Market Commentary October 2022

Highlights:

• Inflation has hurt stock and bond returns this year.
• The Federal Reserve (“theFed”) is raising interest rates to fight inflation.
• Some of the best daily returns in the market happen next to the worst days.
• The more the stock market falls, the higher future expected returns become.
• A recession is possible, but households, banks, and businesses are better prepared than usual.

The third quarter offered a glimmer of hope for investors as stocks rallied from June lows until mid-August before establishing a new (lower) low to end the quarter. As of September 30, 2022, the S&P 500 stock index had fallen 25% for the year. Having officially reached bear market levels (defined as a decline in value of 20% or more from the most recent high) in mid-June, the most recent decline suggested that market participants were seriously concerned about the inflation situation and the potential intervention being considered by the Federal Reserve.

As depressing as the previous paragraph may read, we’ve reminded clients to be cognizant of two things. First, bear markets eventually end. And second, the further stocks (or bonds) fall, the higher their expected future returns become.

“This is Crazy”

We’ve heard this refrain often in 2022. Stock market volatility, mortgage rates, declines in bond prices, and even yields on money market accounts have shocked many. It’s understandable.

But to be fair, 2020-2021 was crazier. Interest rates at zero, mortgage rates at sub 3%, and a stock market that moved higher with almost no volatility is much closer to crazy than 2022. What followed has been an uncomfortable transition back to normal. Stock market volatility and mortgage rates in the 6- 7% range are typical if you look at history.

Stock fluctuations of greater than 1% in a day happen 53 times per year, or 20% of trading days.¹ Declines of over 5% happen three times per year. Declines of over 10% happen annually, on average, and 20% (or bear market) declines occur once every five years.²

Research studies³ have proven that the negative emotional response to financial loss is far greater than the positive emotional response to financial gain. Because of this, down markets can be emotionally challenging. However, short-term volatility is the price investors must accept to participate in the long-term growth of stocks.

The chart⁴ below illustrates (in blue) the calendar year return for the S&P 500 each year going back to 1980. The orange bar represents the largest intra-year decline for each corresponding year.

What is the Fed Doing?

The Federal Reserve has been raising short-term interest rates to combat inflation. Higher interest rates tend to make financing both consumer and business purchases more expensive. The hope is that the cost of financing will eventually get high enough to cause both consumers and businesses to curb spending so that prices stabilize.

Most experts agree that the Fed was too slow to start raising rates as prices began rising in 2021. It is kind of like spotting a small grass fire near the edge of town but waiting until buildings start going up in flames to call the fire department. The Fed is having to play catch-up and is trying to put out the fire without flooding the town while they aggressively raise interest rates.

These rising rates impact savers in several ways. For the better part of the last decade, CDs and money market accounts earned approximately 0% interest. Those same instruments are finally reaping some reward in the form of competitive interest. However, higher rates can, at least initially, wreak havoc on longer-term investment accounts. In the past, increases like these have almost always caused a recession.

As in many financial processes, interest rate increases can take up to a year to impact the real economy. This lag effect makes it difficult for the Fed and the markets to quantify and predict eventual outcomes. Because of this, many financial professionals are pleading with the Fed to be more measured regarding future increases.

The inflation data is looking more favorable, and there is a possibility that inflation peaked in June compared to the prior year. The Consumer Price Index (CPI) for July was up 0.0% compared to June, and August was up 0.1% compared to July.

Consumers currently expect five-year inflation⁵ to be 2.7% — equal to the 10-year average (when we had low/no inflation) and below the long-term average of 2.9%. These inflation expectations matter to the Fed because it helps them gauge how fast consumers are likely to spend money. Current expectations indicate that future spending trends may help the inflation situation.

Fed Chair Jerome Powell has incited the legend of Paul Volcker, who famously tamed inflation by raising short-term interest rates⁶ to over 22% in July 1981. The dramatic rise in rates pushed stocks into a bear market, causing declines of 27% over two years.

A few months prior to Volcker announcing he would change his “anti-inflation fight,” stocks bottomed and recovered the bear market losses in just four months. Contrary to today, Volcker’s inflation problem had been around for nearly 15 years. The current inflation cycle has lasted only 15 months.

Recession Risk

If the U.S. enters a recession, it is widely expected to be less severe than in 2001 and 2008. We agree for several reasons.

One reason is that the balance sheets of both households and businesses are healthy compared to the beginning of prior recessions. Another is that banks in the U.S. are also healthy and periodically subjected to required stress tests because of the 2008 financial crisis. Finally, consumer and investor confidence are near all-time lows.

Financially, the U.S. is in good shape, but emotionally we cannot feel much worse. For more on recession expectations, see our recent blog post authored by Legacy’s CEO, Mike Wren.

Stock prices follow profits and dividends over time. See the chart below, showing the earnings per share of S&P 500 companies compared to the price of the index over 30 years.

Source: www.macrotrends.net

Third-quarter earnings releases will reveal whether businesses successfully passed through their inflation impacts to consumers. If inflation negatively impacted profit margins, it is reasonable to expect that stocks could fall further from here.

We are currently in the 10^th month of a bear market, during which stocks have lost 25% of their value. Bear markets last an average of 11 months, with price declines of around 31%. If we experience an average recession, stocks don’t have far to fall from here.² If we compare this to the last time we fought inflation 40 years ago, again, stocks don’t have much further to drop.

The inflation fight will end. The Fed will pivot. The exact timing is impossible to predict. When this happens, we believe sellers will run out of stocks to sell, and shares will be in the hands of their rightful owners, long-term investors.

At that inflection point, not being in the market could prove deadly to long-term returns. In the last 20 years, 10 of the best one-day performances in the stock market were during or within one month of a bear market.⁷

A Bond Market in Transition

Bonds have historically been a good diversifier for portfolios when stock prices are falling. You might recall that bond prices surged in 2020 as investors sold stocks and sought safety in bonds during the beginning of the COVID-19 pandemic. Because bond yields and prices move in opposite directions, that drop in interest rates had a positive effect on overall bond values in the short term, cushioning the blow for diversified investors. That has not been the case in 2022.

As the stock market sold off this year, investors were also grappling with something not seen in over 40 years — rising bond yields, which is like kryptonite for bond investors.

The trend of falling interest rates ended abruptly in 2020 and began to move in the opposite direction. Inflation added significant risk to those who purchased bonds at those much lower interest rates. This does not mean we expect bond yields to rise to the levels we saw in 1981 (the peak of modern-day interest rates), but the trend has clearly reversed for now.

During the first three quarters of 2022, inflation-fighting rate increases have resulted in a mirror image of bond price performance resulting in a -14.6% year-to-date return in the Barclay’s Aggregate Bond Index.

Summary

Long-term investors have to accept that investing is a two-steps-forward, one-step-back exercise. 2022 has certainly represented a big step back after three wonderful years in both stocks and bonds.

Inflation and the major shift in interest rate policy are the primary issues moving the markets, so unlike other mid-term election years, we aren’t too concerned about election outcomes. After all, the same Federal Reserve will be in power for the foreseeable future regardless of election results.

Breaking the back of inflation can only be done with less demand and more supply. The Fed can only use a blunt instrument (interest rates) to control demand but has almost no control over supply. Only a recovery in the supply chain or shrewdly drafted legislation from Congress can meaningfully impact the supply of goods, and for either elixir, patience will be necessary.

What We’re Doing

In early September, our investment committee decided to exit any remaining international funds in favor of healthcare and domestic companies with strong balance sheets. With inflation management in worse shape in Europe, ongoing military conflict in Ukraine, and currency trends creating headwinds, we felt the risk-reward tradeoff was more favorable closer to home for the time being.

The approach has helped portfolio performance in the short term, but we remain focused on longer-term objectives and continue to monitor the global markets for opportunities.

As investors, we’re all human and susceptible to certain biases. Recency bias occurs when we recall recent information more easily than information obtained further in the past and extrapolate recent patterns when none exist. In other words, we often believe that what has happened recently will continue indefinitely. When stocks are rising, investors expect values to continue rising. When stocks fall, the expectation is that they will keep falling. History teaches us that both expectations eventually result in surprise (and sometimes shock).

We’re more concerned with the fact that stock returns have far outpaced those of bonds and cash over time. We have no reason to believe that will change going forward.

Thank you for your trust and confidence in our firm.

Chris Proctor, CIMA^®
Chief Investment Officer