Q2 2022

Market Update

As we’ve written about and discussed in our webinars, the returns in the markets are more than twice as great when the market is recovering than when risk is lower, and the markets are making new highs.

There is no way of putting a good spin on what happened during the second quarter of this year. There was no place to hide. Investors experienced losses in domestic stocks, international stocks, domestic bonds, and international bonds. While cash was king, people sitting on the sidelines lost buying power to inflation. The S&P 500 fell 16.4% during the quarter (graph provided), primarily propelled by fears of inflation and its impact on corporate profits. 

Second Quarter – S&P 500 Price Movement

Second quarter’s bloodletting coupled with a weak first quarter combined to give the S&P 500 its worst first half performance in fifty-two years (graph provided). You would have to go back to 1970 to find a worse first half of a market year when the S&P 500 plummeted 21%. The S&P 500’s 20.6% first half losses translated into $8.5 trillion in investor losses.

Year-to-Date – S&P 500 Price Movement

According to FactSet, ten of the most popular stocks accounted for almost half of this loss, mounting $4.2 trillion in lost market capitalization. Apple dropped 23%, Amazon was down 36.3%, Microsoft shed 23.6% of its value, while Google lost 24.8%. Meta Platforms was down 52.1%, Tesla crashed 36.3%, Nvidia fell 48.5%, Netflix plummeted 71.0%, Home Depot dropped 33.9%; and Paypal lost 63% of its value. These are stunning losses, especially coming from some of the most stalworth companies in our economy.

Growth-oriented stocks suffered far greater losses and experienced far greater volatility than their value-oriented counterparts during the first half of the year, down 28.1%. This is a bit of a consolation prize, with large-cap value stocks down 12.9% for the year (graph provided). Things were worse for their small-cap counterparts, with small-cap value down 17.3% and small-cap growth down 29.5%.

Value vs. Growth Stocks

As mentioned, the bond market has been providing protection to investors’ portfolios. 

As you can see from the graphs provided, the Bloomberg Barclay’s Aggregate Bond Index was down 10.35% for the year, and Long-Term Treasuries suffered even more, losing 21.25% of their value.

Bloomberg Barclay’s Aggregate Bond Index

Balanced portfolios, those with 60% of their allocation in stocks and 40% in bonds, typically can weather a downturn in the markets. Since the bond market and stock market have suffered similarly, balanced portfolios have experienced their second-worst first half performance on record (graph provided). This is the worst start since 1932!!!

Balanced Portfolio (60% Stocks, 40% Bonds) H1 Performance

Inflation

To understand what is happening in our markets, it’s imperative to understand inflation. In the simplest of terms, inflation is when prices increase. This can occur for many reasons (more to come on this subject). Over the last forty years, inflation has been under control at levels around 2.5% to 3% per year. Recently, our inflation rate has spiked up to 8.6%, levels that we haven’t seen since the early 1980s. This means that it will cost you $108.60 to buy the same goods that you were buying for $100 a year ago. In other words, your dollar isn’t going as far as it used to.
United States Inflation Rate

What Causes Inflation?

There are many causes of our current inflationary environment. Cheap money is one cause. Just a few months ago, the Federal Reserve had overnight bank borrowing rates at 0%. That meant that the banks could borrow money cheaply from the government and then lend it to you cheaply. Just think about the mortgage you have today versus a mortgage that you had in the 1980s or 1990s. I bought my first home in 1996 and was excited that I had a 7.875% mortgage. The lower the mortgage rate, the more people can afford to buy homes (or bigger homes). The average American didn’t have to spend as much to service the debt that they have and as a result, they have more discretionary spending. In just the last few months a 30-year fixed-rate mortgage has gone from under 3% to over 5.5%. This increase will cost a borrower an additional $1,750 per $100,000 in debt per year. While things are getting more expensive now, years of cheap money has helped fuel our current inflationary environment.

Our supply chain woes are another issue. While it is no longer making the same headlines as it did a few months ago, we are still having supply chain issues. The bottleneck has just moved from the ports, inland. We are currently experiencing delays with our rail system and increased demand is overtaxing the trucking industry. Warehouse vacancy rates are at historic lows. If less goods are getting to market and demand remains the same, the price goes up (causing inflation).

The war in Ukraine and the subsequent sanctions on Russia have impacted inflation. Ukraine and Russia are both major exporters of wheat, with Russia being the world’s largest exporter of wheat. Wheat prices skyrocketed up at the beginning of the war due to Ukraine’s inability to export and Russia’s wheat being sanctioned. Recently prices have fallen back to levels seen before the war began. Russia is the world’s third-largest producer of oil, supplying approximately 10% of the world’s oil. You’ve seen the impact that sanctions have had sending national gas prices over $5 per gallon for the first time ever. Approximately one-third of Europe’s oil and 40% of their natural gas comes from Russia. Russia is also a major world supplier of iron products, nickel, and nitrogen-based fertilizers.

Labor Shortages have remained an issue since COVID began. U.S. job vacancies are at record highs. We had seen the percentage of Americans working dwindling due to our country’s demographics. The Baby Boomers entered retirement in record numbers, lowering the percentage of Americans working from approximately 67% to 63% over a fifteen-year time period. We’ve seen approximately 2% of the American workforce leave the workforce and not return. Our labor shortage impacts everything in our supply chain. We’ve seen food costs skyrocket due to labor shortages.

While death rates due to COVID have plummeted globally, COVID remains an issue. The global 7-day daily new case count for COVID is 750,00. This is far below the levels seen earlier this year but above levels experienced during much of 2021. Recent COVID shutdowns in places like China and Vietnam have continued to create supply chain issues on everyday goods

How Does Inflation Impact the Markets?

Inflation’s impact on the stock market comes down to economics 101, “supply and demand.” If the cost of goods has increased, as we’ve just discussed, publicly traded companies have the choice of passing on this increased cost to their end consumer, or they must absorb the cost themselves. Neither situation is good. If they pass on the higher costs to their customers, simple economics will tell you that the customer will buy less of the higher-priced product. This means publicly traded companies’ earnings will fall due to lower sales. If the company absorbs the higher costs, their sales will remain the same, but their profit margins will decrease. Either situation leads to lower earnings. Investors buying companies based upon their future earnings growth suffer the most because these companies’ earnings will be lower than expected. This means the investor has paid too much. The shares of these companies fall in value to align with the lower earnings expectations.

What Is Being Done About Inflation?

The Federal Reserve has done two things in recent months to attempt to combat inflation. During COVID, the Fed was buying bonds to keep treasury yields low. A lot of lending is based upon treasury rates. This is a form of stimulus. The Fed ended this program in March and then began raising Fed Fund rates. 

Fed Funds are the biggest tool that the Federal Reserve has in its arsenal to combat inflation. Raising rates makes borrowing more expensive. The less people borrow, the less free cash is available to spend. The result is to slow the economy. The trick is to raise rates enough to end inflation without slowing the economy so much that we go into a recession. The Fed Futures (the predicted rate of Fed Fund rates) point towards multiple Fed hikes during the year, with the highest probability that rates are at 3.25% to 3.5% at the end of the year (graph provided). Hopefully, with this aggressive stance, inflation will come under control.

December 14, 2022 Fed Futures

Where Do Things Go From Here?

This has been a very tough year to manage money. Market leadership has been all over the board. Defensive stocks have been punished as much as growth stocks. It has been very difficult to defend our portfolios from losses.

As bad as the first six months of this year have been, there is light at the end of the tunnel. The media is making a lot of headlines about the first six months of the year. I heard a great quote from Adviser Investment’s Chairman, Dan Wiener, who said “As far as I know there is nothing magical about the six months from January to June other than the fact that it starts with fireworks and ends with fluttering flags.” He’s right. Why only look at things in quarters or a half year. We went back and looked at all rolling six-month time periods going back to 1957 (see the graph provided). It was bad, but there were other periods that were worse.

Rolling 6-Month Returns for the S&P 500

The next question that should be asked is, how did the markets do after these big declines in the market. As you can see from our study, there were thirteen previous 20%+ declines over any six-month period. The average recovery out six months was 17.6% and out a year it was 28.2%.

S&P 500 Returns After a -20% Six-Month Period

Taking it a step further, when consumer sentiment is this low, it is normally a great time to buy. If you look at the troughs in the Consumer Sentiment Index (graph provided), the average return in the S&P 500 during the subsequent 12 months average annualized return was 24.9%.

Consumer Sentiment Index and Subsequent 12-Month S&P 500 Returns

The same thing that has sent down stocks is going to be the same thing that makes them rise, and that’s inflation. As soon as we know that inflation is under control and starts to drop, investors will flock back into the markets. As we’ve written about and discussed in our webinars, the returns in the markets are more than twice as great when the market is recovering than when risk is lower, and the markets are making new highs. 

Please 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. Make sure that you don’t allow your emotions to dictate your investment decisions. Will there be more volatility in the markets? Probably. There might even be more downside. The markets will recover. When they do it will be very swift.

As always, I welcome your questions and comments.

Jeff Powell

Jeff Powell | Founder & Managing Partner 
Polaris Wealth Advisory Group