Against a backdrop of high inflation, rising rates, growing recession concerns and an acrimonious geo-political backdrop, the S&P 500 had its worst start to the year since 1962. The S&P 500 was down -20% through the first half of the year; the official edge of a bear market. This is not a particularly uncommon event and cannot be a surprise given the dramatic rise of the market since the Covid surge 2 years ago. What is uncommon is the carnage in speculative stocks: Small Cap Growth -40%, SPAC’s -46%, IPO’s -59%, Speculative Innovation Stocks -69%, and Bitcoin -63%. Why is there so much destruction in the speculative side of the market? The culprit here is, surprisingly, interest rates. The Bloomberg Aggregate Bond index was down -10.3% since the start of the year. This is double the previous worst drawdown for bonds (-4.9%) in the past 25 years. The decline in stocks AND bonds at the same time is rare. This combination resulted in balanced funds having a 6-month return that was worse only three other times in the last 25 years. The Vanguard Balanced Index Mutual Fund (60% Equities, 40% Fixed Income) is down -16.94% YTD. Our conservative posture in both stocks and bonds helped us navigate through the first half of the year with better results.
The Fed and Interest Rates
The culprit for the poor returns in bonds was inflation. As it turns out, inflation was not transitory, as the Fed insisted for a year. During Q2 the Fed (and the market) could not excuse inflation any longer and rates rose dramatically. The result is that total returns for the 10 Year Treasury are the worst since 1788. Market consensus expects the Fed to hike rates to around 3.50% by late this year. If inflation remains a threat, then pressure will be on the Fed to continue to raise rates, and there is no clear sign that inflation is abetting. The June CPI (Consumer Price Index) report was worse than expected, with inflation up over 9% in the past year.
The interest rate futures market, as recently as last month, was pricing a peak in Fed Funds over the next year of 4%. However, these same markets are now pricing Fed Funds to only get to 3.50%. Even more surprising is that they expect the Fed to start cutting rates next year. The clear implication is that the futures market believes the Fed is going to run into problems economically (recession) and stop their rate hike program. We expect that when the dust settles, short-term interest rates will be higher, and inflation will remain elevated, at higher levels than the markets are currently projecting.
The Economy, Valuations, and Earnings
Calls for a recession due to the Federal Reserve hiking interest rates are commonplace. The best leading indicators of economic activity, the ISM Surveys, are flashing caution. Fifty is the level between contraction and expansion, and Manufacturing is currently at 53 while Services is at 55. This is a big decline from last year when they were at 65 and 69, respectively. The economy is still expanding, but at a very nominal rate, with the risk that we will dip below 50 in the coming months as the Fed continues raising rates.
The pace and magnitude of the rates repricing has been extraordinary, and it has led to a sharp decline in equity valuations from their pandemic highs. Equity valuations are mostly affected by interest rates. Lower rates allow higher valuations as future earnings are discounted at a lower rate. As rates rise, valuations fall. This decline in valuations makes sense because when rates were essentially zero, throughout most of the pandemic, the cost of capital was extremely low and unprofitable companies were not punished so long as they kept growing.
Over the last 40 years rates have been declining, which has allowed equity valuations to expand. It is likely that this secular trend is over. Forward P/E’s have fallen from a high last year of 23 and are now around 17, the 10-year average. Have they fallen enough? It is possible, but they could also fall further, as the low P/E during the quick bear market in 2018 and the dramatic decline during the Covid surge in 2020 dropped to around 13-14. Our sense is that while the bulk of the decline due to valuations is behind us, we are genuinely concerned that valuations could still move lower.
Further, we believe earnings estimates are also at risk and are compounding the downside risk for equity markets. The near-term challenge for equities is that any meaningful move higher will be predicated on improved earnings. However, analysts have not yet started marking down earnings for the second half of this year. In fact, as recently as last month, analysts’ consensus estimates called for a 7.4% gain in earnings per share over the coming year. How can that be if recession risks are rising? One would think rising inflation pressures, a hawkish Federal Reserve, still lingering supply chain issues, and a slowing economy would pressure margins, but most analysts are not presently expecting this to happen. History has shown that previous Fed Rate Hike cycles have ended in recession accompanied by significant earnings contractions; will it be different this time?
While this Goldilocks scenario is possible, our view is that earnings forecasts will come down, and there will probably be another leg lower to this bear market. We have had eight recessions since 1970, and the median decline in earnings was -14%. If we do go into a recession, even if valuations are at a low, there appears to be potential for more downside due to earnings contractions. If this does occur, it will happen when analysts finally acknowledge that earnings will be affected by a slowing economy.
Projected earnings for the S&P 500 for 2022 are $250. If you take $250 and assign a 16x PE, then fair value is 4000 on the S&P, about 5% higher than where the market is trading. However, if earnings decline by just 10% to $225, which is less than the historical average decline, and you assign an historically attractive multiple of 14x earnings on $225, then fair value for the S&P is 3,150 – 17% lower than current levels. We are not calling for this bearish outcome, but we are concerned that the probability for the market to move lower is quite high, which means that the risk/reward backdrop is still not attractive.
The main positive element in this environment is that sentiment is incredibly oversold. The market has done an excellent job of discounting all the unwelcome news, and at this point, one must consider the possibility that an oversold rally of some magnitude is in the offing, or at least a pause in the decline in both stock and bond prices.
In the current bear market, we have declined by as much as -23% at the mid-June low, but we have had 4 bear market rallies of 6 to 11%. We would not be surprised that a few more bear market rallies are coming, even larger than we have seen so far this year. However, we also suspect that the market is likely to make a new low before the Fed finishes tightening.
While sentiment is very oversold and argues for a rally or at least a pause in the decline, there is evidence that suggests that while investors are feeling bearish, we are not seeing the type of wholesale selling that usually occurs at a secular bottom. Similarly, most brokerage research strategists are still uniformly bullish, with many calling for the market to rally into the year end. This is rarely how bear market declines end. In the short term, another bear market rally is certainly possible, but we believe there is likely to be a second leg lower, which will set the stage for a more meaningful recovery.
In the near term, we anticipate a tug of war between valuations and earnings to occur as analysts adjust their forecast to real time data The market is currently pricing in the same outcome as the last three recessions: the Fed will immediately ease at the first sign of economic or market troubles. However, the lessons from the stagflation periods of the ‘70s and ‘80s suggest that the Fed has much less wiggle room to ease than in the past and that the outcome could be far rockier than most expect. Will inflation moderate like the bulls believe or is the “sticky” inflation of rising wages, a tight labor market and rising home/rental prices likely to keep inflation at elevated levels? The unpleasant reality, for earnings and stocks, is that the Fed has an extremely poor record of attacking inflation without causing a recession.
Interest rates have been in a secular decline for 40 years, and this backdrop has proved to be a major tailwind for both stocks and bonds. Since 2008, all global Central Banks policies have been very accommodating and supportive of equities. However, the winds have shifted, and both Central Bank policies and interest rates are now an impediment to most markets. The past 12 years have provided exceptionally robust equity returns, but our current view is that returns will be more subdued over the next few years, with more volatility.
We have been cautious on equities since the end of last year and remain so. The equity market is confronting rising rates and strong inflation for the first time in 40 years. Against this backdrop, and all the other macro uncertainties, we believe maintaining some reduced exposure to equities is the best approach to weather the unpredictability’s of the current market environment.
We will be contacting everyone soon to discuss our thoughts and reviewing where we are for the year.