The S&P 500 continued its decline in the first three weeks of May but a strong rally in the final week led to a flat market for the full month. From January 3 through May 19, the S&P 500 index dropped 18.7%, the 27th time in the past 65 years the market index had dropped over 15% in five months’ time. As shown in the chart below, in 24 of the previous 26 times (92% of the time) that has occurred, the subsequent 12-month returns have been positive. The returns have been double digit positive 21 times (81%) and in half of these instances, the market’s subsequent 12-month return has been between 20% and 50%.
Stocks have declined despite the fact that first quarter earnings for the S&P 500 companies came in approximately 5% higher than expected with positive surprises in every sector. Revenues were up over 13% with gains in every sector and earnings advanced 9.6%. The reason for the stock decline was lower valuations due to rising inflation. The Federal Reserve has been very tardy in addressing the inflation problem and is now using both interest rate increases and reducing its bloated balance sheet to slow the economy and reduce demand. When the Fed raises interest rates and extracts money from the market via a reduction of its balance sheet, the result is less money to invest in all asset classes. This has also led to falling bond prices. Indeed, the bond market has begun this year with the worst returns since 1824.
One group of investors that is taking advantage of lower stock prices are the companies themselves. Sinking stock prices are letting them buy back more of their own shares, reducing share count and boosting earnings per share. According to the Wall Street Journal, share repurchases by S&P 500 companies are on pace to hit $1 trillion this year. Acquisition activity is also picking up with two of this year’s biggest deals being Microsoft’s takeover of Activision and Broadcom acquiring VMware.
For investors, stocks are a depository of long-term oriented capital. The ideal investment is in a company that can grow at a sustainable steady rate and provide its owner a secure and rising annual dividend, perhaps supplemented by the benefits of stock repurchased with excess capital. The stocks of good companies, with steadily rising earnings and dividends, will ultimately track their records of success. We believe high quality, defensive exposures in sectors like technology and healthcare are best placed to navigate the dual challenges of slowing economic momentum and higher inflation.