Hazelle
in Memos & Musings · 5 min read
The 2022 market crash and recovery
In 2022, we witnessed an unprecedented bear market where the S&P 500 crashed by more than 25% from its peak to the trough. This left many investors in disbelief, considering that we just had a market crash in 2020, which was only 2 years back.
Historical data also indicated that typically a crash of 20% or more happens roughly once every 5-6 years.
What’s even more disheartening for some investors is that they eventually threw in the towel and exited the stock markets for fear of further losses.
However, the S&P 500 formed its bottom in October 2022 and began its bull market rally all the way into 2023.
Initially there were still skeptics who doubted this bull run. Nonetheless, the S&P 500 continued its ascent to gain by more than 20% from the October bottom, and entered into an official bull market by definition.
This is not going to be the last market crash in history
But, this market crash is definitely not the last crash! Moving forward in the next 10 or 20 years, it’s likely that we would be experiencing market crashes and bear markets again in our investing journey.
Well, you probably have heard this statement many times, but do you know exactly the reason why this is so?
By understanding the reason, what action can we take as investors to position our investment portfolio in future crashes or even for the Singapore REITs market crash that we are in right now?
The keyword is market cycle
While we don’t know exactly how many market crashes we are going to experience in the future, there is an explanation for this phenomenon we see. That is, due to market cycles.
Market cycle continues and never ends. For example, markets rarely go from “overpriced” to “fairly priced” and stop there. Usually the growing pessimism will cause the markets to continue right through from “fairly priced” and on to “underpriced” before going back up to “fairly priced” and then “overpriced” again and this cycle continues on and on.
Valuation of the S&P 500 goes through the cycle to fluctuate from overpriced to underpriced and back to overpriced
You can imagine it to be something like a pendulum. When you pull a pendulum to the extreme left and release it, it causes the pendulum to swing back to the mid point before swinging all the way to the extreme right.
As long as there is someone who continues to exert a force on the pendulum, it will continue to oscillate about the midpoint.
Why the market cycle never ends
What is this “force” that causes the market cycle to continue?
Broadly, changes in the economy, changes in profits of the businesses, changes in investors attitude towards risk, investors psychology as well as loosening and tightening of the credit market are some of the main “forces” that influence the market cycle.
Do note that this is not simply just a cause-and-effect kind of relationship. In turn, the market cycle also influences the economic cycle, profit cycle, investors psychology, credit cycle and so on. Each of these cycles exert an influence on one another.
During the 2020 Covid crash, the crash was induced by the exogenous shock from the sudden spread of the coronavirus that resulted in economic shutdown and businesses were struggling to stay afloat.
In the more recent 2022 market crash, it was induced by the central bank intervention to fight inflation by embarking on steep rate hikes. Now of course the geopolitical events that inflated the oil prices also led up to the intervention by the Fed.
How the market cycle works
(Do take note that this is just a general example of how a market cycle may look like and the exact triggers for each new bull and bear market would differ.)
During periods when the economy is growing strongly and corporate profits are rising and beating expectations, we would usually see the news media covering more on the positive economic outlook and earnings.
This boosts the confidence and optimism of investors and they gradually increase their risk tolerance to buy more stocks. Over time, this turns into greed as investors chase after the stock prices, thereby driving up the stock market.
At the same time, capital markets are open and it is easy to make borrowings. Default level is low.
As the stock market continues to rally, investors’ greed and confidence build up. Some would even boast about their intelligence for the investment profits made. At this point, the majority of the market participants think that it is impossible for the stock market to decline!
It follows that the risk is at the highest level now due to extreme greed and optimism, but the problem is that the majority of the investors think otherwise. Many of them adopt the “it’s different this time” “the market rally will never stop” mentality so instead, they feel that the risk is low. That’s why they continue to buy by chasing after the prices even though rationally, it is a more appropriate time to call for defensiveness.
Based on what we witnessed in the stock market over the last couple of years, do you think the stock market will just continue to always rally up?
At this juncture, what we need is just either a deterioration of the economic condition or disappointing corporate profits or increasing default in borrowings to trigger a decline in the stock market. Let’s proceed on to see how the market cycle may possibly move from here.
As the economy eventually slows, corporate profits decline and the level of defaults increases, investors begin to worry about the outlook and shift towards being more risk averse now.
The defaults cause capital markets to close which in turn results in more defaults.
Fewer investors are now willing to invest in the stock market and some of them are selling away their existing positions to keep out of the markets. Hence, stock market prices cascade downwards. As stock prices fall, investors’ pessimism and fear of losing more money grow stronger and more investors are rushing to sell.
You would also see news media reporting mostly on the negative outlook which induces more fear among market participants. Eventually, even investors who have been holding on to their positions capitulate and sell. The stock market cycle is now at its bottom.
It may seem too pessimistic for any one to stay in the market but in fact, this is the time when we should turn more aggressive by buying stocks of quality businesses at depressed prices. However, due to the psychology and emotions of investors, most of them would do the exact opposite and stay away from the markets.
But remember the market cycle doesn’t just stop here. Eventually as the economy recovers and the credit market reopens, defaults will reduce and investors begin to shift towards risk tolerance and participate in the stock market again and the stock market will rally up. Those who took advantage of the market crash to accumulate stocks would then be able to profit from the rally.
How to cope with market cycles
As you can see from the illustration, if we are able to position the risk that we take on for our investment portfolio in response to the market cycle, we would be able to profit from the stock market. There are 2 types of risks that investors face in the stock market: risk of losing money and risk of missing out on the opportunity.
In other words, we have to learn to take on the defensive mode and focus more on the risk of losing our money when the majority are overly greedy and risk-on. On the other hand, when the majority are overly fearful, we can be more aggressive in accumulating assets and focus more on the risk of missing opportunity.
Using Technical Analysis to position the risk posture of our portfolio
The next question you may be wondering is, but how do we know and predict the market cycle movements? Is it even possible?
There is certainly no way that anyone can accurately predict the market cycle movements 100% of the time. For example, we can only recognise a market bottom only after it has passed. The same applies for market tops.
Although we can’t predict exactly where and when is the market top or bottom, what we can do is to identify the tendencies or likelihood of the market declining or rebounding from certain price levels. We do so by applying Technical Analysis to help us study the sentiments of the overall market participants through analysing the price trends, and using technical indicators.
Take for instance, we have shared during our regular market update Zoom webinars that instead of chasing after the prices with the majority, we prefer to buy when stock prices retrace to a support level. This is because the probability of a rebound from the support is higher, thus the risk-to-reward is tilted more in our favour. During market crashes, we are also not afraid of “catching the falling knife” as investors, to accumulate more positions of businesses that are fundamentally sound.
Conversely, when stock prices hit a strong resistance or are overextended, we may offload some positions to recycle our limited capital to put into other stock counters that have a better risk-to-reward setup.
What about the S-REITs market that has been beaten down?
Another market which many investors are concerned about currently is the Singapore REITs market.
The Singapore REITs market has been underwater in the past 2 years, declining by more than 30% due to the high interest rate environment.
As REITs often use debt to finance their property acquisitions, the high interest rates will result in higher interest expenses and thus reduce the distributable income to unitholders. Many investors have since switched to fixed-income instruments such as T-Bills that provide better yields under the current environment and resulted in a sell-off in the S-REITs market.
The question to ask yourself is, do you think interest rates and inflation are going to stay at elevated levels forever?
Just like what we have learnt about market cycles, inflation and interest rates are unlikely to remain at elevated levels forever. Eventually with the intervention of the central bank, interest rates should return to more stable levels.
Historically inflation and fed funds rate do not remain at elevated forever
As the corporate profits of the REITs strengthen in due course, it will boost the confidence of investors to shift towards risk tolerance to invest in the S-REITs markets. Over time, as the prices recover, more investors will re-enter the market to further drive up the prices.
When the majority are still overly fearful, that’s when we can place greater emphasis on the risk of missing opportunities to accumulate assets that have the potential to generate income for us.
If you want to learn more about the key pointers to take note of for S-REITs, catch the replay video of our previous Zoom webinar sharing to find out more.
Concluding thoughts
To sum it up, the stock market goes through advances followed by corrections. It goes through bull markets followed by bear markets. The market cycle never ends because of human involvement that can influence the economy, the corporate profits, the credit market and investors’ risk attitude. Therefore, we position our risk posture in alignment with the market cycle.
When others are greedy and risk tolerant, we should be more defensive and focus more on the risk of losing money. On the contrary, when others are risk averse and fearful, we should turn aggressive and focus more on the risk of losing opportunities.
About Hazelle
Chief trainer of The Moneyball Investors Playbook program and founder of The Joyful Investors, a financial education firm that seeks to help avid investors learn to invest better and make the journey a joyful one. I graduated with a first class honors in Bachelor of Accountancy from Nanyang Technological University (NTU) and started my auditing career in one of the Big Four. I believe that once we know how to build our wealth sustainably, we can then live our best lives ever.
Important Information
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