There is no sugar coating the poor stock market results experienced during the second quarter and for the first half of the year. When the first quarter ended on March 31st, the stock market as measured by the S&P 500 was down 4.95% on the year after having rallied back in late March from lows hit earlier that month. Then in early April, the consumer price index (CPI) inflation reading for March came in at 8.5%, which was the highest yearly advance since 1981. Inflation readings for the subsequent months of April and May registered at 8.3% and 8.6%, respectively. Investors quickly became concerned that the Federal Reserve would be forced to increase the pace of its interest rate tightening cycle to combat inflation. When the Fed met in early May, they increased short term rates by 0.50% and detailed their plan to shrink the size of the Fed’s balance sheet by reducing the amount of treasury securities and mortgage-backed securities held by the Fed. The Fed’s balance sheet reduction strategy is referred to as quantitative tightening. This, along with increasing interest rates, serves to slow the economy with the goal of reducing inflation back closer in line with the Fed’s targeted goal.
In anticipation of a much more restrictive Fed policy, the S&P 500 declined 8.8% in April. The market continued to show higher price volatility in May but was able to maintain its level. Then in June it became apparent the Fed would likely increase interest rates by another 0.75% at its mid-June meeting, which proved to be the largest single Fed rate hike since 1994. Consequently, the S&P 500 posted another weak month in June, declining 8.4% for the month. In our First Quarter 2022 Review & Outlook, we noted the following regarding near-term projections of interest rates:
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.
The Fed has moved much more aggressively than many analysts expected a few months ago. Currently, the market anticipates the Fed will raise rates again by 0.75% at the next Fed meeting on July 26th-27th. Additionally, the year-end projection for short term rates is now in the range of 3.00% – 3.25%, significantly higher than the 2.25% year-end rate predicted earlier this quarter. If the current year-end rate projection proves to be accurate, it would be the highest level since January 2008. David Kostin, Goldman Sachs chief US Equity Strategist, summed up the first six months as follows, “Higher than expected inflation readings translated into a faster than expected pace of Fed tightening, which prompted a back-up in nominal 10 year Treasury yields (1.4% to 3.0%) and a jump in real yields which compressed the S&P 500 Price to Earnings (P/E) multiple by 24% (from 21x to 16x) and led to a 20%+ decline in US Equities.”
All told for the first half of the year, the S&P 500 declined 20.6%, which was the worst first six months of a year since 1970. The Dow Jones Industrial Average declined 15.3%, which was its worst first-half drop since 1962. The tech-heavy NASDAQ and small-cap focused Russell 2000 indexes are both having their worst years ever. Unfortunately, the bear market has not been limited to just equities, as investors have also had to endure a very weak fixed income market since bond values are inversely correlated to rising interest rates. The Bloomberg U.S. Aggregate Bond Index fell 10.4% during the first half of the year, which is the worst first half on record based on data going back to 1975. The weak performance in the fixed income market caused the worst performance for a traditional 60% stocks, 40% bonds portfolio since 1970.
The primary focus of the stock market now is whether we are in a recession, or if one is imminent. Interestingly, Google searches for the term “recession” are as high now as they were in March 2020 during the pandemic. Many market forecasters and economists have raised the probability of a recession, if we are not already in a mild recession, due to factors such as higher borrowing costs, a 40-year high in inflation, ongoing supply chain problems in many products, and higher than normal commodity costs. Economists are worried about the Federal Reserve having to raise interest rates so high to offset inflationary forces that it will push the economy into a recession.
However, ever since the Federal Reserve increased interest rates by 0.75% in mid-June, we have begun seeing some moderation in inflation data. In fact, recently we have seen many commodity price levels decline. While oil prices were around $100/barrel at the beginning of the second quarter, surging to over $120/barrel in early to mid-June, prices have now fallen back near the $100/barrel level. Additionally, other commodity prices such as natural gas, wheat, corn, and copper have also declined substantially.
During the first quarter, the US economy posted a negative GDP growth rate of 1.6%. As of July 7th, the Atlanta Federal Reserve closely watched GDPNow tracker is projecting the economy will contract by 1.9% for the second quarter. Two straight quarters of contraction is the traditional definition of a recession; however recessions are officially pronounced by a panel at the National Bureau of Economic Research, which usually comes well after the fact. From an investor’s perspective, the stock market typically bottoms about four months before the end of a recession.
With recent weak economic readings from key economic indicators such as the ISM manufacturing index and retail sales data, along with a decline in the 10-year US Treasury note, some economists now expect the Fed could scale back its planned increase in interest rates in the months ahead. Professor Jeremy Siegel of the Wharton Business School and frequent guest on CNBC, recently said, “I am increasingly worried about the economic data coming in; practically every real economic data is showing a slowdown. I am repeating my call that the Fed decision at the July meeting should be to hike between 25 and 50 basis points instead of the 75 basis points the market now assumes is pre-ordained.”
When the market experiences a decline like we have seen this year, it typically presents a good buying opportunity for long-term investors. According to Bespoke Investment Group, “Following prior 15%+ quarterly drops, the S&P has averaged a gain of 6.22% in the next quarter, a gain of 15.15% over the next half year, and a gain of 26.07% over the next year.” David Kelly, Chief Global Strategist at JP Morgan Asset Management, recently advised his clients to take advantage of this downturn when he said, “We’re going to see a bounce. The threat of recession has grown, and the economy is certainly going to slow down. But inflation will come down, prompting the Fed to slow down as well. Unless there’s a shock, stocks and bonds can rally.” Rick Rieder, Chief Investment Officer of Global Fixed Income and Head of the Global Allocation team at Blackrock recently said, “We haven’t seen risk assets go down this hard in at least 50 years. But the other side of downturns like this are almost always significant bounce backs. Investors need to be forward-thinking about opportunities as the market stabilizes. I don’t recall the prices of good quality assets looking so attractive in years.”
Market declines are never comfortable, and market volatility and investor anxiety have been well above average this year. During times of market stress, it can feel like there is no limit to how far stocks can fall, but panic is not a sound investment strategy. Like every stock market decline before this one, things will calm down and the good times will return. No matter how many stock market declines you have lived through, each time usually triggers fight-or-flight instincts. While we cannot control the day-to-day movements in the stock market, we can control how we react to them. As Warren Buffett reminds us in one of his many famous quotes, “Nobody buys a farm based on whether they think it’s going to rain next year. They buy it because they think it’s a good investment over 10 or 20 years.” We are buying stocks because history has shown that owning a diversified portfolio of high-quality stocks over the next 10 to 20 years is highly likely to do better than holding cash.
We will continue to look for good investment opportunities in the stock market, and in particular companies that have now declined 20%, 30%, 40% or more that we believe can rebound in the months to come. Please let us know if you have any questions or if you would like to discuss your financial situation in detail. Thank you for being clients of our firm. Please stay safe and healthy.
Marietta Wealth Management, LLC
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