By Ryan O’Donnell, CFP® and Mike O’Donnell, CFP®
Even though people have been nervous about the markets and a looming recession all year, the markets have a way of surprising us. US stocks gained 8.4% in Q2 as per the S&P 500 and were up nearly 17% for the first six months of 2023. Meanwhile, the tech-heavy NASDAQ is up over 29% year to date. Not many saw that coming!
Naysayers argue this market rally has been driven by a handful of mega-cap tech stocks with the rest of the companies not doing much. Further they point to tepid corporate earnings overall and the fact that small cap growth (and value) stocks are lagging, commercial real estate is reeling and taking many REITs down with it. Oh, and the yield curve remains significantly inverted and is likely to remain so until the Fed finishes its most aggressive rate hiking cycle in 40 years.
“The stock market has predicted nine out of the last five recessions.” -- Paul Samuelson
You may have heard that an inverted yield curve (when short term rates are higher than long term rates) has preceded every recession since the 1920s. Yes, it’s true. But what many cynics overlook – including the talking heads on TV--is that a recession doesn’t ALWAYS happen after the yield curve inverts. An inverted yield curve is simply a signal that the majority of investors expect a recession near-term. Their fears don’t always pan out. For instance, the yield curve inverted in 1998 and 2019, but no recession followed until much later. There was also a false positive in the mid-1960s. Meanwhile the current yield curve has been inverted since March 2022—sixteen months ago—and so far, no recession has occurred. In fact, only two-thirds of the time that the yield curve has inverted has the U.S. economy fallen into a recession within 18 months.
Recession not necessarily bad for investors
Many argue that a recession is a natural part of the business cycle. We have to trim the excess in order to set up the next economic expansion, right? In fact, since 1965, the S&P 500 has experienced a median return of +8.5% in the 12 months that followed eight yield curve inversions, according to data from LPL Research and the St. Louis Federal Reserve Bank.
So, if you had listened to all the pundits and fled to cash – especially with rates on CDs and money markets at two-decade highs -- you would have missed out on one of the strongest stock market rallies in recent memory. Of course, our clients already know this.
Sure, a recession is still possible, even though the jobless rate remains near a 50-year low, consumer spending remains strong and inflation is down to its historical average of 3% on an annualized basis. The Fed will likely continue raising interest rates, albeit more modestly, which makes borrowing more expensive for consumers and businesses. Inflation could spike again, especially in the volatile food and energy sectors and more banks could fail, which would exacerbate the already tightening credit conditions. But so far, no crisis.
Given that backdrop, it’s nearly impossible to predict which sectors, countries and asset classes will do well at any given time and which will lag. Remember how well energy was doing last year and how poor tech was doing? What a difference a year makes. The point is that portfolios with larger well-diversified allocations to stocks are considered riskier, but they have higher expected returns over almost every time period. Study after study shows you are unlikely to achieve your financial goals without having some level of risk in your portfolio. With that risk, you’ll have volatility from time to time. But sticking to your plan and not panicking will get you through occasional bumps in the road.
It’s almost impossible to know when to get out (or pare down) and when to get back in. Meanwhile, time you spend on the sidelines can be very damaging to your portfolio since you can’t harness the power of compounding when the market rallies unexpectedly as it has so far this year.
Another indicator that’s encouraging us is that market volatility has eased tremendously this year. It seems more and more uncertainty has been removed from investors’ calculus. As this great chart from Morningstar shows below, we’ve had only two days this calendar year in which stocks moved up or down more than 2%. Compare that to 2022 and 2020 when we had more than 40 trading days in the year in which stocks moved up or down more than 2%. Since 2001, stocks have gained on average 17.2% in years with 10 or fewer trading days of +/- 2%. Compare than to returns of only 0.3% on average when we have more than 10 trading days of +/- 2%.
Further, stocks tend to continue rallying after a strong first half of the year
As a thoughtful financial advisor once observed, “A portfolio is like a bar of soap. The more you handle it, the less you have.”
Major Headlines for Q3
“US Inflation Eased to 5% in March; Lowest Level in Nearly Two Years”
“US Signals Support for Allies to Send Their F-16 Jets to Ukraine”
“S&P 500 Starts a New Bull Market as Big Tech Lifts Stocks”
Nasdaq Posts Best First Half since 1983”
“Fed Holds Rates Steady but Expects More Increases”
Enjoy your summer. As always, I am available to meet or discuss ideas.
PS: Congrats to all the parents of recent college grads. If you’re a US investor and lucky enough to have up to $35,000 left over in your 529 college savings plan, you can roll it over into a Roth IRA starting in 2024, provided the account has been open at least 15 years.
