Quarterly Letter
“Confidence is contagious. So is lack of confidence.”
– Vince Lombardi
The third quarter of 2022, which started promisingly, ended in ugly fashion with nearly all global stock indices at their lows for the year. Downward momentum was ignited in mid-August when Fed Chair Jerome Powell made it abundantly clear that the FOMC would be very aggressive and disciplined with increasing interest rates. Powell stated that their current goal is to slow economic growth quickly to bring inflation in check and acknowledged there would be “pain” along the way. Pain in terms of lower corporate earnings, higher unemployment in the U.S., and lower Gross Domestic Product (GDP) growth.
It is hard to believe that just one year ago, the Fed was optimistically projecting that inflation would be “transitory” and a soft landing for the economy would ensue. That projection has proven to be well off the mark. As a result, investors seem to have lost confidence in the Fed’s ability to engineer an economic slowdown that does not include a recession. That loss of confidence, as Vince Lombardi so aptly noted, has proven contagious.
It is, indeed, an unstable investment landscape, and making an accurate short-term forecast as to what will transpire over the winter is a losing proposition. No one knows. We are reminded of a comment from legendary economist, John Kenneth Galbraith, “There are two kinds of forecasters – those that don’t know, and those that don’t know they don’t know.”
As we enter the fourth quarter, the list of concerns for stock market investors is a long one. They know the Fed currently plans at least two more interest rate hikes this year, and perhaps even more as we enter 2023. They know that once inflation escapes, as it has, it is difficult to corral. They know that most corporate earnings estimates have not been reduced significantly to-date, but that earnings estimates will eventually come down. They know Russia’s invasion of Ukraine has created a quagmire which may last a very long time, impacting trade routes, supply chains and creating a human tragedy of immense scale. Finally, they know mortgage rates have doubled, seemingly overnight, and that oil and gas supply and prices will likely fluctuate considerably through the winter.
On the other hand, the list of positives for stocks is also surprisingly long. When stocks decline in price, for instance, they get more attractive for investment, not less. Who does not like buying things on sale? Earnings growth rates are coming down, but the consumer is still quite strong in the U.S., and most businesses are doing well. Banks are exceptionally healthy and loan demand is reasonable with problem loans virtually non-existent. Supply chain issues seem to be moderating and according to the Department of Labor, there are two job openings for every worker seeking a job. Rents are moderating, used car prices are softening and nearly all commodity prices have come down, some significantly. Hardly typical of a recessionary environment.
As we look to fixed-income bond investments, we find the stock market is not alone with its “confidence” challenges. There may be even more confusion within the bond market, where virtually all fixed-income investments have posted significant negative returns year-to-date. As interest rates soar, existing bonds, should they need to be sold prior to maturity, decline in value. Thus, 2022 is the first year in many decades where we have double-digit losses in both stocks and bonds. With commercial real estate values also down, there has been nowhere, other than cash, to hide.
It is precisely at times like these that many investors begin to question their risk tolerance and re-appraise how much they should have invested in stocks and bonds. They begin to doubt if a recovery can ever occur, and sometimes decide this time is different.
Well, the odds are overwhelming that this time is not different. Instead, years such as 2022 are part of the normal cycle for investments. Good times, followed by even better times, followed by bad times; then good times, followed by even better times, followed by bad times . . . Two steps forward, one step back. Importantly, consider that while the stock market has averaged a ten percent annualized return over the past hundred years, very few years actually generate a return anywhere close to ten percent. In fact, ninety percent of years have posted returns less than eight percent or more than twelve percent.
Given all this, the question at the end of the day is at what levels will the stock and bond markets settle to be appropriately priced for a recessionary environment? In other words, when will investors have confidence that prices have declined to such a level that it becomes attractive to invest for the inevitable recovery? No one can answer that with any certainty, but it seems we are getting close. Given that, we mention a truism followed by most successful investors. Risk is not buying into the next 25 percent decline. Risk is being out of the market for the next 100 percent advance, which, although it cannot be timed, will almost certainly happen with time.
“There are two kinds of forecasters – those that don’t know, and those that don’t know they don’t know.” – John Kenneth Galbraith
Market Commentary
- The third quarter began with a strong equity market rally but ended in ugly fashion. U.S. Large Cap stocks were down 5% while Small Caps fell 2%. International markets fared worse, with Developed Markets down 9% and Emerging Markets down nearly 12%. Year-to-date, all major stock indices show losses greater than 20%.
- Bond prices also continued lower, on pace for their worst year in more than four decades, driven by rapidly rising interest rates. Two-year Treasuries, which began the year yielding 0.7%, jumped to 4.2% by the end of September.
- The Federal Reserve continues to telegraph its commitment to cooling inflation (which remains stubbornly above 8%) and a willingness to tolerate a weaker economy to do so. Historically, the Fed has never been able to tame elevated inflation without causing a recession. The Fed has hiked interest rates by 3% this year, yet inflation remains high and the labor market remains strong.
- Despite all the negative headlines and a challenging inflationary environment, corporate profits have increased nearly 6% year-to-date. Typically, the stock market tends to move in the direction of corporate earnings. Nearer-term, however, Price-Earnings ratios are contracting, a logical outcome given higher interest rates.
No Shortage of Volatility
- The first three quarters of 2022 experienced heightened volatility as markets contended with inflation, rising interest rates, and looming recession among other issues. The S&P 500 Index entered bear market territory for just the fourth time since 1990.
- All eyes remain on Fed Chair Jerome Powell as the Fed’s monetary policy pivots to drive interest rates higher, with the goal of bringing inflation back towards its 2% target.
- Neither equities nor bonds benefit from higher interest rates, which is evident in year-to-date returns. This has enabled a strange period in which good news is bad news and bad news is good news. For example, recent labor market data showed unemployment remains near 50-year lows, but that good news sent the market tumbling on concerns that the Fed will need to act even more aggressively to reduce inflation. Conversely, when the second quarter GDP report indicated negative growth, markets rallied on hopes that the Fed might abate its aggressive monetary policy tightening in order to appease the economy.
A New Regime
- In September, the Federal Reserve raised the Fed Funds rate by 0.75% for the third time in as many meetings, following a disciplined playbook to reduce inflation primarily by taming demand. It remains to be seen whether this can be effective without throwing the economy into a recession – as inflation has yet to meaningfully flinch.
- Food, Energy, and Housing make up more than half of the Consumer Price Index (CPI). However, Fed policy has varying degrees of influence over these components.
- Food prices increased by 11.4% since August 2021, but not from elevated demand. On top of higher labor and shipping costs, an avian flu has meant fewer eggs, a drought in Brazil slashed coffee crops, and war in Ukraine led to a spike in wheat prices.
- Energy prices, including oil and natural gas, have skyrocketed this year primarily due to supply shortages resulting from geopolitical issues, rather than abnormally high demand.
- Housing prices soared in recent years due to undersupply and strong demand resulting from ultra-low interest rates.
Nowhere to Hide
- The pace of rising interest rates this year has been a surprise. In January the 2-year and 10-Year Treasury notes were paying 0.73% and 1.50%, respectively. At the end of September, they were paying 4.20% and 3.69%, respectively; an enormous climb which has resulted in an inverted yield curve.
- Bonds, on average, have experienced double-digit losses year-to-date with the U.S. Aggregate Bond Index down 14.6%, and other bond indices generally down 10 to 20% depending upon their average duration. Bonds are on pace for their worst year in more than four decades and this is the first time since 1981 in which both stocks and bonds posted negative returns through the third quarter.
- The increase in bond yields could be viewed as a positive when considering recent periods of ultra-low fixed-income returns. Investors favoring short-term, less rate-sensitive bonds in recent years have weathered the storm relatively well and may now have an opportunity to shift into higher yielding bonds.
There Is A Bright Side
- Most businesses are doing well despite profit margins squeezed by inflation. The U.S. consumer today is as strong as ever, banks are well capitalized, and credit defaults are rare. Supply chain issues continue to be sorted out, though far from solved. And, perhaps most important to supporting the economy, the labor market remains particularly tight, with nearly two job openings for each unemployed person.
- The prospect of recession naturally strikes fear among many investors, as we have seen in stock markets in 2022. However, with the S&P 500 down 24% from its peak, stocks perhaps look more attractive today than they have since 2020.
- Asking what it would take for the S&P 500 to recover to its all-time high, the picture becomes not so grim. Even if it takes five years to recover, that is a 7.9% annualized return including dividends. Shorten that time frame, and the returns increase.
- Historically, when consumer sentiment hits a low point, the S&P 500 has performed quite well in the following 12 months, averaging double digit returns as shown below. While markets could certainly get worse before better, we are reminded of a quote from Warren Buffett, “Be fearful when others are greedy and be greedy when others are fearful.”
Contributors
© 2022 The Finerty Team
The S&P 500 Index is a free-float capitalization-weighted index of the prices of approximately 500 large-cap common stocks actively traded in the United States. The Bloomberg US Aggregate Bond Index is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
Performance returns cited represent past performance, which is not indicative of future returns. Index and/or Style returns reflect total return, assuming reinvestment of dividends and interest. The returns do not reflect the effect of taxes and/or fees that an investor would incur. Investors cannot invest directly in an index. Opinions expressed herein are solely those of the Finerty Team as of the date of this commentary and subject to change without notice and are not guarantees of future performance. These materials were prepared for informational purposes only based on materials deemed reliable, but the accuracy of which has not been verified. Trademarks and copyrights of materials referenced herein are the property of their respective owners. This is not an offer to sell or buy securities, nor does it represent any specific recommendation. You should consult with an appropriately credentialed professional before making any financial, investment, tax or legal decision. All investments are subject to a risk of loss. Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets. These materials do not take into consideration your personal circumstances, financial or otherwise. Investment Advisory services offered through Moneta Group Investment Advisors LLC, an SEC-registered investment adviser. Registration does not imply any skill or training.
