Market Commentary July 2022

Highlights:

• There are few places for investors to hide this year.
• The sell-off in stocks has almost reached the extremes seen in 2020 and 2008.
• Stocks typically hit bottom prior to recessions.
• Gasoline prices are driving negative consumer sentiment.
• Consumer sentiment is at one of the lowest readings since 1960.
• The inflation rate could be peaking soon!

Going Down?

It is often said that the stock market takes the stairs up and the elevator down. The S&P 500 stock index is down 20.6%, and the broad bond index has fallen 10.3% through June 30th.

Bonds typically provide protection to diversified portfolios, but they stepped into the elevator with stocks this year. The stock market, as measured by the S&P 500 index, officially entered a bear market (defined as a 20% drop in prices from the previous high) on June 13.

On some days, the selling reached extremes similar to that of 2020 and 2008.¹ This has been the worst start for stocks since 1970 (-21%). However, it’s noteworthy that stocks returned +3.5% for the 1970 calendar year.²

2022 has also been one of the worst years for a diversified stock and bond portfolio. A 60% stock and 40% bond portfolio is down 14.98% YTD, which would make it the third-worst year on record IF the year ended at the time of this writing. However, 2022 is only half over.

Even the worst 20-year performances of a balanced portfolio have always produced positive returns down the road. The three worst years on this chart include the Great Depression, Dust Bowl, and World War II.

Getting a Peek at “Peak Inflation?”

In our last market commentary, I mentioned that “inflation should peak soon.” The surge in inflation that started last year was largely due to the price of goods. More recently, concerns have transitioned to the price of services (e.g., dining and travel). Although few economists expect prices to drop anytime soon, the rate of increase is widely expected to slow as we approach 2023.

However, to feel confident that we’ve arrived at “peak inflation,” the data must support it. There are signs that inflation is moderating:

• Supply chains are improving. The rate for shipping a 40-foot container from Shanghai to Los Angeles has now fallen by 38%, indicating an increased capacity to ship goods. The demand for goods has also slowed. The number of ships in the port of Long Beach is down 60%.³
• Store inventories are rising. A major retailer announced that they have too much inventory and will need to discount prices to reduce it and make room for back-to-school supplies and clothing. Discounts put downward pressure on inflation. School supply shopping will start in about 30 days. On June 26, CNN ran a story citing several retailers who are considering refunding money on returns but allowing customers to keep the merchandise due to a glut of inventory.
• Commodity prices are falling. Commodities are used to make things we buy, from food to refrigerators. The Bloomberg Commodity Index, which includes prices for lumber, metals, agriculture, and energy, is up for the year but has dropped 19% in the past month.
• Shelter (housing) is a growing contributor to the consumer price index, and it is about 1/3 of the inflation index. This number is based on house rental prices, not the value of homes. The principal and interest payments on your residence do not increase when CPI does. Your cost only increases if you are buying a new home or refinancing at a higher rate. This component adds to the inflation metric most closely followed by investors, but it does not directly impact most homeowners.

Federal Offensive

Investors are focused on the pace at which the Federal Reserve (“the Fed”) aggressively increases short-term interest rates. By raising rates, the Fed is attempting to reduce consumer spending by making it more expensive to buy goods and services on credit. Less spending leads to less inflation.

Most professional investors believe that the Fed has waited too long to raise rates and fight inflation. By doing so, consumers have continued to spend. That’s allowed the economy to “run hot” and inflation to spike.

Conversely, higher prices eventually lead to less consumption. Less consumption results in lower corporate profits, or “earnings.” Since corporate profits are the key driver of stock returns over time, the markets want to see that the Fed is committed to fighting inflation.

The markets fear that the Fed will quickly raise rates and slam the brakes on the economy, resulting in a recession. Raising rates is a blunt instrument, and the Fed does not have the precision or tools to lower stubbornly high food and energy prices. As the saying goes, “When the only tool you have is a hammer, everything looks like a nail.”

Federal Aid

The bond market has helped the Fed do its job since the end of 2021. Residential mortgages, corporate credit, and commercial loans are closely tied to the bond market. Yields on the 2-, 5-, and 10-year treasury bonds have quickly risen this year, which has increased the cost of money. Historically, the Fed leads the bond market. This year, bonds have led, and the Fed has been slow to react.

Gas Prices Drive Consumer Sentiment

A study by the University of Michigan in 1995 concluded that consumers’ expectations for inflation are highly accurate (90%). Additional research from Fund Strat indicated that the price of gasoline heavily influences consumer inflation expectations.¹ So, the broad outlook for inflation is accurate, but consumers use a narrow lens to judge it.

The University of Michigan consumer sentiment index for June is one of the lowest monthly readings since 1960. High inflation is a key reason.

Wall of Worry

The markets still need to climb a wall of worry. The impact of high energy costs and reduced consumer demand on corporate earnings is still unknown.

July kicks off corporate earnings season. This will undoubtedly contain both positive and negative surprises, which could lead to more volatility.

Personal consumption is 68% of our economy, as measured by GDP. Pundits have been debating whether or not this slowed enough in the second quarter to cause a recession.

The term recession refers to an overall decline in economic activity. The media often defines a recession as a contraction in economic activity lasting two or more quarters. However, the National Bureau of Economic Research has the final say on proclaiming a recession and uses no technical definition.

As the economy tries to escape “stall speed,” the forecasts for a shallow recession are increasing for this year or 2023. Nevertheless, we don’t expect anything as severe as 2001 or 2008.

Where Are the stairs?

After an elevator ride down with stocks this year, investors are eager to reach the lobby, find the stairs, and climb back up. Inflation peaks have historically resembled inverted V’s. The inflation rate typically ascends over many months and then quickly falls.

Since 1940, the average return for stocks 12 months following an inflation peak is 13.2%. When an inflation peak was not followed by a recession, the average 1-year return was 17.2%. Even when a recession followed, the average was 8.8%.⁴

Stock valuations have improved. The price paid per dollar of earnings (P/E ratio) has decreased significantly this year and is closer to the long-term historical average of 15. Additionally, the current P/E ratio of the S&P 500 has fallen close to levels of prior bear markets going back to 2000. Lower valuations make stocks more attractive to investors.

Consumer confidence is near an all-time low. As previously mentioned, June was the sixth-worst monthly consumer confidence reading since 1960.⁵ The chart below illustrates that low consumer confidence occurs when markets are at or near their lows. This is positive for stocks looking forward 12 months.

Stocks bottom prior to recessions. The stock market and the economy are not always in sync. Markets tend to look forward (a leading indicator) while economic data lags. Since 1950, we’ve experienced multiple cycles in which the stock market bottomed out while the economy, as measured by gross domestic product, was still getting worse. 2008 and 2020 are highlighted below, but other stock market recoveries are similar.⁷

After the Fall, Is There a Silver Lining?

After years of outperformance, the technology sector has fallen deeply into bear market territory. As you can see in the chart below, both the tech sector (NASDAQ index in green) and S&P 500 (in blue) performed incredibly well over the last five years, with the S&P 500 doubling and the NASDAQ quadrupling in value. Not surprisingly, the NASDAQ has borne the brunt of the recent downturn.

The silver lining comes into view as we pan out and look at the 10-year chart.

It becomes even clearer as we look at the 20-year chart.

Please note two things in the third chart above. First, the recent decline has been substantial. Second, even after that decline, investors in either the broad stock market or technology stocks realized between a 400% and 1200% cumulative return over the last 20 years. This acts as a reminder that even with short-term ups and downs, the stock market rewards those who wait over the long term.

Summary

The first half of 2022 has been challenging for investors, and we are not out of the woods yet. Consumer prices are still elevated, the Russia-Ukraine conflict is ongoing, corporate profit growth is in question, and the number of recession forecasts is increasing.

Fortunately, both corporate and household balance sheets are in very good shape. There are increasing signs that inflation is near a peak, and I’m not sure how much lower consumer sentiment can go.

Historically, these are positive signs for stocks looking forward. Stocks are likely closer to a bottom than an all-time high. Typically, when stocks bottom, the recovery is V-shaped. It is difficult to predict both the level and timing of such an event. An economist once told me that you can forecast a number or a date, but never both. If economic predictions were easy, we wouldn’t be talking about it so much.

Thank you for your trust and confidence in our firm.

Chris Proctor,
Chief Investment Officer