The S&P 500 index dropped 4.9% last month and 13.3% year-to-date. The NASDAQ index had it worst month since October 2008. Bonds have not provided a safe haven as the 1-10 Year Government/Corporate Index has a total return of -6.4% in 2022. The year started with rising interest rates, high inflation and unthinkable violence and human tragedy in Europe. The period of low to moderate economic growth, alongside low inflation and interest rates that has existed since the end of the financial crisis in 2009 has ended. The massive and unprecedented monetary and fiscal stimulus of the past two years has produced inflation levels not seen for decades. The new environment will, undoubtedly, entail higher inflation and rates than we knew from 2008 to 2020.
The prevailing backdrop highlights the importance of diversification and a focus on quality ― particularly stocks of companies with strong balance sheets, low debt and healthy free cash flow characteristics. Identifying companies which are most impacted by rising costs, and which have the pricing power to pass those higher costs through to consumers and maintain their profit margins will be critical.
Despite the economy growing at a rate below inflation in the first quarter (our recent podcast features Tyler and Jordan discussing the economic report), first quarter earnings reports remain quite positive. With 55% of the S&P 500 companies having reported first quarter earnings, about 80% of companies have reported better-than-expected profits, while margins of non-bank companies have increased from the fourth quarter despite higher inflation. Estimates for 2022 and 2023 S&P 500 earnings have continued to rise. The real damage to the stock market has come in the form of the S&P 500’s valuation, which has fallen to 17.7 times 12-month forward earnings, down from 21.5 times at the start of the year.
The change in valuation is primarily a function of investor sentiment toward stocks which remains terrible, with just 16% of respondents in a sentiment survey by the American Association of Individual Investors calling themselves bullish. There have been four dominant worries for investors:
Inflation and Interest Rates – The main economic focus today is on the Fed’s fight against inflation. The market has most likely discounted the Fed’s probable move of the Fed Funds rate to 3% by early 2023. What is unknown is how quickly the Fed will reduce its balance sheet, which has expanded to $9 trillion from $1 trillion since the financial crisis.
The War in Ukraine – The economic impact of the war is largely related to sanctions and the resulting impact on prices and supply chains.
China’s covid outbreak – Shanghai is in lockdown and Beijing may follow. Obviously, this will disrupt supply chains and could aggravate inflation in the short term, but investors with memories of the winter of 2020 will remember that the economic impact of the pandemic can dissipate quickly with government support once the infection cycle runs its course.
Fears of Recession – All of the above will impact economic growth. The China and Russia impacts will be company specific, but inflation affects everyone. We also know that raising interest rates and reducing the Fed’s balance sheet will inevitably slow the pace of economic growth.
Of course, an examination of market history shows this is not an unusual period. Stock market declines happen with regularity.
Stocks have returned roughly 15% a year over the last decade. There’s a price that long-term investors have to pay for performance like that. It is the inevitable periods of short-term volatility. If you’re willing to pay it in the short-term, one hundred years of stock market history say you’ll be rewarded in the long-term.
For additional market data on the first quarter, see our podcast. Podcast (lvmcapital.com)