“When you narrow down your range and are looking through just that narrow aperture of the lens, the intensity of what you see is so much greater.”
— Michael Snow; Canadian artist
Look no further than the performance of the financial markets in the first half of 2022 for a perfect example of narrow aperture “intensity.”
In this note, we will review the challenging beginning of the year and the reasons for the tough environment, and then back the lens up to preview the bigger picture.
The S&P 500 was down 20.6% through the first half of the year. Since 1928, that index has only generated losses of 20% or more in six calendar years. We’re in rare territory. Neither small nor foreign stocks provided much reprieve (1), and the tech heavy NASDAQ was down almost 30%. Though acute, the downside volatility in equity markets is something we expect and accept as the price for higher long-term returns.
The salt in the wound came from the 5.8% loss endured in the Treasury bond market. (2) Traditionally, a ballast in the portfolio to dampen the innate volatility of stocks and provide cash flow, bonds suffered from rapidly rising interest rates. Intermediate term bonds have only experienced four negative years since 1973, and none worse than 2.0%. Short of photoshopping away reality, 2022 has started as one of the most challenging years in the history of the financial markets.
Although we covered this last quarter, it warrants a refresh:
- Trade tariffs imposed on Chinese imports kick-started increased prices.
- The Covid-related lockdown caused corporations to halt production in anticipation of a long recession. The current pains associated with air travel stem from massive layoffs and early retirement of pilots in anticipation of diminished demand.
- Substantial Government stimulus, both fiscal and monetary, shortened the duration of the economic downturn.
- Global supply chains were, and remain, disrupted by closed factories and labor shortages.
- Consumers, with pent-up demand and swollen savings, went on a spending spree once vaccinated.
- Low inventories of goods and broken supply chains resulted in demand that far outstripped supply and thus, higher prices.
- The Fed misinterpreted inflation to be “transitory.”
- Russia invaded Ukraine, putting strain on both food and energy supplies.
- The Fed, acknowledging they were behind the fight on inflation, initiated an aggressive interest rate rising cycle.
As Snow suggests, backing up the lens reduces the intensity of a picture. Investing in the S&P 500 at the beginning of 2018, a down year for the market, followed by three consecutive positive return years and then, the clunker of 2022, would have resulted in an average annual rate of return of 9.89%. The longer-term investor just experienced a typical average return, albeit, with a considerable amount of volatility.
What if someone just started investing at the beginning of 2022 and feels like they stepped off a cliff? Consider 2008. The S&P 500 fell 36.5% in the face of the Great Recession (and down further in the first two months of 2009).(3) Despite starting with the worst stock market performance in a generation, a down year in 2018, a global epidemic and now, a particularly nasty beginning of 2022, their average annual rate of return by sitting tight….8.9% per year between 2008 and 2022 through the first half.
The key is to never be exposed to the stock market unless the aperture is wide open. One must have a long-time horizon to ride through the inevitable bumps.
The fuzziness in the financial markets’ picture stems mostly from rising inflationary pressures. The 8.6% inflation reported in May exceeded the 8.3% in April (these figures are annualized and are backward looking) and was the highest since 1981. (4) However, future expectations for long-term inflation, after peaking at 3.0% in April, have dropped to 2.3% by the first week in July, as seen in the Federal Reserve chart below. (5)
Why? “The best cure for high commodity prices is high commodity prices.” (6) Higher prices cause consumers to seek substitutes, reducing demand, and attract more capital, increasing supply.
Energy prices, as seen in the chart below, are gradually returning to pre-Ukrainian invasion levels. (7)
Housing prices might be the poster child for higher prices curing higher prices. Not only have house prices soared in the past couple of years, but thanks directly to Fed actions, mortgage rates have nearly doubled. “New housing starts unexpectedly plunged much more than economists projected—and for a second straight month—in May, according to data released Thursday, adding to signs of an abrupt turnaround in the booming housing market.” (8)
Shipping a 40-foot container from China today cost $7,980—down from a recent peak of $20,000—and emblematic of the still dysfunctional, but gradually improving supply chains. (9)
Food costs are seeing relief. “The right mix of sun and rain in the U.S., Europe and Australia has raised hopes that end-of-summer harvests will be plentiful. That should help balance the sizable quantities of Ukrainian wheat stranded in the country by fighting and a Russian naval blockade.” (10)
Coming into Focus
The Fed cannot cure Covid, improve supply chains, or magically replace Russian oil. Instead, it can reduce aggregate demand by slowing the economy. The challenge? Put the brakes on firmly enough to wring out inflation, but not hard enough to cause a recession. Risks remain, including the recent sharp decline in commodity prices and longer-term treasury yields (which peaked at 3.49% in June and were below 3.0% by June 30). Both the stock market and housing permits are part of the Conference Board Leading Economic Indicators and both are flashing a slowdown. (11) The GDPNow model used by the Atlanta Fed to predict economic growth just turned negative for the second quarter of 2022. (12)
What do these economic metrics mean for investing?
Interest rates have normalized. The Federal Reserve’s funny money policies created abysmally low bond yields that assured the failure of the investor to maintain purchasing power. Interest rates have spiked upward, and bonds once again offer respectable rates of return. The higher yields available today provide higher expected rates of return going forward and take some pressure off stocks to do all the heavy lifting.
The Fed will eventually stop raising rates. While this may be due to the successful wrangling of inflation as noted above, it would also happen if the U.S. economy were to go into recession.
Stock valuations are reasonable. The valuation on the S&P 500 has gone from 23 times earnings at the beginning of the year, to 16.5 times—slightly above the long-term average of 15.7. (13) Forecasts for 2023 may be considered less well-defined but are currently $255 for the S&P 500. (14) Applying a historical average price-to-earnings ratio would target the S&P 500 at 4,000 in 2023, 5-7% higher than the June 30 close.
Small cap stocks trade at levels associated with recessions (as seen in the chart below, Price-to-Earnings Ratio along the vertical axis). (15) All else equal, low current price-to-earnings ratios boost expectations of future stock appreciation.
Mean reversion. Albert Einstein once said, “The only reason for time is so that everything doesn’t happen at once.” The stock market may have delivered historical returns of 9-10% per year, but only through years of higher and lower returns does that average emerge. Earlier we mentioned that the stock market has only suffered losses of 20% or more in six calendar years. The chart below shows each of those periods and the subsequent returns to investors over the following five years. The average rebound has been 12.0% per year and all such periods were positive.
WCF did not have to respond to rising interest rates because we anticipated them and kept the maturity of bonds short to mitigate the risk. We recently provided exposure to multi-family housing through a REIT—anticipating that new household formations from millennials will collide with increasingly unaffordable housing prices. We also increased our exposure to healthcare stocks, which tend to hold up well in a faltering economy. We reduced our exposure to consumer cyclical stocks as confidence indicators are weakening. The University of Michigan’s gauge of consumer sentiment reached a final reading of 50 in June, the lowest reading on record going back to 1952. (16)
We may or may not avoid the technical definition of a recession. It should be noted that stock markets tend to drop in advance of a recession and bottom during the recession, suggesting that even undesirable economic outcomes are partially baked into today’s prices. This bear market may be of average duration and magnitude but, it could be better or worse. We would not pretend to identify the market bottom or what triggers the turn. However, we do know the headlines today do not elicit much enthusiasm.
However, the stock market offers the perversity of mirror imaging, where the worse it looks, the better the future.
Despite being enigmatic over short periods of time, the stock market is reasonably predictable over the long run, and for long-term investors, despite the gloomy current headlines, the future of the equity markets is only getting brighter.
- Russell 2000 ETF down 23.5%; EAFE ETF down 18.8%
- Bloomberg U.S. Intermediate Term Treasury Index; January 1 – June 30, 2022
- The S&P 500 dropped in half during the bear market that started in late 2007 and ran to March of 2009.
- “U.S. Inflation Hit 8.6% in May.” Wall St. Journal; June 10, 2022
- FRED; St. Louis Federal Reserve Bank; July 6, 2022. The difference between U.S. Treasury notes and Treasury Inflation Protected Securities (TIPs) has been a reliable leading indicator for future inflation.
- “The Cure for High Prices.” Seeking Alpha; March 28, 2022
- “Oil Falls Below $100. Prices Could Drop Even Further.” Barron’s; July 5, 2022
- “Housing Market ‘In Free Fall’ As New Construction Plummets—Here’s When ‘Reset’ Could Cool Prices.” Forbes; June 16, 2022
- “Companies See Relief in Falling Spot Rates for Transpacific Freight”. Bloomberg; June 23, 2022
- “Wheat, Corn Prices Tempered- Easing Global Food Cost Concerns.” Farm Policy News; July 1, 2022
- GDPNow; Federal Reserve Bank of Atlanta
- Current consensus earning forecast for 2022 is $229 (Yardeni Research; July 6, 2022). SP 500 ended the half at 3785 or 16.5 times.
- Yardeni Research; July 6, 2022
- Yardeni Research; July 6, 2022
- “US Consumer Sentiment Slumps to Record Low on Rapid Inflation.” Bloomberg; June 10, 2022