Global Pandemic, Supply-Chain Breakdown, War in Europe, Inflation Flare Up, Crypto Crash, Bank Collapses, and US Debt Ceiling Debacle. A lot has been thrown at the financial markets, and at investors, during the past three years.

Stock and bond markets buckled in 2022, but eventually stabilized. So far this year, the tone and direction of the financial markets has generally been constructive. And investors have remained resilient.

As we look toward the back half of 2023, a main concern is: will the economy fall into a recession?

Some prognosticators are convinced that recession is the next shoe to drop, and that an economic downturn will lay the financial markets low once again.

David Rosenberg, a prominent Wall Street economist who currently runs his own research shop, is one of the economic bears.

In Rosenberg’s assessment, the odds of a deep recession starting in 2023 are 99%, and the stock market is likely to decline by 30%.

Morgan Stanley’s chief US equity strategist, Mike Wilson, is another naysayer.

In Wilson’s view, lots of economic uncertainty and over-optimism regarding corporate profit growth (meaning companies’ results are likely to disappoint in the quarters ahead) are cause for pessimism. He sees stock price declines ahead.

Billionaire hedge fund founder Cliff Asness, of AQR Capital Management, sees the possibility of a recession that “wouldn’t be mild” and concludes that stocks “are a scary place” to be.

These are smart and successful people (at least by Wall Street standards), so should we heed their warnings and steer clear of stocks? Or at least own fewer of them, if we believe a recession is nigh?

Implied in that question is the assumption that stock prices fall when a recession hits. So, is this true?

The answer is: sometimes, but not always. More accurately, the answer is: recessions have coincided with stock price declines half the time.

Researchers at Renaissance Investment Management have dug deep into the data and have concluded: timing your stock market exposure around a recession is harder than you might think.

The table below, from Renaissance, shows the twelve recessions that occurred in the post-World War II era along with US stock market performance during the recessions.

Interestingly, the stock market rose in six of the twelve observances of economic contraction.

So even with perfect economic foresight at the start and end of a recession, selling stocks at the beginning of a recession and buying them back at the end would have resulted in being better off (by preserving capital) only half the time.

In the other half, the investor with prescience regarding economic events would have foregone stock market gains.

The historical record is worth knowing, especially if you’re prone to worrying about your portfolio when the economy slows down. One interpretation is that market timing can work – if you’re lucky.

But a better approach for long-term investment success (and one that doesn’t require luck to yield satisfactory results) is determining an appropriate asset allocation plan for your individual circumstances – and sticking to it.

The stock market gains so far in 2023 have been pleasing, with the S&P 500 index of large-company US stocks gaining 9.7% through the end of May and advancing further during the early days of June.

Investor enthusiasm about the potential benefits to companies from Artificial Intelligence (AI) has been the main driver recently of the S&P 500’s gain.

According to research from Goldman Sachs, the seven largest technology-company constituents in the index – Apple, Microsoft, Alphabet (owner of Google), Amazon, Nvidia, Tesla, and Meta (owner of Facebook) currently make up about 27% of the S&P 500 index. These ‘tech seven’ have surged 53%, compared with a net zero gain for the remaining 493 stocks.

While this very sizable outperformance of just a few stocks may be unusual, a wide divergence in performance among sectors of the market is typical from year to year. Also, market leadership tends to rotate on a sector basis over time.

While many investors find it helpful to have some perspective on evolving market trends, it’s important to keep in mind that a diversified portfolio is a time-tested way to participate in the positive market trends of today, and limit downside when the market leaders of the moment eventually fall out of favor.

On Wednesday, May 3, the Federal Reserve delivered the 10^th interest rate hike since beginning its fight against inflation in earnest in March 2022. The latest action pushed the Fed Funds short-term interest rate above 5% for the first time in 15 years.

In his press conference following the rate hike announcement, Fed Chair Jerome Powell indicated that he expects the economy to slow down and inflation to continue to decline in 2023.

This implies that the Fed likely will be able to take a break from boosting short-term interest rates soon, and that we may be in for an extended period of Fed inaction.

In this note I share some perspective on what a pause after a period of interest rate increases means for investors holding bonds and bond funds.

In the months and quarters following the pandemic, Wall Street people often used the acronym TINA (There Is No Alternative) when referring to stocks.

After interest rates dropped to the floor in 2020, and stayed there for some time, bonds offered little by way of returns, while many stocks and stock funds paid dividends and appreciated in price, especially in 2020 and 2021.

In 2022, the financial markets turned from TINA to TONR (There’s Only Negative Return) as investors suffered through high inflation, rising interest rates, and stock and bond bear markets.

However, the change in the interest rate environment, which started in 2021 and accelerated in 2022, brought a benefit, by way of higher yields, that improves the long-term outlook for bond fund holders.

In 2023, we’ve got BANANA – Bonds Are Now A Nice Alternative. In some cases, bonds and bond funds now present compelling yields with satisfactory total return potential.

The chart below compares where yields were for different types of bonds two years ago (in early March 2021) with where yields are today, following a period of inflation-fighting by the Federal Reserve.

The sharp yield increase resulted in a steep decline in bond prices in 2022. What does this mean for investors going forward?

DoubleLine, the bond fund manager, has done some research on this topic. Their analysis shows that the prospects for positive returns from bond fund holdings, in years following sharp yield rises (and corresponding price drops) is quite good.

The average price of bonds in the Bloomberg US Aggregate Bond Index (a broad measure of High Quality Corporate and Government bonds) going back to its inception in 1977 is $100. Today, the average price is in the low $90s.

According to DoubleLine, investing in High Quality bonds when the average price of the index is between $90 – $100 has typically meant returns of between 5% – 10% during the next 12 months. In years following sharp yield increases, bond returns historically have been positive.

While 2022 was painful for bond fund holders, the next several years (assuming the average bond price remains below $100) may be more pleasurable for investors who have significant bond allocations in their portfolios.