These are trying times. Stocks, measured by the S&P 500, dropped 0.6% for the month of May and are now down 12.7% year-to-date. At the same time bonds, measured by the AGG (iShares Core U.S. Aggregate Bond ETF), are down over 8% year-to-date. Over the last 20 years, stocks and bonds have generally maintained a negative correlation, acting a little like a hedge on each other. At various points in history, stocks and bonds have exhibited periods of both positive and negative correlations, depending on the macro economic conditions at that time. This year has been quite difficult because stock and bond prices have fallen in tandem, and investors have not been able to find any respite from the downward pressure on their investment portfolios.
Investors began selling in earnest January 3rd, catalyzed by the Federal Reserve’s announcement in early December 2021 of its plan to tighten financial conditions more quickly than the markets were anticipating. The result of that policy change has been a steady drop in stock prices, which has lowered the multiple (the forward P/E ratio) on the S&P 500 from 21x in January to 17x today. During that same period, EPS estimates (forward 12 months) have increased from $222 to $237. The bad news is that stock prices have fallen persistently in attempting to interpret the impact of higher interest rates on stock prices; the good news is that earnings expectations have increased since the start of the year. As with dividends, earnings are a primary factor in the markets’ determination of future stock prices.
We are finding the current backdrop a challenge in developing a clear road map. Our primary effort is to help our clients continue to hold onto their stock portfolios while we move through these turbulent times. To this end, we believe it is critical to focus on owning high quality stocks: typically, well-known companies that are well managed and have a long history of innovation and financial strength. Our second focus is on companies with a strong free cash flow (and typically a dividend, though not always) as this is a central factor in valuation assessment across Wall Street. The third is on an approach referred to as “Growth at a Reasonable Price” (GARP), where we identify companies with relatively high (recurring) rates of growth that also sell at attractive relative valuations. This sounds easier than it is and sadly the only sector that has truly stood out this year are oil and gas related stocks, an area we tend to avoid. There has been no safe- haven.
While I have confidence the markets will stabilize, I think a patient will be critical. The eventual price recovery will not happen as quickly as the rebound from COVID in early 2020. On the other hand, I do not think markets will drop into a prolonged spiral as they did in the wake of Y2K and the 9/11 attacks. Today, the market has largely been revalued. The job market is robust, and wages have moved higher for much of the labor force, and there are signs the housing market is beginning to temper. Inflation is the issue having a pronounced effect on consumer sentiment. If the Federal Reserve can successfully bring inflation down without tipping the economy into a recession (the Goldilocks outcome), this will buoy investors and prices.
The biggest challenge is to continue to own stocks during these times – we understand that maintaining confidence that prices will recover is not easy, but when prices do recover, we want to be fully invested in stocks. In my opinion, we must also guard against the impulse to move with the market (flavor of the day) which risks our getting wrong footed as things normalize. Our approach is to patiently continue to own quality growth-oriented stocks and bonds with the confidence that the markets and prices will sort out. We have always approached investing in this way and have never come upon a replicable or affordable approach that allows investors to avoid or hedge these inevitable downturns.
As we move forward, please do not hesitate to call if you want to discuss your plans, investment needs or specific investments. We are happy to speak or meet with you. Our offices will likely be under construction until July, but after that we are happy to meet you there or over Zoom in the interim. Until then, please take good care.
Bruce Hotaling, CFA
The views and opinions stated herein are those of Bruce Hotaling, are as of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation. This note contains forward-looking statements, predictions and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements.