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The first half of 2022 was one of the most painful periods in history for investors…
- The S&P 500 fell 20%, on pace for its largest annual decline since 2008 and 3rd largest ever (after 1931 and 2008).
- The 10-Year Treasury bond fell 11.5%, on pace for its worst year in history by a wide margin (the 11.1% record loss in 2009 was for the entire year).
- A 60/40 portfolio of US Stocks (S&P 500) and Bonds (10-Year Treasury) declined 16.6%, on pace for its worst year in history (1931 currently holds that ignominious distinction).
- Investment Grade Bonds fell 13.9%, on pace for their worst year ever and first double-digit annual percentage decline.
- High Yield Bonds dropped 14%, on pace for their second largest annual loss after 2008.
- REITs fell over 19%, on pace for their largest decline since 2008.
As one might expect, there’s been no shortage of rationales as to why markets have been so turbulent:
- The highest inflation rate in 40 years (8.6%).
- Tighter monetary policy with the expectation of continued tightening to come.
- War in Ukraine and its deleterious effects on inflation.
- Plummeting consumer sentiment and growing fears of recession.
Ascribing reasons for declines is the easy part, for bad news is always in ample supply during periods of market stress. Much harder is trying to figure out what comes next.
On that front, most now seem to be in the bearish camp, believing the back half of the year will merely be a continuation of the first half blues. While that’s certainly possible, so is a snapback rally, as we saw in a number of the other worst starts in history (1932, 1962, 1940, 1970, and 1939).
But predicting short-term performance has always been a fool’s game, and an exercise in futility for long-term investors.
What happens over the next six months only matters if you plan on making the biggest mistake an investor can make: selling everything and turning temporary volatility into permanent loss.
In the last 50 years, that’s been a losing strategy every time for equity investors with a long time horizon (10+ years), as the future returns were not only positive, but above average.
And there’s a good reason for that. Big declines lead to lower valuations, and lower valuations tend to lead to better long-term returns.
The opposite is also true, and the carnage in the first half of 2022 didn’t happen in a vacuum. We entered the year with yields near record lows and valuations near record highs, a function of the halcyon days of the last decade.
But trees don’t grow to the sky, and the most powerful force in markets (mean reversion) has finally started to take hold, with valuations falling (CAPE ratio moving from 37 to 28.7) and yields rising (10-Year Treasury yield moving from 1.52% to 2.98%).
This reversion to the mean has been extremely painful for investors in the short run but will ultimately be good for investors in the long run.
Because every major asset class is in a better position today than where it started the year, with higher yields on Treasury bills, Treasury bonds, corporate bonds (investment grade & high yield), REITs, and equities. And higher yields are indeed a good thing, as they tend to pave the way for higher long-term returns.
That’s the upside of downside.
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Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.