I recently had a Zoom call with a client who expressed concern over how erratic the stock market has been. I explained that this feeling is completely understandable and conversely, the more fearful she becomes, the more she should consider buying stocks. She blinked and raised an eyebrow at me. I offered to explain with an example. “What is your favorite drink?” I asked. She told me, “Red wine, Cabernet Sauvignon.” “Wonderful!” I said. “Now imagine you walk into the liquor store and your favorite Cabernet is selling for its usual price. How many bottles would you buy?” “I would buy one bottle,” she said. “Okay,” I said. “Now, if you walked into that same liquor store two weeks later and your favorite bottle was on sale for 25% off, how many bottles would you buy then?” “I’d buy a case!” she exclaimed. “Exactly,” I said. “The financial markets are the only markets where no one wants to buy them when they’re on sale.”
In times of heightened volatility, it’s easy for all of us to lose our long-term perspective. After all, when the market trends up two thirds of the time (on average), we are used to mostly experiencing market gains. Along those same lines, we’re generally used to bonds holding value when stocks capitulate. The start to this year has been an unusual one in that regard.
The first four months of this year provided the worst bond returns (-10%) since 1842![1] The combination of historically low interest rates, record inflation, and an aggressive fed funds hiking cycle has caused a major repricing in fixed income securities. The simple explanation to the impact of rising rates is that newly issued bonds now offer higher yields, making older bonds with smaller coupons less attractive. For those bonds with a longer term to maturity, the price impact is more severe because you must wait longer to reinvest your principal. In addition, most bonds don’t have variable coupons, so they are generally not interest rate or inflation protected.
We’ve gone through rate hiking cycles many times before, but the difference this year is the speed and size of the hikes along with a backdrop of persistent inflationary pressure. The Federal Reserve has been very transparent in outlining their planned hiking schedule. The bond market has quickly priced in most of the hikes for the calendar year. This means the worst of the repricing (assuming the Federal Reserve follows their announced playbook) is likely behind us for 2022. Bonds sport higher yields and some opportunities, especially in investment grade credit, have begun to appear. Intermediate term corporate bonds now have a yield of 4.35% which exceeds the long-term average inflation rate of 3.64% (1958 – 2022).[2]
Stocks have also repriced alongside bonds, with the S&P 500 index down -14.3% as of May 26th, with Consumer Discretionary (-27.8%), Technology (-21.5%), and Communication Services (-26.6%) leading the worst performing sectors. On the flip side, Energy is up a whopping +58.3% this year after entering the year with very low valuations in addition to their direct link to commodities, which have historically proven a great inflation hedge.
The best way for investors to regain perspective is to revisit fundamentals and market history. Below are some of my favorite charts that help put today’s markets into context.
The S&P 500 is currently priced close to its average historical price (as measured by a multiple of annual earnings). The 25-year average price for the S&P 500 is 16.85x annual earnings, currently the S&P 500 is priced at 17.06x annual earnings.[3]
International stocks look cheap relative to their historical earnings multiples, with Europe trading at a 16.2% discount and China at a 14.6% discount to their averages over the past 25 years.[4]
In addition, it’s worth noting that the stock sectors that have performed best this year are more on the “value” side of the ledger. Think “old economy” sectors like energy, materials, industrials, and financials. While we must balance the risks associated with the Russia/Ukraine war, Europe has healthy exposure to many of these “value” sectors. In some cases, more so than in the U.S.[5]
Volatility, though uncomfortable, is common. While the average intra-year drop over the past 42 years has been -14.0%, annual returns were positive in 32 of those 42 years. That’s not to say we’ll finish with a positive return in 2022, but reversals occur, and often quickly.[6]
Consumer sentiment is regularly a contrarian indicator, meaning the more pessimistic consumers are, the better the future return opportunity is for stocks. Over the past 8 sentiment troughs dating to 1975, the subsequent 12 month return on the S&P 500 has averaged +24.9%. Great opportunities arise when investors are fearful.[7]
Lastly, economic growth in the U.S., while moderating, is still healthy. While GDP growth declined from Q4 of 2021 to Q1 of 2022, the year over year number as of Q1 2022 was +3.5%.[8] The U.S. consumer is also healthy with household debt payments as a percentage of disposable income remaining at a 40-year low, year over year unemployment below the 50-year historical average and year over year wage growth exceeding the 50-year average.[9],[10] Taking all this into consideration, the probability of a recession through the first half of 2023 remains low.[11]
Now, I would be disingenuous if I told you I felt the opportunity to be greedy is at our doorstep. The second half of 2023 is more uncertain. The Federal Reserve has a heavy lift – trying to tighten monetary policy enough to get inflation under control without pushing our economy into a recession. It’s too early to tell how things will play out, but a clear takeaway is that the economy looks healthy and stock prices (especially outside the U.S.) are not expensive today.
With some areas of the market already on sale, we’re rebalancing to take advantage of this dislocation. It’s certainly possible stocks will get cheaper before they recover, so we may have a very good buying opportunity on our hands. We’re recommending our clients be patient, stick to their long-term plans and risk tolerance, and make sure they have adequate liquidity to endure a recessionary outcome. Practice prudence, but dust off those shopping bags and get them ready. Your favorite Cabernet may soon be on sale.
[1] https://www.wsj.com/articles/its-the-worst-bond-market-since-1842-thats-the-good-news-11651849380
[2] BLS, FactSet, Federal Reserve, J.P. Morgan Asset Management, Guide to the Markets – U.S. Data as of May 26, 2022
[3] FactSet, FRB, Refinitiv Datastream, RobertShiller, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management, Guide to the Markets – U.S. Data are as of May 26,2022
[4] FactSet, MSCI, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management, Guide to the Markets – U.S. Data are as of May 26,2022
[5] https://www.capitalgroup.com/advisor/insights/articles/2022-midyear-international-outlook.html?sfid=1068609101&cid=80761193&et_cid=80761193&cgsrc=SFMC&alias=A-btn-LP-2-CISynCTA
[6] FactSet, Standard & Poor’s, J.P. Morgan Asset Management, Guide to the Markets – U.S. Data are as of May 26,2022
[7] FactSet, Standard & Poor’s, University of Michigan, J.P. Morgan Asset Management, Guide to the Markets – U.S. Data are as of May 26,2022
[8] BEA, FactSet, J.P. Morgan Asset Management, Guide to the Markets – U.S. Data are as of May 26,2022
[9] FactSet, FRB, BEA, J.P. Morgan Asset Management, Guide to the Markets – U.S. Data are as of May 26,2022
[10] BLS, FactSet, J.P. Morgan Asset Management, Guide to the Markets – U.S. Data are as of May 26,2022
[11] https://www.cnr.com/insights/speedometers.html