“In my nearly 50 years of experience in Wall Street I’ve found that I know less and less about what the stock market is going to do, but I know more and more about what investors ought to do.” – Benjamin Graham
When the new year started, investors thought the performance of the stock market would benefit from pent-up consumer demand for travel, leisure, concerts, etc. In addition, healthy consumer balance sheets because of a strong labor market and positive stock market performance the past three years, accompanied by increasing housing values, could help propel corporate earnings and drive further gains in the market. The unemployment rate stood at 3.9% when the year started, and spent the first quarter at 4% or less, which is a sign of a healthy labor market. The big headwind to start the year was the rapid rise in inflation to its highest level in four decades. The consumer price index (CPI) sat at 7.0% at the end of 2021, and subsequently posted increases of 7.5%, 7.9%, and 8.5% for the first three months of 2022. Elevated inflation has hurt consumer spending and has pushed the Federal Reserve to tighten its monetary policy.
After the S&P 500 index reached a new high on the first trading day in January, it then fell 14.2% to its intra-day closing low of the first quarter on February 24th, the day of the Russian invasion of Ukraine. The S&P 500 subsequently rallied 10% through the end of March to post a first quarter decline of 4.95%. According to Bespoke Investment Group, since the end of World War II, there have only been eleven other quarters where the S&P 500 dropped 10% or more from a closing high and then later traded 10% or more above its intra-quarter low. The good news is among this data set, the S&P 500 was higher ten out of eleven times one quarter later, and higher every time a year later.
The major stock market indexes suffered their first quarterly declines since the start of the pandemic. In addition to the retreat in the S&P 500, the Dow Jones Industrial Average was down 4.57% while the NASDAQ was down 9.10% for the quarter. Sector performance in the first quarter was led by energy, as the sector increased more than 39% with the dramatic increase in oil prices. U.S. crude oil prices climbed more than 33% to over $100 per barrel during the first quarter, which caused significant increases at the gas pump. The three lagging sectors were Communication Services, Consumer Discretionary, and Technology.
The bond market was not immune to losses in the first quarter. The Bloomberg US Aggregate Bond index, a broad basket of US Treasuries, investment grade corporate, and mortgage-backed bonds, posted a decline of 5.93% for the first quarter, about one percent worse than the S&P 500. Bond performance tends to suffer in the short-term when there is a rapid increase in interest rates like we experienced in Q1. The 10-yr Treasury bond rate hovered at approximately 1.5% to begin the year. Due to anticipated Federal Reserve interest rate hikes, the 10-yr Treasury moved higher through the quarter to around 2.5% in late March. A move of this magnitude was enough to cause the worst quarter for US bond performance in more than forty years.
Beyond the atrocities of Russia’s invasion of Ukraine, the war is causing consternation for all monetary authorities around the world. The impact of the war could be inflationary for commodities such as energy and wheat. The war may also dampen consumer spending in Europe while also further complicating worldwide supply chains beyond the continuing impact of Covid-19. It is projected the war in Ukraine is likely to reduce global growth by at least 1% this year while pushing up worldwide inflation by another 2.5%, according to a forecast by the Organization for Economic Cooperation and Development.
Despite the strength of the labor market as measured by the low unemployment rate, the job market has befuddled the Federal Reserve. According to the latest employment figures released there are 4.2 million people out of the work force compared with the period before the pandemic started. This means those people are not employed or looking for a job. There are also 2.1 million fewer people on company payrolls. This helps explain why employers continue to look for help when there are more than 11 million open jobs that employers cannot fill.
The Federal Reserve is hopeful that healing supply chains and the return of more workers to the job market will bring down inflation this year and in 2023. Recently, Chairman Jay Powell stated that the Fed is prepared to raise interest rates in 50 basis point increments after raising the short-term interest rate by 25 basis points in March. At the March Fed meeting, Fed officials projected short-term rates would end 2022 slightly below 2%, and up to 2.75% by the end of 2023. The Fed’s goal is to reduce inflation by raising interest rates without tipping the economy into a recession. Goldman Sachs has a slightly more aggressive forecast, with the Fed raising short-term rates a half percent in May and again in June, followed by 25 basis point increases at its four remaining meetings in 2022. If this plays out, short-term rates will hit 2.25% by year end. Goldman Sachs also forecasts three more rate hikes in 2023.
Yields on U.S. Treasury securities reflect investor expectations for both short-term interest rates set by the Fed and growth expectations of the broad economy. When an economic expansion begins, interest rates are typically low. Then as the expansion takes hold, interest rates should increase while maintaining an upward sloping yield curve of higher long-term rates. But occasionally the yield curve inverts, as it briefly did on April 1st, where short term rates are higher than long term rates. A yield curve inversion implies that growth is expected to slow, and historically has been a leading indicator of an economic recession. However, when just a few points along the yield curve invert, as has been the case currently, the probability of a recession does not dramatically increase. It is not until the majority of the points on the yield curve invert that a recession becomes likely. As for stock market implications, Goldman Sachs research shows returns for the S&P 500 have typically been positive in the two years following yield curve inversions.
Despite all the economic worries here and abroad, there are several reasons to believe the economy can continue on a positive path forward. The labor market continues to be unbelievably strong, with record levels of job openings, rising wages, high demand for workers, an increasing labor-force participation rate, and an unemployment rate that has fallen to 3.6%. Consumer spending exhibits resiliency despite high inflation. According to the Federal Reserve, an estimated 60% of households continue to hold onto excess savings built up during the pandemic. Additionally, household net worth increased more than 37% between the first quarter of 2020 and the fourth quarter of 2021 as the stock market and home prices increased. The hope among economists is the underlying strength of the consumer will be enough to offset any mild recession that might occur over the next 12-24 months.
First quarter corporate earnings announcements begin during the second week of April. S&P 500 company earnings are expected to increase 4.5% from the prior year, which is consistent with median growth rate over the past decade. And this is despite the inflationary pressures on input costs and labor. When March ended, the S&P 500 was trading at 19.6 times 12-month forward earnings estimates, which historically is not a very expensive level, especially considering interest rates are still generally low.
Bespoke Investment Group recently released some interesting historical market performance data. Over every historical rolling one-year period since the inception of the S&P 500, the index has been positive 75% of the time. This means that if an investor bought the S&P 500 total return index at any given point since 1928, the odds were significantly in the investors’ favor the index would be higher one year later. Somewhat surprisingly, over every rolling one-month period, the S&P 500 has been higher almost 63% of the time. Naturally, the numbers increase as the holding period increases. Over every rolling two-year and ten-year period, the odds increase to 82% and 94%, respectively. The takeaway for investors is the longer the period, the more likely there will be positive returns. This is the reason a sound, consistent long-term investment strategy should be superior to day-trading and short-term market timing.
Please let us know if anything has changed in your financial situation.
Marietta Wealth Management, LLC
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