On June 13, the S&P closed down 21.8% from its January 3 record close, surpassing the 20% pullback traditionally used to define a bear market. This is the last of the three major averages to enter bear market territory.
The term “bear market” has chilling and scary connotations. Investors immediately think of years of stock market famine, followed by recession and high unemployment. It is not unusual for some investors to calamitize the future when they hear that term.
Bear markets are not pleasant, but they should be put in context. They are part of the cyclical behavior of markets. Bear markets are not a time for panic, alarm, or anxiety. They are generally short-lived and are followed by new highs. Data show that the faster a market enters into bear territory, the shallower they tend to be. The last bear market occurred in March, 2020. It took three weeks for stocks to rise 20%, taking them out of bear territory.
There are numerous secondary, yet significant, reasons for the recent decline in stock prices. The war in Ukraine has increased energy, fertilizer, and wheat costs. China’s economic slowdown and supply chain shortages are also putting pressure on the prices of goods.
The major reason for the decline in stock prices, however, is inflation, which has caused the Fed to raise interest rates and declare its commitment to keep raising rates until inflation is curbed. Consumer prices surged 8.6% last month from 12 months earlier. On a month-to-month basis, prices jumped 1% from April to May.
Inflation for the past three months has become our unwanted guest. He rides in our cars; shops for food with us; buys clothing with us; and goes to the movies with us. He is ubiquitous. Inflation has had a profound and widespread effect on American society. It has brought the Dow, S&P, and Nasdaq into bear territory.
The Fed said they would be “nimble” in adjusting interest rates to economic conditions. Perhaps the word “aggressive” would be more accurate, as they raised interest rates by 0.75% at their last meeting. By raising rates aggressively, the Fed hopes to cool spending and investments without tipping the economy into a recession.
It is a high-wire act which, we believe, they are doing well. Evidence of the Fed’s efficacy may be seen in big-box retailers, such as Target, Walmart, and Macy’s, who have not been able to sell the goods they have in inventory. Generally, retailers respond by discounting prices.
The rapid rise in inflation, increasing rates, and the resulting decline in stock prices came as no surprise to us at Fortis. Throughout 2021, we argued that the Fed was largely ignoring the inflationary potential of quantitative easing. Last December, we set our plan in motion for confronting rising inflation and interest rates and their harmful effect on equities. The following reflects our decrease in equity exposure across our ETF and Stock Models since the beginning of January:
| Jan 2022 | Feb 2022 | March 2022 | April 2022 | May 2022 | June 2022 | |
| Equity | 30% | 42% | 30% | 38% | 38% | 32% |
| Fixed Income | 41% | 34% | 42% | 21% | 21% | 20% |
| Real Assets | 21% | 19% | 21% | 26% | 26% | 26% |
| Cash & Equiv. | 8% | 5% | 7% | 15% | 15% | 22% |
We have created a defensive ETF strategy. Fixed Income allocations are up, and Equity and Real Asset weightings are down. Cash is up significantly as we await re-entry points in the stock market. Cash allows us flexibility, while Corporate Bonds and Commodities produce returns close to the S&P 500 without the volatility. In April, we exceeded our benchmark by 1.78%, and in May we performed at benchmark.
Our proprietary Fortis Sector Rotation Model has significantly influenced our stock portfolio strategies. As of June, we are overweighted Consumer Staples, Utilities, and Energy. Since April, every other sector has been underweighted. Tech, Health Care, and Discretionary have the most significant underweight deviations from the S&P 500 benchmark.
Our defensive positioning paid off. For April and May, the Fortis Leaders 50 Stock Strategy and Fortis Alpha 40 Stock Strategy returns benefited. Table below shows the return percentage vs. the S&P 500.
| April 2022 | May 2022 | |
| Fortis Leaders 50 Stock | + 3.48% | (-.23%) |
| Fortis Alpha 40 Stock | + 3.95% | (-.19%) |
Watching for a Bottom
On Wednesday, the Fed raised the interest rate by 0.75%, the largest increase in 28 years. The Dow jumped 300 points, even with the prevailing sentiment the Fed will again raise rates in July, possibly by another 0.75%. Our primary focus is watching for a market bottom, which will roughly coincide with the end of the current rate-hike cycle. The good news is the end looks near, and we do not intend to reduce our equity exposure in the coming months. Several indicators encourage us to believe we are close to a bottom:
1. Dumb Money. We compare daily volume traded in short or inverse ETFs relative to the volume traded for levered long ETFs. When the percentage of short volume rises to 60%, it has consistently signaled a tradable bottom. At present, short ETF volume sits at ~50%. This past December, short ETF volume was below 20%, an all-time low which was a critical part of our decision to reduce equity exposure. The current reading of 67% is conversely a screaming buy signal.
2. Volatility measures are an essential part of our bottom watch matrix. In early December, we saw the VIX hit 28.5 and register a sell signal. Today, the VIX reading is 29.62. Our analysis tells us we want the VIX to be around 25 to become more aggressive in buying equities.
3. Breadth Thrust Indicator is another powerful, short-term market Indicator with broad-based participation, usually requiring ~90% of stocks within a universe to engage. This Indicator reflects market momentum by comparing advancing issues to all issues traded, both advancing and declining. The assumption is that sudden money changes elevate stocks and signal greater liquidity. Currently, 94% of S&P 1500 stocks’ volatility are above their one-year average.
4. Macro-economic factors round out our watch list. Before rate hikes and the Russia-Ukraine conflict, we highlighted the 2-10 yield curve and inflation expectations as macro data points that would guide Jerome Powell. Since then, various yield curve measures have diverged, and inflation expectations over the next 12 months have exploded. We will focus on the core Personal Consumption Expenditures Price Index, which excludes food and energy prices. This Index makes it easier to see underlying inflation trends by excluding prices that tend to have dramatic swings. This Index is closely watched by the Federal Reserve in establishing monetary policy. Monthly inflation data is continuing to soften, and, as we mentioned in previous post, there are emerging signs inflation has peeked.
There are credible reasons for investors to sell stocks. We would rather see investors, however, tolerate the chaos in the markets rather than to make emotion-driven, fear-driven, panic-driven decision. Good quality stocks that have been beaten up badly, such as Target and other consumer discretionary stocks, however, selling good stocks when they are down would be short sighted. When the stock prices are lower, the natural rebalancing in our strategies allows us to purchase a greater number of shares. The S&P 500 has come back from each of its prior bear markets to rise to another all-time high. The bear will end, and, according to history, the greatest profits have been made just after it ends. Patience will be required.
Novelist Ernest Hemingway espoused a sentiment that may be applicable to today’s investors: “Courage is grace under pressure.” Courage and grace are needed especially during difficult financial times to maintain cool heads, emotional poise, tenacity, and confidence in the future.
