Now is not the time for investors to be brave.
The second quarter of 2022 was one of the worst we have seen in terms of market performance.
It was only the ninth time since WWII that stocks fell more than 15% in a quarter. The average stock in the S&P 500 was down over 40%, with a large swath of the non-profitable universe down 60% or more. With bonds also down 10%, there was no safe place to hide.
Recently, we wrote about the two phases of stock price declines that occurred this year, a valuation correction and concern over future earnings. The P/E ratio (price to earnings) of the S&P 500 declined over 20% in the first quarter, returning to its long-term average range. Stock markets are forward-looking. When it appears that a company’s earnings will grow, the P/E ratio of its stock usually increases as investors pay up to own a company with increasing profits. When it appears that the entire economy may slow (leading to a broad contraction of earnings), almost all stock prices go down. We believe that this is what we are experiencing now.
Stocks rallied after the Federal Reserve announced a 0.75% rate increase in late July. Optimists interpreted Chairman Powell’s comments as dovish, meaning that future aggressive hikes are less certain. The market (remember, forward-looking) appeared to us as overly optimistic. The current trajectory of the Federal Reserve suggests it will drive the economy into a recession.
Much of our inflation woes are due to inadequate supply rather than excess demand. COVID and the resulting supply chain disruptions started it, and the war in Ukraine sustained it. The Fed has recently mentioned headline inflation, which is largely driven by gasoline prices. Forcing oil prices down can only occur by slowing the economy enough to sufficiently destroy demand to equalize constrained supply – which will also create job losses and economic contraction (recession).
Gasoline prices have been coming down over the last several weeks. We are seeing other signs that point to improved future inflation readings as well, such as commodity and housing price declines. Still, there is a long way to go to reach the Fed’s target of 2%, and strong employment data give the Fed confidence that the economy can withstand rate hikes.
It’s true that the overall economy has been strong, but it is slowing down. We continue seeing wage growth and high demand for workers, yet the jobs available index suggests that hiring is cooling. Wage growth is a double-edged sword because it allows businesses to continue passing on cost increases. In the fight against inflation, good news is bad news. Consumer spending remained strong in Q2. Spending patterns shifted from goods (household furnishings, etc.) to services (travel, entertainment). Consumers are beginning to put off planned expenditures (in reaction to high prices). GDP (Gross Domestic Product) declined again in Q2.
The cards are in the hands of the Federal Reserve. Without declaring a pause in aggressive rate increases, the second leg down in markets is happening. We don’t believe this is the time to be a bold investor. It can be fruitless attempting to time the market on the false belief that we have all the information and can foresee the future.
With that said, there is much to look forward to.
Markets have already priced much of a recession, and barring some inflationary surprise, the Fed will raise interest rates to the point they need to by early next year. The ultimate rebound should be quite strong when investor sentiment turns around. And with companies and consumers in generally very good financial condition, the seeds of market recovery are abundant. It will come. We just don’t know when.
Our clients take comfort in the structure of our investment paradigm. We segment client assets by time horizon, giving client portfolios the ability to weather serious downturns. We only take meaningful market risk with assets that can truly stay invested for the long term.
We encourage our clients to continue living life without stressing over market conditions. Allowing us to focus on the markets and our clients to focus on enjoying life!