Polaris Q3 Market Update:
It is Different this Time
Global supply chains continue to be challenged, while the Fed is engaged in the most aggressive rate tightening cycle since the early 80’s. Concurrently, we are seeing dramatic increases in bond yields as well – meaning outsized losses in an asset class typically regarded as being safe (more on this later). This definitely has not been your typical market downturn.
Suffice it to say, this has led to an extremely difficult environment for investors. Throughout this article, we will put the challenges currently facing the global capital markets into perspective, as well as provide a road map for how we intend to navigate this tumultuous environment.
After falling -16.4% in the second quarter, and posting the worst first half since 1970, the S&P 500 rallied 17.4% from the June lows to the August highs, before stronger-than-expected inflation reports and aggressive tones from the Fed regarding future rate increases sent the markets to fresh lows. By the end of the quarter, the S&P
As of the end of the third quarter, the S&P 500 continued its march into Bear territory, finishing the first three quarters of the year down -23.9%.
Growth-oriented stocks have suffered far greater losses and presented investors with much more volatility than value-oriented stocks in 2022.
The Russell 1000 Growth TR Index finished Q3 down -3.6%, versus a loss of -5.6% for the Russell 1000 Value TR Index. Year-to-date however, the Russell 1000 Value has fared much better (relatively speaking), down -17.8% versus a loss of -30.7% for the Russell 1000 Growth – though it should be noted that significant losses have occurred in all nine domestic size/style categories.
Value stocks currently trade at attractive valuations below long-term averages, and at a significant discount to the broad market, whereas growth stocks continue to trade at a premium to historical valuations.
What has made 2022 even more difficult for investors is that during most cyclical bear markets, risk-off asset classes like U.S. Treasury Bonds typically provide a modicum of safety and capital preservation. Consider that in 2008 for example, when the S&P 500 declined by -37% for the year, the iShares 20+ U.S. Treasury ETF actually gained 34%! Suffice it to say, that has not happened this time around.
Through Q3, the Barclays U.S. Aggregate Bond TR Index is down roughly -15%, marking the worst start in history for the bond market (and that is going back to pre-1800s!).
With respect to the performance of the fixed income markets, it is important for investors to recognize that as interest rates in our economy rise, the prices on existing bonds fall.
The longer a given bond has until it matures, the more sensitive the price is to rising interest rates. This is clearly evident in the yearto- date performance difference between the Bloomberg U.S. Aggregate Bond Index (with an average maturity just under 9 years) down -15%, as compared to the iShares 20+ Year U.S. Treasury ETF being down almost twice as much, declining -28% through the first three quarters of the year.
Inflation in the United States has spiked in recent years, with headline inflation up 8.3% year-over-year in August – though down from the 9.1% high posted in June. Whereas we are starting to see inflationary pressures come down in key areas such as energy and new/used vehicle prices, inflation has remained far more persistent in categories such as housing.
Source: Bureau of Labor Statistics, FactSet, Federal Reserve Bank of Philadelphia, University of Michigan, JP Morgan Asset Management. Contributions mirror the BLS methodology on Table 7 of the CPI report. Values may not sum to headline CPI figures due to rounding and underlying calculations. “Shelter” includes owners equivalent rent and rent of primary residence. “Other” primarily reflects household furnishings, apparel, education and communication services, medical care services and other personal services. Professional forecasters reflects the latest quarterly Survey of Professional Forecasters on a 1-month lag. The Survey of Professional Forecasters is conducted by theFederal Reserve Bank of Philadelphia and reflects the median estimate by professional forecasters of average CPI inflation over the next 5 years. Guide to the Markets – U.S. Data are as of September 30, 2022.
The Federal Reserve, led by current Fed Chairman Jerome Powell, is tasked with curbing inflation and stabilizing prices in our economy through monetary policy. The federal funds rate is the target interest rate set by the FOMC (Federal Open Market Committee, the policy making body of the Fed). This is the rate at which commercial banks borrow and lend their excess reserves to each other overnight, but more importantly this rate serves as a benchmark influencing lending rates in our economy as a whole. When rates are high, obviously borrowing costs go up, making goods/services less affordable. When goods/services are less affordable, demand goes down. When demand goes down, so do prices – at least eventually. That is what the Fed is currently trying to achieve.
We began 2022 with the fed funds rate near zero. Since that time, the Fed has embarked on the most aggressive monetary tightening cycle since the early 80’s. And for the first time in history, they have increased the fed funds rate by 75 bps (aka 0.75%) in three consecutive meetings.
As of now, it appears the Fed will continue to be aggressive in their efforts to combat inflation, with the highest probability of rates being at 4.25% to 4.50% by the end of the year.
Should the Fed continue down this path of monetary tightening, one can expect potential further headwinds in the global capital markets.
So Now What?
2022 continues to be an exceptionally difficult landscape for investors, and it’s not just that we’ve experienced a true “no place to hide” environment. Adding to the complexities is the velocity with which the capital markets have begun to move in recent years.
The average length of a bull market going back to the 1920’s is fifty-one months, with an average rate of return of 162%. The bull market that began with the Covid lows put in March of 2020 lasted only twenty-one months (the shortest on record since 1960), yet over that abbreviated period of time posted a 114% gain for the S&P 500.
Our last bear market prior to 2022? Well, that was in 2020 and it lasted only one month (the shortest bear market in history) and registered a decline of -34%.
Source: FactSet, NBER, Robert Shiller, Standard & Poor’s, JP Morgan Asset Management. (Left) The current peak of 4797 was observed on January 3, 2022. (Right) *A bear market is defined as a 20% or more decline from previous market high. The related market return is the peak to trough return over the cycle. Bear and bull returns are price returns. **The bear market beginning in January 2022 is currently ongoing. The “bear return” for this period is from the January 2022 market peak through the current trough. Averages for the bear market return and duration do not include figures from the current cycle. Guide to the Markets – U.S. Data are as of September 30, 2022.
With losses as they currently stand, an investor in the S&P 500 would require roughly a 36% gain over the next year to get back to the highs achieved during the January 2022 peak. Over two years, one would require an average annualized return of 17.6%. You get the point, given our current backdrop, patience and discipline remain paramount – though admittedly, not easy.
The reality is that the global capital markets post-Covid (if we can even say that), are far more volatile versus historical norms. As a tactical money manager, aiming to adapt portfolios to prevailing market conditions becomes much more difficult in these environments – as underlying trends have lacked stability and often times have demonstrated incongruent price action.
At Polaris, we track the markets in a multitude of ways. In an effort to reduce the “noise” of daily news flow, various opinions, etc. – we are constantly measuring what underlying factors or sectors in the markets are currently expanding or contracting from a trend perspective. This is what we refer to as “regime analysis”, as we seek to identify market leadership.
While stating something has a lack of stability in price action is likely self-explanatory, what is it we mean by “incongruent price action”?
One need not dig very deep into the weeds to find the answer. In fact, simply looking at the quarterly performance of two rudimentary
indices in Q3 provides a very clear-cut explanation. In the past we have made reference to the S&P 500 Low Volatility Index as being a good proxy for lower risk stocks. Conversely, the S&P 500 High Beta Index provides a good proxy for higher risk stocks.
While the S&P 500 was down roughly -5% in Q3, the S&P 500 Low Volatility Index actually faired worse, down -6.2% for the quarter. Strangely, the S&P 500 High Beta Index performed the best – which makes almost no sense.
The only way it does make sense is to dig a bit further and apply the same analysis to monthly performance, at which point one can clearly see that the High Beta Index only outperformed on the quarter because of the massive outperformance generated in the month of July (when it was up nearly 16% in a single month). After that, it was among the worst. But taking a closer look here at the monthly performance divergences, it should become abundantly clear just how volatile underlying market currents have been.
When markets violently whipsaw between favoring either risk-on or risk-off assets, it can become a death knell for investors. As one segment of the market gains momentum, investors pile in, only for that sector to then rapidly reverse course. When this happens even one time, this can provide a significant lag for investors versus a traditional benchmark. When it happens repeatedly, one stands the chance of potentially locking in a permanent impairment of capital. The same holds true in environments such as these when investors falsely believe they can time when to be in or out of the market, choosing aggressively to raise cash in their investment accounts. The reality is the velocity of the underlying markets have simply been too extreme in recent years.
To be clear, in more stable environments, there are times in which an investor can successfully navigate the markets utilizing cash to lower risk in their portfolios. This is not, nor has it been one of those times. At which point, one has no other choice but to exercise patience, diversify equity exposure into quality companies, and remain disciplined. Of course, that is easier said than done, but statistically the data is irrefutable.
Consider the historical average rate of return generated by individual investors is only about 40% of the long term return of the S&P 500.
More than anything, the average rate of return generated by individual investors has significantly lagged appropriate benchmarks due to their proclivity to allow their emotions to impact their investment decisions. The problem is the prospect for forward looking returns are much higher when consumer sentiment is at the lows. When investors are feeling good, forward-looking returns are much more muted.
The University of Michigan has been generating their Consumer Sentiment Index data since the early 70’s. Just a couple months ago, consumer sentiment readings came in at their lowest levels in history – even lower than during the Global Financial Crisis in 2008, or during Covid shutdowns in 2020. That seems extreme to us, and when sentiment is this depressed, forward-looking returns are actually much more promising. The subsequent 12-month returns from the 8 prior sentiment peaks has only been 4.1%; from the troughs in sentiment the average rate of return is nearly 25%.
We’ve said it several times in prior publications, but the returns of the market are highest when recovering from losses, with a percentage gain per annum of nearly 36% going all the way back to the early 1900’s!
Are we suggesting this is the bottom? Unfortunately, no – but that doesn’t mean it couldn’t be! In Fed-speak terms, this market remains very “data dependent”. Meaning, should inflation numbers continue to abate, the Fed could choose to pivot away from current policy statements, taking on a much more dovish tone (implying being more rate-friendly). We won’t know that until the moment it happens, at which point the biggest gains historically come during the first few days off of a market bottom. Should one think they can time that, they are highly likely to fail. After all, with all the doom and gloom rhetoric out there during bear markets, even when markets do bottom, no one believes it initially, and that makes getting back in nearly impossible.
One final point we should make here with respect to the markets is to remind investors that the stock market is a leading indicator. That means, that in effect, the market is trying to price in future outcomes. In 8 out of the 9 prior recessions, stock prices began moving higher before our economy got better. That is highly likely to be the case this time as well.
Our current bear market is like none other, even for life-long investors in their twilight. Never before have we been faced with steep losses in both the stock and bond markets at the same time, while also managing our way through significantly higher levels of inflation and asset class volatility. Understandably, such an environment tests the mettle of even the most ardent investor.
During challenging times like this, what is most important is to understand the context of your investment returns given the current economic landscape and to exercise patience and discipline, devoid of emotional interference. We all know that is much easier said than done, but given the rate of the declines we’ve experienced up to this point across various asset classes, and how dramatically bearish sentiment has been – the odds of the markets generating outsized returns in the coming months and years are dramatically in our favor.
Now is also the time to review your portfolio with your financial adviser at Polaris Wealth. Review your financial plan. Invest based upon your long-term time horizon, not based upon what is going on in the markets today. Realize the investment opportunities present in the markets today, are some of the greatest we’ve seen in a generation. For outside assets or cash individuals may be holding on the sidelines, now is the time to formulate a plan and take action.
Polaris Wealth Advisory Group is a federally registered investment advisor. The information, statements, and opinions expressed in this material are provided for general information only and are subject to change without notice. This material does not take into account your particular investment objectives, financial situation, or needs, is not intended as a recommendation to purchase or sell any security, and is not intended as individual or specific advice. Investing involves risk and possible loss of principal capital. Diversification does not ensure a profit or protect against a loss. Past performance is no guarantee of future returns. Advisory services are only offered to clients or prospective clients where Polaris Wealth Advisory Group and its representatives are properly licenses or exempt from licensure. No advice may be rendered by Polaris Wealth Advisory Group unless an investment management agreement is in place.