September brought a grim close to the third quarter in the markets, with both stocks and bonds posting some of their worst monthly losses thus far in 2022. The hawkish tone of Jay Powell’s press conference reinforced the message he delivered from Jackson Hole in August—that the Fed is committed to doing what it takes to tame inflation, even if that brings economic pain. The S&P 500 lost -9.2%, the Nasdaq lost -10.4% and the Bloomberg Aggregate Bond index lost -4.3%. This leaves most of stock indexes in bear market territory as we enter the final quarter of 2022. Every sector was negative in September, with the Real Estate sector losing the most at -13.2% and the Health Care sector proving the most resilient with only a -2.6% loss. The yield curve inverted more steeply—rates rose across all maturities rose but even more on the shorter end. The 2 Year Treasury yield—widely indicative of where the Fed plans to move its Federal Funds Rate—began September at 3.51% and finished the month at 4.22%. Meanwhile the 10 Year Treasury yield rose from 3.26% to 3.79% over the course of the month. September was chock full of headlines broadcasting that yields across the maturity curve were at their highest points since before the Great Financial Crisis of 2008.

It appears as though markets have begun to recognize, over the past six weeks, that the likelihood of a “soft landing” is pretty remote. Because the Fed can’t control the supply side of the inflation problem, its only tool is to cool demand. This is synonymous with an economic slowdown. As we’ve said month after month this year, the forward-looking prospects for the market will continue to depend on inflation and the Fed’s response. The seemingly slow-motion nature of this year’s grind lower is certainly difficult for investors to endure, but what is the alternative? We remind readers that timing the market is notoriously difficult, if not impossible, to do well; that markets tend to bottom out months before the economy does; lastly, the returns in years following recessions are historically some of the strongest periods for investing. Let’s consider these points separately.

The best demonstration of the folly of timing the market is to examine the impact on one’s return by staying invested vs. missing some number of the best return days. Putnam Investments put out an analysis earlier this year that considered the 15 years from the beginning of 2007 through the end of 2021. If an investor simply bought an S&P 500 index fund and never sold it during that time period, their annualized return would have been 10.66%. By contrast, missing the 10 best days in that 15 year stretch more than cut their return in half, to 5.05%. Missing the 20 best days brought it to only 1.59% and missing the 30 best days led to a negative return of -1.18%. A proponent of market timing might respond, “No problem, I’ll just make sure I’m invested during the good days and get out of the market when things turn sour.” The problem with that mentality is that the best days tend to cluster around the worst ones, and more often than not they come after them. In 2022 alone, through September, five out ten of the best days for the S&P 500 have occurred within a week following one of the ten worst days.

Next, it’s important to remember that the stock market and economy are two different entities that don’t rise and fall in lockstep. An investor might wonder why they should stay invested if the odds suggest a recession is imminent in 2023. The reason is that the stock market is prone to bottom out before the recession occurs or before it can be confirmed to have occurred after the fact via backward-looking data. The market is a forward-looking discounting mechanism and so it makes sense that stock indexes tend to hit their bottom before economic facts on the ground signal recession. Now, with two consecutive quarters of GDP contraction in the first half of this year, it’s fair to suggest that we have already had a recession and may still be in one. With other economic indicators still strong (3.6% unemployment being the most striking) it is also fair to suggest that the economy has not been in a recession, at least in the traditional sense of the term. The National Bureau of Economic Research (NBER) put out an enlightening table of S&P 500 returns broken out by the six months before a recession, during a recession, and for the one, three, five and ten years following a recession going back all the way to 1948. In the 12 recessions that have occurred since 1948, the S&P 500 was negative before six of them, negative during six of them, and only saw negative returns in the one year following recessions in one of them (the March-November 2001 recession). The takeaway being that most of the negative stock returns associated with recessions occur before or during the recession takes place. The data also tells us that the average historical recessionary drawdown since 1948 is 31% in the S&P 500. With the index already down for the year by 24%, it really doesn’t have that much more work to do to hit that average.

Finally, investors should always be looking forward, and in that spirit, it is helpful to consider what history tells us we could expect now that we’re already in the middle of a bear market with a potential recession looming. The same NBER data referenced in the previous paragraph is informative here, because we can see how the S&P 500 has performed multi-year periods following a recession. On average the S&P 500 has done the following after the past twelve recessions:

• One year: 20.93%
• Three years: 48.63%*
• Five years: 93.49%*
• Ten years: 256.41%*

Clearly, investors who keep their money in the markets during the toughest periods of bear markets and recessions have historically benefited from outsized returns. This makes sense intuitively by considering stock and bond market valuations. At the beginning of the year the forward-looking price-to-earnings ratio on the S&P 500 was 21.4. Through the end of September, it is now only 15.4. By the same token, the 2 Year Treasury Bill started the year yielding only 0.78%, and as of the end of September it’s yielding 4.22%. When would you rather be an investor in stocks and bonds—January 1, or today?

*doesn’t include the March-April 2020 recession

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