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Cleaning Up After the Party

In a note last year ‘What Happens When the Punch Bowl is Taken Away’ we used the common analogy in the economic world of central bank stimulus withdrawal being similar to a punch bowl being pulled away at a party. Since that note inflation has not only stuck around but accelerated way past our expectations, and evidently the Federal Reserve’s. Fast forward to now and the punch bowl has not only been pulled away but cleaning up is beginning at the party. Yesterday's much anticipated Federal Reserve committee meeting resulted in a policy rate hike of 75 bps, the biggest since 1994, and a stark contrast to the ultra-easy monetary policy coming out of covid. What's more is that the central bank is going from quantitative easing (pushing cash into the economy) to quantitative tightening (pulling cash out of the economy) in a short period of time. The Fed is aiming to use its tools to moderate demand which should permeate throughout the rest of the economy including supply chains and the labor/housing market. Just as in past cycles this will likely be a key driver of markets and the main source of volatility until a pivot in policy is apparent. 

A bottom in the equity markets is likely to coincide with a peak in inflation and an improvement in forward looking business surveys. There are several indicators that inflation is beginning to peak now but until a practical energy policy is adopted or the red hot labor market cools it feels premature to say we are there yet.Further destruction is likely ahead for the economy as the Fed embarks on their mission to stifle demand as outlined in the previous paragraph. However, there is a critical timing issue for investors to consider. In every business cycle downturn, equity markets lead the economy by several months, if not longer. That is to say equity markets anticipate this economic weakness and price it in before it happens.

The chart above shows six major post-war business cycle downturns. In each one the markets fell in anticipation of an economic decline, and then bottomed out and rose before the overall economy improved. So far most major equity benchmarks have crossed the 20% drawdown threshold which constitutes a bear market. Under the surface speculative areas of the market have sustained even more damage (we will expand upon this in future notes). This does not mean that a bottom is in the equity markets yet but typically after these declines we are closer to an end then a beginning. Our second chart below is an update to one we have sent out in the past showing a history, and surprising frequency of drawdowns in the equity markets.  In short, we are likely to see further deterioration in the economy over the next quarters, but the equity markets will rebound before the recovery is evident. 

This leads us to the market timing challenge.Consistently selling investments with the goal of buying them back at lower levels requires essentially perfect timing and market depth which might not be there at the time. Additionally, the market moves so quickly that consistently trying to time these moves almost always ends up hurting performance in the long run as missing just one or two of the best days in the market (which typically happens at the very bottom) detracts immensely from long-term performance. We expanded on the perils of this topic in our note last year ‘For Stocks, Time Really is Money’.

The recent volatility has not changed our investment process and we continue to stick to our fundamental framework for managing money. This begins with owning proven companies that have a track record of navigating through past periods of stress while paying generous dividends and taking share from competitors. Also critical is having 6-12 months of operating cash set aside so as to not disturb investments at an unfavorable time. For new cash it means sticking to our buy discipline of paying reasonable prices for new holdings opportunistically as markets are selling off. This process may be uncomfortable in the present but is a vital component for long-term returns.

We will keep you updated as we navigate through this period of market stress and I encourage you to revisit the past notes linked in this blog. As always we are available to discuss in greater detail.

Commentary Disclosures: Covington Investment Advisors, Inc. prepared this material for informational purposes only and is not an offer or solicitation to buy or sell. The information provided is for general guidance and is not a personal recommendation for any particular investor or client and does not take into account the financial, investment or other objectives or needs of a particular investor or client. Clients and investors should consider other factors in making their investment decision while taking into account the current market environment.

Covington Investment Advisors, Inc. uses reasonable efforts to obtain information from sources which it believes to be reliable. Any comments and opinions made in this correspondence are subject to change without notice. Past performance is no indication of future results.


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Covington Investment Advisors, Inc.
301 E. Main Street
Ligonier, PA 15658
Phone: 724-238-0151
Fax: 724-238-0148