Transcript of the podcast:
MIKE TOWNSEND: It feels like everywhere you turn today, experts are talking about recession—when we'll be in a recession, whether we're already in a recession, whether the Fed can keep us out of a recession, how long the recession that we may or may not be in will last. But there are no obvious answers. The economic data paints a confusing picture. Inflation is at a four-decade high, with gas prices, in particular, remaining stubbornly high. Yet unemployment remains near a historic low. Last week's jobs report showed the economy adding jobs, not losing jobs, and wages growing in some areas. It feels like it's become harder than ever for investors to even know what data points they should be watching for signs of what might happen next.
Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to. In just a few minutes, I'm going to be talking with Kevin Gordon, a senior investment researcher with the Schwab Center for Financial Research, about recessions, inflation, gas prices, the housing market, the recent jobs report, and more. We'll talk about what all these different indicators are telling us and what investors should make of it all. But, first, a quick update on a couple of the key issues in Washington that investors should be keeping track of.
Congress just returned this week from a two-week recess on either side of the July Fourth holiday. And I think the rest of this month is crucial for determining whether Democrats are going to be able to pass some kind of economic package before the midterm elections. Reports are that momentum has been picking up in the long-stalled talks among Senate Democrats in the White House. As WashingtonWise listeners will recall, the House approved the Build Back Better Act, a package of nearly $2 trillion in spending focused on social programs and climate change last fall. But opposition from Senator Joe Manchin, the moderate Democrat from West Virginia, killed the bill in the 50-50 Senate at the end of 2021.
Talks with Senator Manchin to find common ground on a slimmed-down package that is more focused on combating inflation and reducing the federal deficit have continued in fits and starts over the last seven months without a lot of obvious progress. But in the last couple of weeks, those discussions have accelerated as Democratic leaders focus on passing something that they can point to as helping ordinary families in the lead up to this fall's midterm elections. Agreements have reportedly been reached on some issues, including steps to reduce prescription drug prices and to improve the financial health of Medicare. Talks are continuing in other areas, like climate change measures. But there are a lot of hurdles still to overcome and a lot of places where this could fall apart, as has happened repeatedly over the last six or seven months. But Democratic leaders return to Washington this week with real optimism that a consensus can be found.
One note for investors on this still-developing economic package, consensus does seem to have emerged on a specific tax change to help offset the spending priorities. Democrats say that they will include an expansion of the net investment income tax, the 3.8% surtax on investment income for wealthier filers that helps to support Medicare. The proposal is to apply the tax to income earned from so-called pass-through businesses, like sole proprietorships, partnerships, LLCs, and S-corporations. It would apply to individuals earning more than $400,000 a year. That would generate more than $200 billion, enough to extend the solvency of the Medicare program by an additional three years to 2031. Now, as I said, there are lots of issues still to be resolved to get this package finalized, but if that happens, this tax proposal looks like it will be part of that final package.
On another key issue we've been following, the Senate is continuing to make progress on a retirement savings bill. Prior to the July Fourth recess, the Senate Finance Committee unanimously approved the bipartisan Enhancing American Retirement Now Act. The bill is similar in concept to the Secure Act 2.0 that passed the House earlier this year, but the details differ. For example, the House bill would slowly increase the age at which individuals must begin taking required minimum distributions from their retirement accounts. That age is currently 72, but under the House bill, it would increase to 73 next year, then go to 74 in 2030, and 75 in 2032. The bill that passed the Senate committee last month would skip the intervening steps and just go straight to age 75, but not until 2032. So that's just one example of how the Senate bill differs from the House bill, and those details will eventually have to be worked out.
The next step is for the Senate bill to be merged with a bill passed earlier in June by the Senate Health, Education, Labor, and Pensions Committee, and then for the combined bill to be approved by the full Senate. That could happen by the end of this month. As I've been saying, this legislation looks like it's on track to pass Congress before the end of the year, but the haggling between the House version and the Senate version is unlikely to be resolved until after the midterm elections.
On my Deeper Dive today, I want to take a closer look at the state of the economy. Are we headed into a recession? Will inflation start to come down? And how will that impact things like gas and housing prices? And how does the latest jobs report factor into everything? To help us sort through all of this confusing information, I'm pleased to be joined today by Kevin Gordon, senior investment research manager here at Schwab. Kevin serves as the research associate for Liz Ann Sonders, Schwab's chief investment strategist. Kevin, welcome to the podcast.
KEVIN GORDON: Thanks, Mike. It's great to be here.
MIKE: Well, Kevin, I think we need to start with a word that seems to be on everyone's minds these days, recession. In the media, and in conversations with investors, it feels like there's almost an obsession about when we are going to be in a recession or whether we're already in one. So why is it so hard to say, "Yes, we are," or "No, we aren't" in a recession?
KEVIN: So the first thing that I note is that we should probably embrace the fact that we'll have a recession at some point. And I don't really know why, but the discussion around recessions is often framed in a way that suggests that they aren't inevitable. But the reality is that recessions are a part of every business cycle. They always happen at the end; it's really just a matter of when and not if. And thinking about the definition of a recession, I think it's probably the reason it's caused some consternation amongst consumers or investors, because a recession is a decline, a significant decline, in the economy. Broad-based, not just specific areas, but it's often thought of as two consecutive quarters of negative GDP. And when you think about the first quarter of this year, we had a negative 1.6% annualized growth rate for GDP, and we also have in the second quarter tracking from the Atlanta Fed, they have a GDP Now model that they put out, and they're tracking for another negative quarter as of the time that we're having this conversation.
So, you know, the definition of a recession is often thought of as two negative quarters back-to-back, but that's not the definition. The real definition is put out by the National Bureau of Economic Research, the NBER. And they look at four indicators, specifically, income, personal income; manufacturing and trade sales, which is sort of a catch-all into business sales; industrial production; and then payroll growth. So for them, they just look at those four indicators. They go back to the collective peak in activity—not just for one of them, but for all four of them—and then they determine whether we're in a recession.
And I think that when we talk about sort of the fear of recession today, it's understandable, because we have the Fed hiking aggressively. We have stocks entering a bear market. We have growth slowing. We've got inflation at a 40-year high. So there's no question that the fear of one is certainly elevated. It's just a matter of how soon it's going to happen, or when, if it's this year or whether it's next year. But, ultimately, the NBER will be the official arbiter of it in determining whether we're in a recession or not.
MIKE: Kevin, as you say, just the word "recession" is scary. But if we are in or headed into a recession, we do have some history to guide our expectations. So can you give us a refresher on what recessions look like?
KEVIN: Well, they all have different flavors. And, in fact, I think one of the reasons that investors are on edge with regards to a recession is recency bias. So if you look at the past two recessions that we've had, being the pandemic and the global financial crisis, they were epic in their own respects.
So the pandemic-induced recession was a total shutdown of the global economy, and the other was a systemic housing bubble that took down the global financial system. So I think it's understandable that the fear factor today is heightened to a significant degree from both the consumer and the investor perspective. But for what it's worth, barring some major exogenous event, which is never forecastable, we think that the next recession has the potential to be more of the garden variety. And by that, I mean it will probably follow a similar sequence of relatively mild recessions in the past, similar to what we're seeing now, especially in terms of what the Fed is doing. So when you think about inflation, if it starts to run hot at the same time that the labor market is getting tight, wages start to rise at a pretty rapid rate, and it contributes to what is called an overheating economy. And so to get that under control, the Fed has to start hiking interest rates. That starts to put some downward pressure on demand. And for businesses, that's tougher, because the cost of borrowing money goes up. The cost of investing goes up. And for consumers, specifically, things like mortgage rates and anything tied to consumption or investing for consumers, those costs start to rise, as well.
So all of that starts to affect confidence on the consumer and the business side. And so if rates are going up as demand is falling, a weakening in consumer spending eventually leads to less revenue for companies. And, ultimately, that just translates into smaller profits for businesses. And, unfortunately, the easiest way to alleviate that pressure is to cut large costs, and that just means layoffs have to occur at some point, because labor is often the largest cost for businesses.
So to some degree, we're starting to see that play out today, albeit primarily in certain segments of the economy. So if you think about where layoffs and profit margin weakness has been concentrated mostly for now, we see it mostly in the stay-at-home sectors. So those that had benefited from the economy being largely shutdown. But the rub is that now that the economy has broadly reopened for the better part of, I would say, a year, there just hasn't been as much demand for those sectors anymore. And we've started to see this broad-based shift from goods-oriented consumption towards services. So the unfortunate reality with that is that those businesses don't have as much to work with from a revenue, from a profit perspective. And they, unfortunately, have to start letting go some of their workers.
MIKE: Well, Kevin, let's talk more about what's going on in the job sector, because last week's jobs report was a positive surprise, right? We added some 372,000 new jobs. Unemployment remains at a historically low level. Wages grew in some sectors. So isn't all of that a good thing?
KEVIN: Yes, it was. But it was actually quite amazing to me at how much analysis I saw after the jobs report, specifically, that focused on just the here and now, meaning the headline payrolls figure and something like the unemployment rate. And, yes, we had a strong beat for payrolls. We had an unchanged unemployment rate at 3.6%. It's great to see, but I saw a lot of headlines that had suggested that we were somehow very far away from a recession because payrolls were firmly in positive territory and the unemployment rate did not tick up. But if we look at something like payrolls, there were a couple of blemishes in the non-farm payroll number, specifically within the Household Survey.
So there's two surveys that come out when we get the Non-Farm Payroll Report, the non-farm payroll number, which is the one that we always see that gets the headline, and then the Household Survey, which is another metric that's calculated by the Bureau of Labor Statistics, and it includes household workers, gig workers, those that are in the agricultural sector, so workers that aren't captured in that non-farm metric. And if you look at the change in both of those surveys, over the past three months, non-farm payrolls are up by 1.1 million, but the Household Survey has fallen by 347,000. That's a pretty serious divergence, especially when you go back in history. And the Household Survey, historically, has been more volatile, the changes on a month-to-month basis have been a little bit more erratic. But the difficulty when we get to this part of the economic cycle and when we seem to be at a turning point in terms of getting closer to a recession is that the Household Survey tends to lead the Non-Farm Payroll Survey, meaning if we're starting to see weakness in the Household Survey, it could suggest that the Non-Farm Payroll Survey is about to weaken, as well. And we won't know that until we're into a recession and until the labor market starts to really deteriorate, but I think that if we, ultimately, go into one pretty soon, we'll know that this was sort of giving us a tell.
But back to payrolls and why I don't think that we should be thinking about, you know, a strong payroll figure completely doing away with the fact that a recession could be close, just want to consider the idea that payrolls are a coincident indicator, meaning if you look back in the full history of the payroll data, it's almost always the case that payrolls are really strong when a recession has started. So they've either been at their peak, or in some instances, they've actually been rising even after the recession has been underway.
So if we think about the 1970 recession, for example, payrolls didn't peak until March of 1970, and that was actually three months after the recession had started. And if you look at the 1973 recession, payrolls didn't peak until July of 1974, and that was seven months after the recession had started. So that's just two examples of why I find it a bit strange that pundits or market observers often just point to the strength in payrolls alone and determine that that's, you know, no way indicative that a recession is on the horizon.
And, lastly, on the unemployment rate, that is among the most lagging labor market indicators, let alone among the most lagging of the broader economic data. And the reality is it's always low right before a recession starts. So the fact that we're at 3.6% and we haven't moved at all over the past couple of months, that is not indicative that a recession is nowhere near us. And it actually doesn't really tell us anything in a leading sense about a recession, because when you look back at the full history of the unemployment rate, it starts to rise after the recession has begun. And it doesn't really take a whole lot of an increase or a jump, because if you go back to the 1940s and you analyze the unemployment rate at every recession, if you look at its trough right before the recession starts, the average increase from the trough in the unemployment rate, so the very lowest point, and the start of recession is just 0.3%. So that would just mean today, for example, and I'm just using this as an illustration, but if the unemployment rate were to jump to 3.9%, that wouldn't be a leading indicator to tell us that a recession is coming. It would most likely signal, if we were using the historical average, it would just most likely signal that the recession was already underway.
So given that and the fact that payrolls are a coincident indicator, we just have a lot more focus on the leading indicators. And the two that jump out to us most right now are initial jobless claims and layoff announcements, and both have been trending higher over the past couple of months. And that's really consistent with what you've seen with companies' hit to profit margins, the struggling consumption demand, the fact that inflation is starting to eat away at actual income growth. And, again, I hear all the time that if you look at the absolute level of initial jobless claims, they're near their all-time low, so that somehow signals strength. But, again, it's rate of change that matters.
So if we think about what jobless claims have done over the past few months, they've risen at a pretty intense rate relative to history, and I'll just give one stat and a way to think about it. We typically look at jobless claims on a four-week average, just to kind of smooth out the data. And the trough in the four-week average occurred in April, and jobless claims have moved up 36% from that trough. And if you go back throughout the full history of claims data, just the average increase from a pre-recession trough to the start of a recession has been 20%. So we're well above the territory that should be sending a little bit of warning signs, just to put some color around the jobless claim data.
MIKE: Well, Kevin, let's broaden the lens for a minute, because the U.S. economy, obviously, doesn't operate in a vacuum. Last week, oil prices finally started to make some significant moves downward. But part of the reason for that, I think, is kind of worrisome. There's a growing concern about a global recession and that it would limit the demand for oil.
Because economies are so interconnected today, could a global recession have an impact on the U.S. economy in ways that maybe we haven't really been thinking about enough yet?
KEVIN: So I think, in many ways, the global growth weakness has already started to have a major impact on the U.S. economy. And if we just look at oil by itself, the barrage of sanctions that we've put on Russia and our excluding them from the oil trade has caused a pretty major disruption in oil supply. And we were already dealing with supply problems before Russia's invasion of Ukraine, but the halting of Russian oil imports has certainly not helped, and it's clearly been reflected in the spike in oil prices this year, even though we've started to come off the boil more recently. But as most listeners have probably experienced lately, the spike in oil prices has led to an unbelievable surge in gasoline prices. So, right there, there's a direct hit to the U.S. consumer, especially when you move down the income and the wealth spectrum to less affluent consumers, because they tend to spend more of their earnings, their monthly share of earnings, on energy.
And the other way to think about the impact to the U.S., but really the world, as well, is through higher food costs. So Russia and Ukraine are both major producers of staples like wheat. They're also major producers of fertilizer. So the rub with this war and the longer it drags on, or even if we were at some sort of ceasefire or a truce, the ripple effects from what has happened, are, unfortunately, not really known to us because there is a fertilizer supply effect that will be felt, many months, maybe many years from now, and the estimates sort of vary.
But that's really the rub with this, is that it's going to put a constraint on global food supply. And that, unfortunately, puts upward pressure on prices. That's just the nature of how supply and demand work. And we've already started to see it filter through to some of the U.S. data and some of our inflation metrics. And one of them that we keep an eye on, specifically, maybe because the Fed, it's their preferred measure, is consistent with the release of the consumption data every single month. So the consumption data is the Personal Consumption Expenditures, and then there's a separate metric calculated from that and they just add deflator at the end of that. So it's Personal Consumption Expenditures Deflator. That's just the inflation metric, similar to something like the Consumer Price Index, which is the CPI. But if you look at that and how it's tracking on an annual basis, it's currently increasing at a 6.4% annual rate at the time that we're having this conversation, and the food component of that is 0.9% of that gain. And just to kind of put some perspective and color around that, it was only contributing 0.05% a year ago. So right there, just in a year's time, we've had a pretty significant jump in how much food inflation is contributing to overall inflation.
MIKE: Well, speaking of that inflation metric, let's talk more broadly about inflation, given that's definitely another thing on everyone's minds these days. The Fed has been aggressively raising interest rates. Reports are that some of the pandemic supply chains issues are easing. Yet aside from the anticipation that oil prices might start coming down, it doesn't feel like much has changed over the first half of the year in terms of inflation.
One of the interesting things to me is that even though we have inflation higher that we than we've seen in 40 years, we also have these very low unemployment numbers. And with so many people working, there's still a lot of spending going on. We saw that in record numbers of cars on the highways over the July Fourth weekend. The airports that weekend were packed across the country. All that demand and all the spending, that helps keep prices high.
So are you seeing signals that we might be at the end of that spending, that people are starting to change their behavior because of these persistently high prices, or, and I guess this is kind of a frightening thought, will it take a recession with the layoffs that might come with it in order to slow the spending and bring down prices?
KEVIN: So this isn't my attempt at deflecting the question, certainly, but I think the answer is both. And if we look at the company and the industry levels, we're already seeing some evidence that consumers are starting to shift their spending habits away from higher-priced goods and towards lower-priced goods. And not only that, but they're making less frequent trips to stores and they're buying less in actual unit terms. And that hasn't led to a complete collapse in consumption itself, but the mix matters for profit margins and overall inflation and overall economic growth. And it really matters when you start to factor in the inventory restocking that companies have seen this year. And the rub with the inventory rebuild is multifold. So consumers either don't have as much cash today, whether it's because inflation or they've spent a lot, they've already purchased a lot of what they needed or wanted over the past year, or they want to spend on services now that the broader economy is open, and services have also gotten more expensive. So that doesn't bode well for companies with large inventories because they can't just keep higher stockpiles around. They have to eventually cut prices to reduce them and liquidate those inventories. And, unfortunately for the companies and their profit margins and profits overall, that just means that they have to sort of weaken.
And the other tough aspect for companies is that the Fed is actively trying to put inflation back in the bottle. And given inflation is a coincident economic indicator, it moves hand in hand with pricing power for companies. So the nature of falling inflation just means that profits eventually start to weaken, and that can all eventually start to feed on itself, which becomes recessionary. But, again, barring some exogenous event that we can't forecast or can't see, we don't think really at this point that it needs to be some sort of epic meltdown that people are expecting or fearing. And one reason for that is that if you look in an aggregate sense, companies' balance sheets are pretty strong relative to history. And, certainly, on the household side, balance sheets are definitively stronger than what we saw when we were entering the financial crisis.
So, yes, while it may take a recession for inflation to come down, I'm just not sure that it has to be as severe as those we've had in recent history like in the financial crisis, or certainly in the pandemic-induced recession. But that will depend on whether inflation can come down markedly towards the Fed's target and whether inflation expectations become unanchored. But the good news is that we are starting to see some pressures ease.
MIKE: Well, I think for most people, and you talked about this just a minute ago, the most obvious way they measure what's going on right now is by what they're paying at the gas pump. I feel like everybody wants to tell me their story about the crazy price that it costs to fill their tank. But the president released oil from the strategic reserves back in April, and several states have suspended their gas tax. We've seen global oil prices start to be coming down. We've started to see a little bit of relief at the margin at gas pumps. But what do you think it's going to take to really see gas prices fall in a consistent way alongside overall inflation?
KEVIN: Well, I think it'll certainly be a mix of alleviating the supply side for oil production, but also a hint of demand destruction. And with inflation still running hot in absolute terms, and overall income growth just not keeping up with overall price growth, consumers are having to stretch themselves more to make purchases. And we know this because the savings rate has completely collapsed. We've seen credit card debt climbing at some of the strongest rates in history. So not only are consumers struggling to keep pace with inflation, but in doing so they've sort of had to resort to taking on more debt. And when you add higher energy costs to that list of problems, there's just a demand elasticity aspect that simply suggests that consumption will eventually slow.
And in some ways, you're actually starting to see that at the gas pump. So at the time that you and I are having this discussion, the average gasoline price in the U.S. has come down for almost the entirety of the past 30 days. Now, we're starting from high levels, so that's not me saying that we've come all the way back to a level that's comfortable for everybody, but it's still worth cheering that we're moving down and we're not consistently moving up anymore for the time being. But I also think that in a way through the wealth effect, the weakness in asset markets will sort of help bring down inflation. And it sounds a bit odd, it may sound counterintuitive, but if you just think about the drop in asset values and what it does to investor psychology, the reality is that confidence can be sapped rapidly, especially if your net worth even on paper is cut by the percentage declines that we've seen this year. And I don't think this cycle is any different, especially since the weakness has been broad-based across stocks, across bonds and real assets like housing.
MIKE: Well, that's an area I wanted to ask you about, housing. You and Liz Ann Sonders recently wrote about it together. So what is the housing market telling you about what's going on in the broader economy, or is the housing frenzy of recent months an anomaly in this post-pandemic environment?
KEVIN: Yeah, so as you can imagine, we've been getting a lot of questions on this and whether, specifically, it's a repeat of the financial crisis and the subprime bubble that eventually led to the overall takedown of the global financial system. And I think it's important to cover because the housing market today is very much a perfect case study in my mind on simple supply-demand dynamics.
So if you think about what COVID did to the housing market, it dealt a pretty epic demand shock, maybe one of the largest that we've seen certainly in recent history because consumers were, number one, faced with newer realities and the ability to spend more time at home, so maybe they were going for larger space. And, number two, the ability to actually move to different parts of the country. So that started to distort certain markets like the Austins or the Floridas of the world, and, you know, you saw a pretty mass migration into some of those parts of the country. And the rub with it is that supply wasn't really able to match demand, and certainly not that quickly. One of the reasons that the housing market had sort of started to collapse on itself during the financial crisis was because homes were being built so rapidly and demand was also surging. So when all of that fell on itself, it sort of created that downward spiral. But we just don't have that today. We have a very much opposite market, I would say, which is completely supply constrained.
But if we think of the housing market in sort of the aspect or the viewpoint of a stool, and you think of the three legs to the stool, the first leg of the stool to falter, in my opinion, was the decline in real incomes. And so the fact that inflation started to eat away at actual income growth, and we've seen real, you know, inflation-adjusted income contract this year, that was a real hit to consumers. The second was just the surge in home prices. So at the front end, you were getting down payments that had to be larger. You were getting bidding wars that were pushing up the prices of homes. And then adding onto the third of that, which has been the increase in interest rates, which has been certainly the most recent of the three with how much mortgage rates have come up this year. That has put a significant damper on overall demand. And so that's a similar scenario that was playing out in the financial crisis, but it's also very different because lending hasn't been as obscure in the sense that those with higher credit scores are getting the majority of mortgages. And the fact that we're just not seeing an overbuilding of homes.
So like I was mentioning just a couple of minutes ago, one of the features of this market is that we are under-supplied, which in a way is good because we don't have all these values that would come collapsing down if the market were to turn lower because we don't have a lot of people that have gone into homes. But at the same time, affordability has still been stretched. And one of the ways that I think about affordability, and sort of a catch-all way to measure it, and there's a lot of metrics that will be thrown in here, but just sort of take them line by line. If we take into account the median price of a home today, and the average mortgage rate, and the average wage of a non-supervisory worker, so, you know, the majority of workers today, and just factor in simple statistics like a 20% down payment and the average numbers of hours that a U.S. worker puts in every month, the average hours that a U.S. worker today would need to work on a monthly basis to afford a current mortgage payment is 66 hours, and just a year ago it was 47. So that's a pretty serious increase over one year. And just for some color, 66 hours is actually the highest since 2007. So you're starting to see affordability from all of those angles, the three legs that I mentioned to that stool, really come under pressure.
MIKE: Well, Kevin, let's shift gears a little bit to talk about investing in this market. You know, there have been so many new young investors that have come into the market over the last two or three years. They've, obviously, never experienced this kind of sustained downturn. But, really, it's not just young investors; it's most investors. This year saw the worst market performance over the first half of any year since 1972. So the overwhelming majority of investors have not experienced this kind of situation. So what happened over the first half of 2022, and do you see it turning around?
KEVIN: Yes, so I think this bear market has given investors a lot of pause because what … it started as what I think of as several mini bears, and it sort of turned into a full-blown bear. And some of the mini bears that had emerged go back all the way to, actually, the beginning of 2021, and that, to me, is not super surprising when you think about the turn in the liquidity tide that we started to see. So February and March of 2021 was really when we saw what I think of as maximum accommodation from both the fiscal and the monetary sides. So we started to see a rolling over … not a negative rate of change, but just a rolling over of the growth rate of things like money supply and how much fiscal stimulus that we were getting, and there was an indication that at some point rates were going to move up. So that started to hit the speculative segments of the market, like SPACs or non-profitable companies or heavily shorted companies, they started to get hit the most and implode, and their performance throughout 2021 was pretty abysmal. And even today, if you look at their performance since that time period, so the past year and a half, they're off their peaks by upwards of 80 or 90%.
And I think it's important to look at their collapse because it, ultimately, started to spread to more traditional market indexes. And I don't want to say that they were the outright cause of it, but given where we were with the shift in monetary policy and the fact that inflation was moving up at such a rapid rate, we soon found ourselves in a situation where traditional indexes like the S&P 500®, the NASDAQ, the Russell 2000 have now all entered bear markets. And I think that one of the reasons this bear market feels different for a lot of investors is because of this near-term inverse relationship between stocks and bond yields. And by that I mean that when the Fed was engaging in more aggressive policy, especially this year, rates moved up at a really rapid pace, and that coincided with weakness in stocks, which meant that stock and bond prices were moving down together. And that has put a ton of pressure on the average investor with, I'll put in air quotes, a "traditional" portfolio that has, you know, a mix of stocks and bonds. And I don't like to frame it as 60-40 because I think that everybody has their own personal mix, but if you've got exposure to stocks, if you've got exposure to bonds, it's been a really rough year. And many investors haven't experienced that, or if they have, it's probably been a while. And I think that's causing some shifts in psychology for investors. I think it's prompting them to rethink not only how they allocate their stock exposure, but also how they adjust just their overall asset class exposure.
But, specifically, from a stock perspective because that's what I focus on with Liz Ann, the carnage that we've seen in the highly speculative parts of the market, I just hope that it reinforces the fact that at the end of the day, fundamentals matter a whole lot, and rates are not going to stay at zero percent forever. And I think one of the benefits, actually, with the broad-based weakness that we've seen in the stock market is that it started to unearth some opportunities. And I want to be careful with the distinction here between price-based opportunities and maybe something like fundamentals-based opportunities. And on a price side, if you look at the broader stock universe, and we use the Russell 3000 as a proxy for that, so it's 3,000 stocks roughly, and if you look at the average member, their maximum drawdown over the past year, it's amounted to nearly 45%. So, right there, the average member has been cut in half by almost 50%. But I do want to mention and stress that that's only been on a price basis, because up until this point that you and I are talking about this, none of the earnings estimates from the analysts have actually been adjusted.
So if you're thinking about valuations and the fact that they might look attractive because your standard P/E ratio has just gotten completely crushed this year, I would just note a little bit of caution because we haven't seen that E component actually weaken, and we know from what companies are saying, much of what you and I have talked about, whether it's with inflation or with Fed policy, that we probably still have to see a lot more earnings weakness baked in. And we actually think that for the next leg of this bear market, that's probably going to be the main driver, is that earnings weakness.
But that doesn't mean that there aren't areas to sort of look at, especially from a high-quality perspective, and I'll end on that note saying that we've just been really strong advocates of looking for stocks, or members, or even industries that have a high-quality wrapper. So things that have a strong free cash flow, or a high earnings, or a dividend yield, or even strong trailing and forward earnings growth, that's where you've been able to find the most consistent outperformance for stocks.
MIKE: Well, I think what you're saying there about the psychology of investors is really, really important. There's just a lot of fear out there. There have been countless stories written recently about investors who have been refusing to even look at their 401(k) over the last six months, let alone make changes to it. But on the other hand, you also have investors who are panicking and saying, "Should I sell everything?" which we know is also not a good strategy. So what are you saying to investors who are either paralyzed, on the one hand, or maybe overreacting to opportunity in this bear market? How do investors keep calm and make good decisions in this kind of environment?
KEVIN: Well, the first thing I'll emphasize is that panic is never a strategy in the worst of times, and greed is not a good strategy in the best of times. So on the panic side, selling positions out of complete fear, especially if you've already incurred substantial losses just on paper, is not a plan or a strategy. That's just giving into a reaction, and it's often driven by emotions. And the same goes on the opposite side. If you're doing an all-or-nothing bet on a name or a sector, that really isn't investing—it's just gambling—and it's certainly going against one of the fundamentals we preach of diversification.
And one of the ways I think investors can steer clear of that behavior is, you know, to the extent it works from an affordability perspective, work with an advisor. Having outside guidance from an objective party, I think, is crucial, especially during market downturns. And even if you're not in a position to hire on an advisor or work with somebody, I just think that there are practical disciplines that can be adopted, and this goes for everybody. But the simplest exercise in my mind is just to go through and ask yourself, what's your time horizon and what's your risk tolerance? And not falling into the trap of thinking that both are tied to each other. And I say that because I often get approached, specifically, by young investors who think that just because they're younger they should automatically be aggressive. But some of them are often the first to call me when the market drops by 10%. So if you can't handle a 10% drop, and you're going to want to sell everything, then you aren't a risk-tolerant investor, and you really need to sort of readjust what your tolerance is.
And the last thing I'll encourage is just to remember that investing is personal. You know, we're flooded with information these days—if it's through traditional news channels or if it's through social media—and the unfortunate part of that is it presents us with a lot of anecdotes of investors who may have been really lucky and seen massive gains, or if they got lucky on a trade. And I think the dangerous part of that is it often makes us feel like we've missed out on something. So to the extent we can get away from that thinking, I just think that it can help smooth out the bumps, especially in this environment of extreme volatility.
MIKE: Well, that's great advice, Kevin. This has really been a great conversation. Thanks so much for taking the time to talk to me today.
KEVIN: Thanks so much for inviting me, Mike.
MIKE: That's Kevin Gordon, senior investment research manager with the Schwab Center for Financial Research. You can find the article on the housing market that he recently co-wrote with Liz Ann Sonders by visiting schwab.com/learn.
Well, that's all for this week's episode of WashingtonWise. We'll be back in two weeks with a new episode, so take a moment now to follow the show on your listening app so you won't miss an episode. And if you like what you've heard, leave us a rating or a review. That really helps new listeners discover the show. For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript. I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.
After you listen
"Recession" is the word of the hour—no matter the hour. We are all watching and listening to find out what the Fed will do next, if it will make a difference, what's happening with jobs and wages, where interest rates and prices could be going, and when our portfolios might make a turnaround.
Kevin Gordon, a senior investment researcher with the Schwab Center for Financial Research, joins Mike Townsend to discuss the nature of recessions, what measures Schwab is watching, and why they matter when assessing where we stand. Kevin also shares insights on how the economic downturn is impacting the U.S. housing market, the bottom lines of corporations, and the financial system overall. He also offers some thoughts about how nervous investors can remain grounded during this period of economic and market uncertainty.
Mike also gives an update on the momentum that is building with Senate Democrats and the White House as they try to pass their long-stalled economic package, along with new developments in the tax plan they are considering to offset some of their spending priorities. He also reports on the Senate's continuing progress on retirement savings legislation.
WashingtonWise is an original podcast for investors from Charles Schwab.
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