Market Commentary May 2022
Highlights:
- Inflation has continued climbing, but the growth rate is expected to peak.
- Concerns of a recession and stock valuations have added to volatility.
- Investor sentiment is the worst it’s been since 2009, just before the stock market bottomed.
- Markets bottom on bad news, not good news. Is it so bad that it’s good?
Markets don’t like uncertainty, and we’ve had our fair share in 2022. The Consumer Price Index (CPI), the gauge for inflation, is driving much of the concern and is weighing on consumer and investor confidence.
The Russia-Ukraine conflict has exacerbated inflation by driving up energy and agriculture prices. While food and energy only make up 20% of the CPI, they are the most frequent purchases and, therefore, top-of-mind with consumers. Energy and prices of new and used vehicles continue to make up roughly 50% of the inflation rate.
Inflation should peak soon. That does not imply that prices will drop, but the growth rate should decrease. That’s a process known as disinflation.
Signs of improved supply chains should make goods more readily available (more supply). No more government checks, less government spending, and the Federal Reserve selling bonds means that there is less growth in the money supply. Rising bond yields and higher short-term interest rates increase the cost of borrowing, which slows consumption (less demand).
The University of Michigan consumer sentiment survey below illustrates that confidence is nearly as low as during the financial crisis. Historically, low consumer sentiment is a contrarian indicator of positive future stock returns.
What The Market Is Willing To Pay
The selloff in stocks is a result of inflation, rising bond yields, and high stock valuations.
At the grocery store, you might notice that they label Price/Ounce on the tag so that shoppers better understand the value. For stocks, a widely used gauge of value is the Price/Earnings, or P/E, ratio. This helps investors understand how much they are paying for each dollar of earnings (profits).
The 30-year average is around 16 times earnings, and the S&P 500 has been trading above 20 times since the recovery began in March 2020. When interest rates are abnormally low, market participants are willing to pay more for the same earnings. When rates rise and risk-free alternatives actually earn something, stocks must offer better value.
This year’s steep decline in stocks, particularly the technology names, reflects this sentiment. The good news is that much of the tech sector is still printing money, and earnings will eventually catch up to current prices, creating a potential “bottom” for those stocks.
I am recycling this chart from last quarter. Believe it or not, the S&P 500 is not much lower than when Russia invaded Ukraine on February 24, but the severity of selloffs has increased. A recovery in stocks could take more or less than the historical average of 4 months, depending on upcoming inflation data and the degree to which bond yields rise, which could create an “alternative” to stocks, potentially bucking the “T.I.N.A.” trend I discussed last quarter. The key take-away is that as we transition from one cycle to the next, calling the precise top and bottom consistently is extremely difficult.
So Bad, It’s Good?
On April 27, 2022, the American Association of Individual Investors (AAII) survey reported that 59% of respondents are “bearish,” or negative on the stock market in the next six months. The average is 30%. Only 16% are “bullish” or positive on stocks. The average is 38%.
Bearish sentiment is the highest it’s been since the financial crisis. On March 5, 2009, 70% of respondents were bearish on stocks. Four days later, on March 9, 2009, the stock market bottomed and proceeded to appreciate significantly for the next 11 years.
Despite the extreme volatility the week of May 4, 2022, the survey actually indicated bullish sentiment increasing — a reminder that markets bottom on bad news, not good news.
In last quarter’s commentary, I said bonds were keeping me up at night. If you’ve watched the bond market so far this year, you can understand where I was coming from.
Military conflict normally entices investors to buy higher-quality bonds, particularly United States Treasury bonds. However, investors tend to sell those same bonds in an inflationary environment. With both scenarios playing out simultaneously, the market decided that it was more concerned about inflation than the involvement of the U.S. military in a foreign conflict, at least for now.
The broad bond market index (AGG) has suffered one of its worst periods in history. See the chart below. The Long-term Treasury index (TLT) illustrates investor concerns around purchasing power risk.
Headed Toward a Recession?
The economy surprisingly contracted in Q1-22 by an annualized 1.4%. This has spawned new concerns about a potential recession.
It wouldn’t be the first time the Federal Reserve raised short-term interest rates and sent the economy into recession and stocks into a bear market. A bear market is defined as a drop of 20% or more in stock prices.
The Fed began raising rates in March. Since 1954, recessions have begun, on average, 50 months after the Fed starts raising rates, or a median of approximately 40 months. The shortest time span on record is 12 months. So, while a recession is inevitable at some point, the precise timing is anything but certain. The odds and timing of the next one should become clearer in the second half of 2022.
A Tough Year for diversified Investors (So Far)
A traditionally diversified portfolio includes both stocks and bonds, mainly because bonds rarely lose value in the same year stocks do. In fact, in the 93 years from 1928 to 2021, there have only been three years in which the S&P 500 and U.S. Treasury Bonds both lost significant value. (We’ll excuse 2018 when bonds lost just 0.02%.4)
U.S. Treasuries (depending on maturity) have lost as much as 22% of their value this year, and the S&P 500 is also well into double-digit losses. If this performance holds for the rest of the year, we will join those three other exceedingly rare years: 1931 (Great Depression), 1941 (WWII begins), and 1969(Vietnam War peaks)
Where Are We Focused
In terms of stock exposure, we continue to be focused on the U.S. balancing growth and value. The bond market, undoubtedly the trickiest money to manage in 2022, has not left many places to hide.
We have, however, kept our interest rate risk as low as possible and adjusted the credit quality of our bond fund holdings to mitigate some of the pricing pressure related to rate increases. We continue to monitor both stock and bond sector opportunities as this historical rate cycle transition unfolds.
Summary
The financial markets have been challenging in a manner unlike many other times in history. A 40-year interest rate cycle seems to be ending, and it has been an uncomfortable transition period for bond and stock investors alike.
We have nearly eight months to go, and it wouldn’t surprise me to see stocks stage a come back in 2H 2022 if corporate earnings hold up and inflation either peaks or moderates.
We use modest annual rate of return projections when modeling client financial plans because we have to account for years with negative returns as well as years with positive returns over 20%. They are a normal and anticipated part of the process.
It’s never fun while it’s happening. And the media isn’t as pragmatic as I am when it comes to market norms and history. But that’s their job: to grab your attention! Unfortunately for them, this too shall pass. This period is another reminder to remain steadfast in your long-term investment strategy.
As always, we genuinely appreciate the trust you place in your financial advisor and our firm.
Chris Proctor,
Chief Investment Officer
