The Anatomy of the Bull Market that Began in 2022
Introduction
The bull market that began on October 12, 2022, was marked by a recovery despite the economic challenges brought on by the COVID-19 pandemic and geopolitical instability. The market's resurgence was not only driven by an overall economic recovery, but also by substantial shifts in technological change, central bank actions, and sectoral leadership. Let’s explore the key drivers that contributed to its growth, the challenges it still faces, and the broader economic and geopolitical context that shaped its trajectory.
Background: Post-Pandemic Recovery and Geopolitical Challenges
The prior bull market to the current one that we are in unfolded in the aftermath of the dramatic market downturn in early 2020. The pandemic threw global markets into disarray, with widespread economic disruptions and lockdowns, resulting in a sharp market sell-off. However, as vaccines were rolled out globally and economies began to reopen in late 2020 and into 2021, the market started to recover. By the end of 2021, stocks had regained much of their lost ground, driven by optimism surrounding the reopening of economies, government stimulus packages, and pent-up consumer demand. It was a lesson in market dynamics and the power of coordinated efforts.
2022 brought a shift in the narrative. Several factors would lead to a severe 25% S&P 500 bear market (correction) that transpired from January 2022-October 2022. These included the ongoing effects of COVID-19, which continued to disrupt supply chains, enhancing the backdrop of persistent inflation which peaked in June of 2022 on a year over year basis. The economy toiled with two quarters of negative real GDP growth in Q1 and Q2. New geopolitical risks arose as evidenced by the Russian invasion of Ukraine in February of 2022. The Federal Reserve also began the most aggressive interest rate hiking cycle in 40+ years to stave off inflation. While the year was marked by challenges, it also laid the groundwork for the current bull market, a testament to the cyclical nature of market forces.
I have mentioned the bull and bear markets that have come just before this current bull market for a reason. When studying bull markets, an integral dynamic that investors should evaluate is to look at the bear market that preceded it for clues into how the following bull market will look, not only in terms of duration and strength but also in volatility. Bear markets have a very synchronous relationship to the longevity of the bull market. The key variable appears to be whether or not the preceding bear market was associated with a recession. If it was, precedent suggests that the subsequent bull market delivers higher returns and less volatility. Markets preceded by a non-recessionary bear market tend to be weaker and more volatile.
The chart below illustrates this well.
Bull markets not associated with a prior recession trail bull markets that were associated with one by about 22% after two years and 25% after three years. The non-recessionary bull markets also face slightly greater maximum drawdowns in their first three years. One attributing factor for this may be that a “no recession” bull market doesn’t have a significant change in its underlying valuation. The average starting P/E multiple (a measure of a markets valuation of its price divided by its earnings) of a bull market not associated with a prior recession is 16.5x versus 14.0x for a bull market which was preceded by a bear market associated with the recession. Over long-term periods, starting point valuations matter.
This insight ties very closely with my study of market cycles dating back to 1977. Studying bear markets is critical to understanding how the future may play out. As a matter of fact, my work has shown that bear markets define the bull market that follows them. Bull markets actually play by different rules depending on the conditions leading up to their birth. In the context of our market today, with this current bull market having been preceded by a bear market not associated with a recession, investors should likely expect lower returns and a larger maximum drawdown through the first 3 years of this bull market’s life. Market returns in years 1 and 2 have been higher than what history would dictate on average. Using this as our guide, we would expect year 3 to potentially be lower from a return perspective.
Style and Capitalization
Calling this market narrow might be an overstatement. This bull market has been driven by large capitalization US stocks. In fact, it has been the weakest start for small caps in any bull market in modern history. This does not surprise us, as you’ve likely heard us talk about the small cap index being one that contains many struggling companies, with many being unprofitable. Some companies have been in this universe for long periods of time and have not been successful (or they would have moved to another larger cap index). Others have fallen into the index because they have performed poorly. One of the more modern dynamics of capital markets pertains to the length of time that companies are staying private. IPOs (Initial Public Offerings) that come to market are now usually larger than the small cap universe allows by market capitalization. This adds up to an index that may be hindered in the future given this dynamic fueled by the large amounts of capital in the private equity and venture capital markets. These dynamics result in our recommendation for an underweight to the small cap category and that if money is to be allocated to small cap that it be actively managed. Markets also tend to narrow as they age. If small caps didn’t perform at the beginning of this bull, I would not expect them to start anytime.
Are Markets Getting “Smarter”?
Lest we forget that the Fed held the federal funds rate at around zero as recently as the first quarter of 2022. Adding to that, the Fed was also still buying billions of dollars of bonds every month to stimulate the economy. All this despite 40-year highs in various measures of U.S. inflation measured at that time.
But then the Fed moved forcefully. Over the next 16 months, the central bank raised the fed funds rate by more than five percentage points. Risk assets and the bond market sold off aggressively creating the bear market that we speak about in this piece. All that changed on October, 2022, as the momentum shifted. It appeared at that time that the market began to realize that the Fed may be able to pull off the historically difficult “soft landing,” and rallied in anticipation of that belief. In another first, this market rally has been larger than any other in history between the Fed’s last hike and their first cut the market bottomed even though the Fed would go on to raise interest rates six more times (75bps, 50bps, and then four 25 bps hikes) before they would eventually pause for over a year.
Markets seem to be learning from history and made an attempt to anticipate Fed cuts even though they were far off in the future. “Don’t fight the Fed” didn’t work in this instance. This is just another example of the market’s ability to arbitrage away future good Fed news. Investors - take note.
Conclusions, Lessons and Portfolio Positioning
It will pay to be active in less efficient areas of the market, including US small cap, International small cap, and Emerging markets.
Simply stated - expect more volatile returns going forward. As a reminder, this bull market was not preceded by a recession. The strong returns so far in this run could be interpreted to mean that markets may be a bit ahead of themselves. Investor optimism, a contrarian indicator, also continues to be at high levels. This has historically been a sign of at least a pause in a bull market’s trajectory.
Inflation will be the key. Bond yields have continued to move generally higher since the election. Higher inflation does eventually impact the P/E (valuation) multiple, as investors are willing to pay less for stocks as inflation rises. Expect 2025 to be a year in which earnings growth must be the primary driver for stocks.
Markets appear to be evolving, showing an increasing ability to anticipate policy changes. It was almost as though investors had developed a knack for deciphering the Fed’s next moves, reacting with a level of confidence that seemed both calculated and optimistic.
Additional thematics such as AI could still be in early innings. One clear fact that we cannot overlook is that we are at a technological pivot point in human history. AI has the potential to change all businesses. Productivity is the key to standards of living, as it allows for greater efficiency of companies. This dynamic could be incredibly shareholder friendly, resulting in improved margins and efficiency. If firms are able to do everything from manufacturing to services more effectively and with less cost, all will benefit. This is another reason to emphasize that we have exposure to the major large cap businesses, in order to seize upon this along with private exposure in the venture capital and private equity frameworks. Active management may also add some value in the large cap space, in order to truly to identify the advantages of the technological shift.
The optimism of technological innovation provokes the ultimate question: how much of the good news has already been priced into this bull market? We believe that an appropriate posture is to be neutral to your overall portfolio target allocation. Given our previous commentary and outlook, look for us to eventually add exposure to risk assets on market weakness.
I hope you enjoyed this written journey that dissected the bull market we have had over the past two years. I always try to incorporate history into my decision making because I believe it is something that forces all of us to understand how markets traditionally perform after bear markets which historically has given investors some hints as to what they may do in the future.
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