So Far This Year
Coming into 2022, both stocks and bonds were richly valued. Valuations were at a premium because corporate profitability was strong, interest rates were low, the economy was re-opening, and market participants thought inflation was temporary, primarily due to supply chain issues that would resolve themselves. This year, as we are all experiencing, inflation has not only persisted but increased as supply chain issues are continuing and wage pressures have grown, as two million workers have not yet returned to the workforce. The war in Ukraine and the COVID related economic shutdown in large parts of China have exacerbated these inflationary pressures.
As a result, both the equity and bond markets have sold off significantly this year. As of May 12th, the S&P 500 has fallen by 18.43% from its peak and the yield on 10-year Treasuries rose from 1.631% to 2.852% this year. The sell-off in the US equity markets has not been uniform however. For example, the equities of companies with little or no earnings but disruptive technology have declined far more than companies with strong balance sheets that pay a dividend. The justification for the high valuations for many of these disruptive technology companies was that they could use cheap money to finance their enterprise until earnings materialized. Many of these companies have lost around 50% of their market value as investors were no longer willing to pay a premium for the potential of future earnings, especially with the head winds of higher borrowing costs.
The result of the sell-off in the equity market is that valuations have become more reasonable. Valuations for large cap US stocks are now in-line with median historical valuations. Small- and mid-cap stock valuations are well below historical median valuations. For the first time in a while, some stocks appear cheap, although some valuations do remain inflated even after the sell-off.
The bond market has also repriced as the Fed is no longer keeping the Fed Funds rate at 0 or buying mortgages to stimulate the economy as it did during the COVID related economic shut down. The Fed has taken the Fed Funds rate to 0.25%, but bond market participants are expecting the Fed to increase it to as much as 3% over time. Reflecting this anticipated increase in these short-term rates, yields on short-term Treasuries rose and prices fell. (Bond prices move in the opposite direction of yield). Longer term Treasury yields rose as well due to inflationary concerns, and the yield on corporate bonds and mortgages have risen substantially as well. So far this year, we have seen the unusual situation where prices for both bonds and stocks declined.
Where From Here
The fundamentals of the US economy are still strong but are beginning to slow. Corporate profitability continues to increase, household leverage is low, job growth is at high levels, and the Conference Board’s Leading Economic Indicators do not indicate a recession in the near future. Both the equity and bond markets have re-priced to reflect the new inflationary environment, and valuations in both markets appear reasonable.
However, there is significant uncertainty surrounding Fed policy and inflation: if the Fed tightens too aggressively it could dramatically curtail demand and cause a recession; if it does not tighten aggressively enough, inflation could persist or even increase. Also, there is a possibility that corporate profitability declines and interest rates continue to rise. In that case, valuations that currently appear reasonable could fall further. Because of these risks, we would not be surprised to see more short-term volatility in financial markets. Some of these risks appear to be reflected in current equity and fixed income prices, but there is still significant short-term uncertainty regarding the direction of these markets.
While we cannot predict whether markets have bottomed in the short term and each client’s individual situation is different, in the great majority of cases, staying the course is the best course. Historically, equity markets do appreciate over time, and investment programs can become derailed when investors exit the market during a decline, lock in their losses and miss a recovery when it occurs.
We continue to closely monitor both the financial markets and the underlying economy and will make occasional tactical tilts to take advantage of dislocations but not at the expense of diversification, which in the long run protects portfolios.