruptions, a strong US dollar, etc. As such, it is no great surprise that stocks have pulled back. The only sector in positive ground this year is energy, followed by only modest declines in the more defensive sectors of utilities, consumer staples and health care.

With companies set to report their third quarter earnings and update their outlooks during this uncertain time — the early results have not been encouraging — investors are wondering if there is any reason to believe that the stock market slide will come to an end soon.

Potential For Upside Surprises?

When one examines past stock market downturns, the decline often ends not with a bang, but with a whimper. By that we mean that one should not expect some meaningfully positive news that turns the deeply negative sentiment around. Not since March 2009, when the stock market bottomed following the financial crisis, have investors been as bearish as they are right now. During such moments of extreme pessimism, it often only takes “less bad news” for stocks to stabilize and begin to recover.

With inflation and central bank rate hikes in focus, any easing of inflation (perhaps due to the recent declines in commodity prices) or talk from the central banks that they might ease up on future rate hikes could spark a meaningful rally in stocks.

The Best Time To Be In The Market

While we do not advocate trying to time the market, it is worth noting that we are about to enter a period that has historically been one of the most bullish for stocks. Since 1950, the S&P 500 has had an average gain of 15% in the twelve months following the US mid-term elections, which take place on November 8 this year. The US stock market generated positive gains in each of those post-election periods. That includes in 2018-19 when the S&P 500 generated an 11.7% one-year return despite starting the period with a 14.7% decline in the first seven weeks.

Long-Term Resilience

Regardless of what impact the election cycle, the outlook for the economy, or any geopolitical tensions might have on the stock market in the near term, for most investors it is worth remembering that the stock market has generated very attractive long-term returns for investors that rode out whatever crisis presented itself over the years. At various times, those crises have included major wars, double-digit inflation, pandemics and deep recessions. The characteristic that best describes the market’s ability to rebound from periods of uncertainty is one that we should all aspire to exhibit: resilience.

 

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