“If you have trouble imagining a 20% loss in the stock market, you shouldn’t be in stocks.” – Jack Bogle
“In investing it is never wrong to change your mind. It is only wrong to change your mind and do nothing about it.” – Seth Klarman
The month of May was much more interesting than the tepid returns for the month suggest. The stock market indexes turned noticeably lower, bailed out by a strong rally over the final sessions of the month. Bond yields stabilized, allowing the index to post a modest 0.58% gain for the month. Commodities – the strongest area of the market, continued to produce positive returns of 3.56%. The US Dollar Index lost 1.47% vs. a basket of currencies.
All data as of 06/01/2022, Source: Wells Fargo Investment Institute. [Wells Fargo Investment Institute, Inc. is a registered investment advisor and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.]
This month we want to talk about the big picture for the stock market. Included in the analysis will be our thoughts on what might lie ahead in the coming months. We fully understand that the world is a bit crazy (technical term) these days with a number of negative risks that are hard to quantify. If any of these risks would come to fruition, the situation would substantially change our analysis.
We entered the year believing that the stock market’s three year run of substantial gains would have 2022 paying the price. Protect and participate was the theme of our 2022 Market Outlook.
At the time inflation was a problem but nowhere near the 9% number printed in April. Real Gross Domestic Product (GDP) expectations were around 4%. There was no reason to consider a war breaking out in Europe that would not only disrupt both the energy and foodstuff markets, but is likely to lead to a breakdown in the global world order.
With that as the background, it comes as no surprise the S&P500 is off to one the worst starts of the year ever. On May 22 the index hit a low of 3810, almost 1000 points off the all-time highs reached on January 3.
One of the technical tools we use for analysis are Fibonacci Retracement levels. The 3810 bottom is very interesting as it lines up with the 38.2% retracement off the April 2020 lows AND the 61.8% retracement from the September 2020 lows. The rally that ended the month tells us that this is a market bottom. What it doesn’t tell us is if it is THE market bottom.
Chart #1: Source: www.stockcharts.com
The turn higher in the S&P500 came just as the noise surrounding the stock market has turned really negative. Turn on the financial news over the past few weeks you could hear everything from JPMorgan CEO Jamie Dimon warning of an “economic hurricane” on the horizon, Goldman Sachs sounding in agreement with this assessment, and comparisons to the 2000 Dot-Com market crash. As typically happens during market selloffs, the uber-bears resurface with forecasts of historical doom-and-gloom. Case in point: John Hussman calling for a selloff of 60-70% off the January highs (please note: the 2008 financial crisis ended with the S&P500 down 58% from the October 2007 peak to the March 2009 lows).
Some or all of this may indeed happen. The world is not in a great place right now. It is possible. We would argue not probable.
It is always important to remember the stock market is a forward looking by nature. What happened yesterday or will happen tomorrow is of little concern. The perception of what the world will be like 9-12 months from now is what’s important. And right now, the argument from economists goes something like this:
“Although major swaths of the economy — including the job market and consumer spending — remain robust, there are mounting worries that rising borrowing costs for consumers and businesses, after years of near-zero interest rates, could cause a sudden retrenchment.” (Source)
On the surface that sounds pretty serious reason to batten down the hatches. HOWEVER … If you read it again, those worries are not built on the current reality, but thoughts of what could happen. Put another way – fearmongering.
Our point: what you see and hear reported in the financial news can be more about headlines, sensationalizing, and selling ad space than about a rational look at the factors that drive the stock market. And what really matters is what is truly happening with interest rates, the economy, and corporate earnings.
Interest Rates
Interest rates are important for a number of reasons. For capital intensive businesses, higher interest rates increase interest expenses, lowering profits. For highly leveraged companies an increase in rates can result in bankruptcy. For the market overall, rates and valuations move in opposite direction. Lower rates typically produce higher valuations with high rates result in lower valuations. This isn’t exact an exact science but more of a general principal.
As we enter June 2022, we know that short-term rates have started to move higher, and there is a high probability will continue to increase for at least the June and July meetings of the Federal Open Market Committee (FOMC). Chairman Powell has been clear that the Fed is very concerned with inflation and will do what is necessary to get it under control.
In general, rising interest rates is considered to be negative for the stock market. The FOMC doesn’t just randomly increase rates “just because.” No. Rate increases are done to cool down an overheated economy. Put another way, rate increases are a way to lower economic growth.
It is important to note that the level of real rates –the interest rate adjusted for inflation – is still historically very low even as nominal interest rates. This is a result of the combination of historically low rates and currently high levels of inflation. So, even as interest rates have moved higher, the real cost of capital remains at economically accommodative historically low levels.
Our Point: Rates have moved higher and likely to continue on an upward trajectory, yet we are a ways away from credit conditions that would stifle economic growth.
Chart #2: Source: www.macrotrends.net
The Economy
According to the BEA, 1st quarter Real GDP contracted at an annualized rate of 1.5%. Covid issues played a factor during January and the economy was much better as we entered the second quarter. Current expectations are for a rebound to around 3.0%. Full year expectations remain at 2.4% with a cooling off to 2.0% for 2023.
This is important. It is important because, right now, the economic growth forecast remains positive through 2023. It is also subject to change as the situation changes.
It is also important because the economy is what drives corporate earnings.
Our Point: The economy is not as hot as it was during the return to normalcy in 2021, but slower growth is not a recession.
Corporate Earnings
With all the problems facing corporations today – supply-chain, wage pressures, lack of workers, inflation – first quarter earnings turned out to be quite impressive. According to Factset, 79% of S&P500 reporting companies reported earnings above estimates. Revenues also exceeded expectations for 74% of reporting companies. For the full year analysts are predicting a 10.1% earnings growth rate.
Not the nearly 50% rebound in earnings in 2021, but solid growth.
Looking ahead to 2023, the current expectations call for 9.2% earnings growth.
Our Point: Expectations are always subject to change, but the outlook remains positive, even with a large number of issues companies are struggling with.
Putting it All Together
In our opinion, the talk of recession and gloom that has grown louder as the market correction has deepened, is not based on the current economic background or a realistic view of the more immediate future. Interest rates are moving higher. Yet are not so high as to cause concern. The economy isn’t in danger of an economic recession, and company earnings continue to move higher.
That doesn’t mean there won’t be a recession – a lot can happen, some of it unexpected. And the stock market doesn’t always reflect economic reality. The stock market isn’t rational.
Looking ahead we are keenly aware that the May market lows may not be THE low, and that more investor pain could be on the horizon. But we are also cognizant to the current reality that while things feel bad, this is exactly what it is supposed to feel like! Stock market returns over the cycle are better than bonds or cash BECAUSE of times like this.
The risk of variable returns results in better overall returns for the stock market investor.
Final Thoughts
Since the end of the Great Recession in 2009 until a few months ago we have been living in a world of low interest rates, cheap debt, and a fear of deflation. COVID, government stimulus, and a vastly different global economic reality have changed the economic paradigm.
What we believe we are experiencing is an adjustment to the new reality. A transition.
Changing times are never easy to live through. With change comes risks. With change comes opportunity.
The opportunity right now is that at the end of this transition – whenever that happens – is the next business cycle and the next move higher for the stock market.
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Asset allocation and diversification are investment methods used to help manage risk. They do not guarantee investment returns or eliminate risk of loss including in a declining market.All investing involves risks including the possible loss of principal invested. Past performance is not a guarantee of future results.
Index returns are not fund returns. An index is unmanaged and not available for investment.
Dow Jones Industrial Average: The Dow Jones Industrial Average is a price-weighted index of 30 “blue-chip” industrial U.S. stocks.
S&P 500 Index: The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value.
S&P Midcap 400 Index: The S&P Midcap 400 Index is a capitalization-weighted index measuring the performance of the mid-range sector of the U.S. stock market, and represents approximately 7% of the total market value of U.S. equities. Companies in the Index fall between the S&P 500 Index and the S&P SmallCap 600 Index in size: between $1-4 billion.
S&P Small-Cap 600 Index: The S&P SmallCap 600 Index consists of 600 domestic stocks chosen for market size, liquidity (bid-asked spread, ownership, share turnover and number of no trade days) and industry group representation. It is a market value-weighted index (stock price times the number of shares outstanding), with each stock’s weight in the index proportionate to its market value.
MSCI World Index: The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance.
MSCI EAFE® Index: The MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.
Bloomberg Barclays U.S. Aggregate Bond Index: Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.
NASDAQ Composite Index: The NASDAQ Composite Index measures the market value of all domestic and foreign common stocks, representing a wide array of more than 5,000 companies, listed on the NASDAQ Stock Market.
Russell 2000® Index: The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents
Technical analysis is only one form of analysis. Investors should also consider the merits of Fundamental and Quantitative analysis when making investment decision. Technical analysis is based on the study of historical price movements and past trend patterns. There is no assurance that these movements or trends can or will be duplicated in the future.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility.
Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline of the bond’s price. Credit risk is the risk that the issuer will default on payments of interest and/or principal. The risk is heightened in lower rate bonds. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
Investing in commodities is not suitable for all investors. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. The prices of various commodities may fluctuate based on numerous factors including changes in supply and demand relationships, weather and acts of nature, agricultural conditions, international trade conditions, fiscal monetary and exchange control programs, domestic and foreign political and economic events and policies, and changes in interest rates or sectors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks, including futures roll yield risk.
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