Hot Mess

A common tendency is to try and put the current circumstance into some historical context to gauge how bad things are and what a recovery might look like.  Here at the mid-point of 2022, with both the stock and bond markets having historically difficult years it is as challenging as it gets, no matter what time period we compare it with.  Stocks, measured by the S&P 500, are down 19.9%, and bonds, measured by the AGG (the iShare Core U.S. Aggregate Bond ETF) are down 10.4%. The markets will right themselves, we simply don’t know how long it will take.

Interest rates are the market’s dog whistle.  Stocks are responding to the continued threat of rising interest rates; the old Wall Street mantra “don’t fight the Fed” is at work.   After a long period of hesitancy, the Federal Reserve now seems determined to take a page from Paul Volker’s 1970’s playbook and tame inflation.  In times past, fiscal policy (spending and taxation) was a far more targeted and effective tool at controlling unemployment and inflation. In our hyper politicized world, this is sadly not an option.

In my opinion, the quick and intense fiscal response to the COVID outbreak was the correct strategy in a moment of urgency.  The ultra-low interest rates and stimulative retail spending that ensued led to a huge valuation surge in stock prices, a positive but ultimately unsustainable boost. The price correction we are working through now is a natural “reset” that will run its course.  Rates have largely normalized and a common error is to over-extrapolate, when in fact reversion to the mean is the more normal outcome.  I don’t think rates will move dramatically higher from here.  This is optimistic, though if true it will help re-establish a foundation under valuations.

In some respects, inflation looks to have crested.  Several near-term measures are falling and forward-looking measures do not indicate high inflation expectations.  The stickiness of the “transitory” inflation and the energy and food price spikes related to the Ukraine invasion have fueled vast consumer fear; in fact, consumer sentiment has virtually never been lower than it is today.  In my opinion, this is a useful contrarian indicator that we are close to the end of this down cycle.  It also looks as though many of the other COVID road blocks such as logistics networks, labor supply and related supply chain breakdowns will clear more quickly than originally assumed. 

A substantial overhang is the issue of slowing growth.  Q1 GDP was revised down slightly to -1.5% and Q2 is now expected to come in at -2.1%, according to the Atlanta Fed’s GDPNow.   An economy contracting at that rate is in recession, no matter when the official declaration is made.  On a more granular basis, we are concerned with the effect on margins, and thus earnings per share, due to rising interest rates, high inventory levels and even the misleading effects of stock-based compensation plans.  There is a prevailing commentary that earnings forecasts for S&P 500 companies are too high and must come down.  We will know more shortly, as 2Q earnings will be reported over the next few weeks.

Our game plan is simple: patiently own high-quality assets and hold ample cash to allow markets time to normalize.  It’s an oversimplification to think there is an algorithm that allows investors to dodge difficult markets.  The truth is stock prices move up and down in ways that often overpower our emotional sensibilities.    It is easy to get wrong footed in stressful times.  In my opinion, most of our long-held growth stocks will rebound nicely as the backdrop tempers and the urgency to raise interest rates dissipates.    We also have capital gains in mind, considering the discomfort of paying taxes in years the market is off.

Please don’t hesitate to check in if you want to review things or have any financial planning questions.  We are always available for you.   We are also back in our offices, so please feel free to stop in if you are in the area.  Enjoy the summer and be safe out there.

Bruce Hotaling, CFA

Managing Partner