After guiding clients through the “Tech Crash” early in my career, I was told that it was a once in a lifetime event on par with the Dutch Tulip Mania of 1636. A few years later we had the “Great Recession”, arguably the worst financial conditions since the Great Depression circa 1929, a once in a lifetime event. 2020 brought the COVID pandemic, the first global pandemic since 1918 and yes, you guessed it, a once in a lifetime event. And now we have 2022 in the record books, a year that will go down in history as one of the worst years ever for moderate and conservative investors only rivaled by 1871. Why was 2022 so bad for investors? Because we just experienced one of, if not the very worst year in U.S. history for the bond market. The bond market is supposed to be your shelter in the storm but in 2022 it was the storm. This was something we talked about in last January’s newsletter and the reason why we eliminated bonds altogether from most of our models in late 2021. There was no shelter for the storm in 2022 and that is why it will go down in history as a once in a lifetime kind of year. So now that it's over, where do things go from here?

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The good news is, I think the market goes a lot higher. The bad news is, I think the market goes lower first. ​

 

This time last year, none of the standard warning signs for recession were flashing “red”. Now, nearly every single sign is flashing red and some of these indicators have track records of up to 100% accuracy. We must view market and economic expectations through the perspective of “probabilities” and the probabilities for a recession are the highest I’ve ever seen in my career.

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If a recession is imminent, then the probabilities are extremely high that the market has not seen the bottom yet. The stock market has never bottomed prior to a recession since 1945 and the 1945 market was MUCH stronger technically than the one we have today. 

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So, if a recession is probable and the stock market usually bottoms in the midst of a recession then we should be positioning ourselves for a lower low and that’s exactly what we’ve done. Our cash levels are the highest they’ve ever been. For moderate and aggressive risk portfolios, we added a hedge by shorting the stock market with a percentage of the models. This hedge will rise when the market falls helping to create a buffer in the portfolio. I keep watching the bond market for a good time to add them back into the mix as protection in the portfolios, but I still don’t trust the interest rate outlook and bond market just yet. I’d like to see more confirmation that inflation is subsiding significantly before adding bonds back to the mix.

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The next question is, how low will it go? Well, it can go quite a bit lower. The average decline for a recession driven bear market tends to be quite a bit lower than what we’ve seen so far. The high end would be around 3200 on the S&P 500 and the low end would be around 2800 on the S&P 500. The S&P started the year at 3840 so that equates to a 16% to 27% drop from where it sits today. First, I don’t think the lower level is as likely given the strength of the economy heading into this “expected” recession. Secondly, our portfolios should move less than half that much or less given the cash. positions and the short hedge that’s in place. But half of that move can still feel painful. Just remember, it’s the down markets that really allow you to make significant returns. We will look to sell the hedge and buy the market very aggressively on the way down to the bottom.