Barron's Streetwise - Bear Market Playbook

Episode Date: May 13, 2022

A pair of top strategists discuss what to buy now, and stay away from. Learn more about your ad choices. Visit megaphone.fm/adchoices

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where people were for the first time saying, holy crap, maybe we really will get a recession. Maybe the Fed really is not going to be able to land the plane. Welcome to the Barron Streetwise podcast. I'm Jack Howe. The voice you just heard is Lisa Shallott. She's the chief investment officer at Morgan Stanley Wealth Management, and she's talking about the possibility of a recession. Whether or not we get one of those, we're quite close to a bear market for stocks, but I wouldn't quite describe Lisa as bearish. In a moment, we'll hear from Lisa and another strategist on some bear market guidelines for investors, including some

stocks that look attractive now. Listening in is our audio producer, Metta. Hi, Metta. Hey, Jack. I want to thank you and Jackson for doing a great job on the podcast while I was on vacation for two weeks. Well, happy to. Did you have fun? Mostly. I went to a water park with my family and I did fine on the barreling baboon and the rippling rhino, but I hurt my tailbone on the anaconda. Oh, no. Yeah. At that point, the screaming hyena was out of the question.

I was pretty much laid up for the afternoon of the thirsty turtle. I am sorry to hear that. Well, thank you. I have made a full recovery, but the stock market's had a rough ride of its own while I was gone. All weekend, I was getting a nasty feeling about the market and how it would open this morning. Right now, we are looking at the Nasdaq down almost 1 percent. The S&P 500 is also lower. The Dow lower as well. And just taking a look. Because what the market did yesterday was take back the gains and continue the fall that had already been started. Interest rates rise and we move closer to

recession. And no matter what they tell you, when rates rise, at some point, stocks fall. The S&P 500 index was recently down 18% from its high point in early January. That's only a couple of points short of the traditional definition of a bear market a market drop of 20 percent one big investment bank wrote that investors are on pace for their worst year ever which seems alarmist when I hear things like that I like to mention to people that a dozen blocks north of Barron's headquarters in Manhattan is Central Park, and there's one small section used by sunbathers called Sheep Meadow, only it has no sheep. It used to, but during the Great Depression, when belt tightening wasn't just a figure of speech, the city's hungry and homeless built shacks in parks called Hoovervilles, and the sheep were moved to Prospect Park in Brooklyn for fear that Hooverville residents in Central Park would eat them. So I hesitate to call anything about

financial conditions today the worst ever, although the researchers who wrote that were making more of a technical point. The stock market has gotten off to its worst start in more than nine decades. Bonds are supposed to help offset downturns like that, but they're getting crushed too, because the Federal Reserve has begun aggressively raising interest rates and will soon start selling down its bond portfolio. Meanwhile, inflation is raging. That's why the Fed is doing these things to begin with. So if you take a 60-40 portfolio of stocks and bonds, and you measure its return year to date,

and then you subtract for the latest reading on inflation, and then extrapolate all of that as though it will continue for the rest of the year, you end up with a diversified investor losing nearly half his or her portfolio value in real terms. And that would be the worst performance in U.S. data going back just over 100 years. But there are some giant caveats. The most glaring of them is that nothing of the sort has happened yet. It's only mid-May. Assuming that a once-in-a-lifetime bad start for 60-40 portfolios will set the pace for the rest of the year isn't quite ludicrous, but it's a big leap. Also, the latest reading on inflation, 8.3%, is a backward-looking number. Inflation could stay high, but the Fed has

powerful tools to bring it down, and bond investors are betting that it will be successful. The difference in yields between ordinary treasury bonds and ones that adjust for the rate of inflation suggests that investors expect inflation to average 2.9% a year over the next five years, and 2.6% a year over the following five years. 6% a year over the following five years. I don't want to make light of the current sell-off. Stocks could easily fall further, but the most remarkable thing about current conditions is not how difficult they've gotten. It's how easy they were. Bear markets are normal. There have been 10 of them since 1950. If we add in five more that were just a fraction short of being 20% downturns, then bear markets have been about as common as American presidents. The average downturn has taken more than two years to get back to even. A handful have taken

more than four years. But today's 35-year-old investor, since graduating from college, hasn't experienced a bear market that took more than six months to bounce back. The tech-heavy Nasdaq 100, which is already well into bear market territory, hadn't had a down year since 2008, back when Apple launched its second-generation iPhone, which came with 3G phone service and a new software feature called the App Store. I'm sure there are some newer investors out there who are wondering what to expect from a bear market that doesn't bounce right back, if that's what we're headed for. Let's just say for now that this is no time to double down on

cash-burning startups or meme stocks, or cryptocurrency. I think there are also veteran investors out there who remember a pair of dire downturns in the early 2000s, and who became nervous about the fierce run-up of the past decade, and who've been under-invested in stocks. For them, it's already time to start buying. Trying to time the bottom is futile, but investors can pay elevated valuations and still do well if they hold for the long term. Let me give you an example. The S&P 500 has come down from over 21 times forward earnings estimates at the end of last

year to a recent 17 times. The long-term average is about 15 times. Now, since 1988, the index has returned an average of 10.6% a year. But even an investor who only bought during moments when the S&P was trading at around 17 times earnings, like now, has seen mid to high single-digit average returns, mid to high single digit average returns, provided that he or she held for 10 years. Bullishness during downturns can sound naive. There's a tempting intellectualism to stock market perma bears, but their returns stink. The best long-term investment mix is about 60% optimism and 40% humility. Now, there are also investors who just want to know what tactics strategists recommend for recessions and downturns. Hello, Jack. This is Arjun from Jacksonville, Florida. I've been listening to your show since its inception. I think you're doing a great job. My question is regarding a recent Deutsche Bank research article,

which is predicting a recession in the United States in the second half of 2023. How do you think individual investors should approach this in terms of rebalancing our portfolios? Thank you. Thank you, Arjun. And with that, let's hear from Lisa Shallott at Morgan Stanley. Morning. Hey, Lisa. How are you? I'm fine. Thank you. When I caught up with her this past week, she'd been stuck in a little city traffic, which sounded at first like a positive economic indicator. I live in the city, but I was at a meeting crosstown. So I was just trying to get back to my office here. And, you know, since Wednesday is the only day that people actually go to work,

there's traffic. Why is that? I think that might be similar in our office too. Why is Wednesday the day? Well, it then creates a six day weekend, the way I calculate, right? Thursday, Friday, Saturday, Sunday, Monday, Tuesday. We finally achieved the six-day weekend. Lisa talked about how the Fed has had no experience with simultaneously raising interest rates and making big bond sales. She thinks investors are wondering if the Fed can pull off a so-called soft landing, that is, bring down inflation without triggering a recession. She notes that the so-called Fed put, the belief that the Fed will ease conditions if needed and get the stock market roaring again as

a result, is pretty much gone. Let's pick up the conversation there. Lisa was talking about how much further the stock market could fall under a gloomy scenario. That means the worst case scenarios is probably another 20 to 30% that could happen, that could. Okay. And I think what I'm trying to say is last week, I think people were putting kind of a zero probability on that scenario. I think this week that suddenly has maybe a 10%. We're not at 80 or 90 for sure, but it is now on the table. And to your point, the Fed put for the first time probably since 2009, since the great financial crisis, is gone. They've got no room short of a deep recession and short of another 20 to 30 percent downside in this market to bring back that Fed put. Is it too early for investors to be thinking about buying? I mean, people who've got the

stomach for it, you know, the S&P 500, I don't know what it's down now, something more than 15% for the year. But there are plenty of S&P members that are down much more than that. Is it time for shopping yet? or is it too soon for that? I think it's absolutely time for shopping if you're a long-term investor. But I think it's time for shopping at the stock level. And this is what's really key. We're going through a very tough period in the economy. We're going through a period in the economy where overall growth may be slowing,

where the cost of debt capital is going up, and the cost of equity capital is going up, meaning companies really have to think about their investments, where costs have gone up, where the scarcity of labor is an issue. And last but not least, we have these geopolitical overlays. Now, on the most elementary basis, the geopolitical overlay at the minute has produced a 20-year high in the U.S. dollar. Now, a 20-year high in the U.S. dollar may not be bad for U.S. consumers who import a huge percentage of our consumption, but the economy is not the S&P 500, and it's not corporate earnings. Corporate earnings are 40% levered to non-U.S. sales. And that means that our competitiveness is reduced with a 20-year high in the dollar, and we're subject to negative translation of overseas revenues. So there's a lot of factors here that are going to complicate the scenario.

If you were one of these people who wanted to go shopping, I mean, what are the kinds of characteristics that people should be thinking about? What matters most right now beyond, you know, hey, this one's down 70%, you know, what are the things that you need? Yeah. Given all those factors that I talked about, you need very high quality and reliable cash flows. You tend to find that in companies that have a really good track record of growing their dividends. And so we'd be looking at high quality cash flows, high dividend paying stocks. We'd be looking for management teams that have a track record of navigating recessions or navigating hard times, because that's what separates the wheat from the

chaff. So, you know, and that's really where I was getting to is you don't want to be going whole hog into just buying this ETF and that ETF and trading up and down and sector rotating. You really want to be buying what we think are the winners. Now, one of the things that we've really tried to emphasize is against this whole backdrop, what defines winners? Is it last cycle's dominant companies or is there going to be a new set of winners, which history suggests happens almost every time you have a big catalytic shock to the economy, which we had with COVID. So are a lot of the FAANGs and the mega cap tech companies great companies? Yes, but they may no longer be great stocks. And what makes for a great stock? What makes for a great

stock is a stock that is priced in a way, right, where the upside that they deliver is not priced in yet, where they can deliver surprises. So where do we think you're going to get surprises? We think you're going to get surprises in financials, in energy, in industrials, in healthcare, in consumer services, in transport, in infrastructure-linked type companies. Why? Because these companies, no one's betting anything on them at the minute. No one's counting on them to do anything. And the likelihood is that they're actually going to be able to expand margins in this backdrop because they're digitizing their business models. Lisa made a few other points for investors to consider. The reason she says it's time for buying at the stock level, but not necessarily the index level,

is that she feels the S&P 500 is still too concentrated in a handful of tech giants that, as she puts it, are starting to eat each other, like a game of Pac-Man, as they compete for the same eyeballs and subscriptions and services. For bonds, she's more upbeat. The 10-year Treasury yield, she says, tends to end up about where the Fed funds rate ends up during tightening cycles. where the Fed funds rate ends up during tightening cycles. Morgan Stanley predicts the Fed funds rate will end up around 3%, give or take. The 10-year Treasury yield has been hovering around that level. So Lisa says that the worst punishment in bonds is probably over, and that investors who've been avoiding them should buy. She's particularly bullish about overseas markets, which are much cheaper than the U.S. relative to earnings. She says investors could get a double-barreled benefit

there, as markets like Europe and Japan appreciate, and as their currencies bounce back relative to the dollar. Coming up, one investment bank has a machine learning portfolio model it has used to identify stocks that are well positioned now. That's next, after this quick break. Hey guys, back at the playground again, huh? Yep. You know what this playground could use? A wine country. Heck yeah. And some waves.

So we could go surfing. Oh, yeah. Ah, love that. A redwood forest would be cool. I'm in. Ah, ski slopes. Let's do it. Um, can a girl go shopping?

Yeah, baby. Wait. Did we just invent California? Discover why California is the ultimate playground at visitcalifornia.com. Welcome back. You heard Lisa. Hey, Jack. Yes, madam.

I have a follow-up question. Okay. What happened to the sheep? The sheep? Well, they were in prospect. I'm going to guess that they retired with city pensions and moved to Florida, but I'm going to have to check into it. Now, we heard Lisa mention earlier that cash flow and dividends are welcome stock characteristics now. There are exchange traded funds attract those things, and they're doing relatively well. One called Pacer U.S. Cash Cows 100, ticker C-O-W-Z,

whose top holdings include Valero Energy and McKesson and Dow and Bristol-Myers Squibb. It's about flat this year. There's also one called Spider Portfolio S&P 500 High Dividend, ticker SPYD, which has some of the same names but yields a much higher 3.8%. It's returned more than 3% so far this year. The S&P 500's dividend yield is exceptionally low at the moment, but B of A Securities expects index members to increase their payments by 13% this year. There are many individual stocks in the S&P 500 that have plunged from their highs. Around 200 of them are down more than 30%. Investors can look through this group and find, for example, Boeing, one of the world's two big jumbo jet suppliers, down 70%.

NVIDIA, the dominant player in high-performance computing, down 49%. And BlackRock, owner of iShares and the world's most successful asset gatherer, down 37%. And investors can decide for themselves whether these stocks represent good deals. But there are more sophisticated approaches. I recently spoke with Keith Parker, the top U.S. stock strategist at UBS. He's fairly bullish, pointing out that stock valuations have fallen faster than they did just over two decades ago following the dot-com stock bubble. And the other thing, Jack, is we've seen a recession probability indicator based on the pace of the hard data, and that is not indicating the slowdown that you usually get before real

recession risk. So very low probability they're seeing of recession as well. risk. So very low probability they're seeing of recession as well. Keith says investors have just gone through a vol shock or sudden period of high volatility. And right now they should focus on quality. It's messy and it's uncertain. And what we recommend at this stage is you want to put money into things you have the highest conviction in, right? And usually after these vol shocks, they don't take a day or two to rebound. Like you typically have periods of consolidation. And after vol shocks, what tends to lead is quality stock. So when everything goes on sale, what do you buy? You don't buy the cheapest house in the neighborhood or the most expensive. You buy typically the highest quality at a reasonable price. Now, quality can be a

broadly descriptive term. When I said earlier that investors shouldn't double down on startups or meme stocks or cryptocurrency, I meant that those are low quality investments. In fact, some of them I don't consider investments. Startups that burn a lot of cash can become successful. The problem now is that it's becoming more difficult for these companies to secure cheap financing. Ones that don't have a clear path to profitability or a willing buyer could struggle. Meme stocks seem to benefit from viral buying. I'm not sure we'll see a lot of that at a time when meme chasers are sitting on deep losses, so I'd be careful about buying the dip on the

likes of GameStop and AMC Entertainment. Crypto has passionate fans, and they don't take kindly to skeptics, but I have to call it like I see it. There are no cash flows or asset values or dividends to serve as fundamental pegs of value. They're just price momentum, and that makes crypto fairly unique in that it seems to become less attractive the further prices fall. In other words, there's no such thing as value crypto. I think it's fine for the curious to put a smidgen of cash in crypto for fun, but personally, I view the optimal portfolio allocation to crypto as zero. You might disagree. When Keith talks about quality, however, he's not talking about a general view. His team has used a machine learning software model to determine which stock market factors

bode the best during conditions like we have now, a late point in the economic cycle with the possibility of heading into a recession down the road. Arjun, that's similar to what you were asking earlier. The researchers came up with a list of measures for things like profitability, financial strength, and efficiency, which they collectively labeled quality. Then they screened the stock market for companies with high and rising quality and some other promising signs, like good free cash flow yields and sales growth. The names they came up with included Alphabet, Coca-Cola, Chevron,

U.S. Bank Corp., Pfizer, and Waste Management. Tactical investors might want to consider some stocks on that list, but I also think that riding out the downturn with a prudent mix of stock and bond index funds or individual holdings is fine too. In fact, Arjun, my rough plan is to do as little as possible. If conditions worsen, I might complain about it to anyone who'll listen, but I plan to stay invested in the same stuff. I might rebalance my portfolio if one asset class strays far from my preferred allocation, but that's about it. Hope that helps. Thank you, Lisa and Keith and Arjun, and thank all of you for listening. To hear your question on the podcast, just tape it on your phone.

Use the voice memo app and send it to jack.how at barons.com. Meta Lootsoft is our producer this week. Write a review on the podcast on Apple. Follow me on Twitter. That's at Jack Howe, H-O-U-G-H. And whatever you do, stay off that anaconda water slide. Your tailbone will thank you. See you next week.