Q2 Review: Understanding The Bear
July 7, 2022
by Jordan Hucht, CFP®, ChFC®, AIF®
Forgive me in advance, as this newsletter will be a bit longer and more technical than usual. My intent is to help you understand the current bear market, the factors that led us here, and what will likely determine what happens next.
But first, a personal analogy. My wife and I welcomed our third child to the world a few weeks ago, and I can’t help but draw parallels between newborns and bear markets. They’re difficult, they make you worry, and leave you wondering things like:
- What does the future hold?
- When will the next blowout happen?
- Is this all worth it? (Kidding, of course.)
- And how long will it be before things get easier?
Because we’ve done this before, they don’t last forever, and eventually, they develop into something else. Instinctually, you know there will be long-term rewards, but it’s still going to be no fun at times.
With that analogy in mind, let’s examine what’s actually happened in the markets this year and the major factors at play.
First, let’s look at fundamentals. Though boring, the relationship between interest rates and stock prices tells the tale of what’s brought us to this point mathematically.
Generally speaking, lower interest rates support higher valuations, whereas higher rates tend to suppress valuations. Though there are always other factors at play, math is the primary driver here. Valuations are a measure of how much investors are willing to pay for a company’s stock per dollar of that company’s earnings (the price-to-earnings ratio). When money is cheap (i.e., low rates), investors are willing to pay more for a company’s future earnings because of the low cost of capital. This is the time-value of money effect: a dollar earned in the future is worth less than a dollar earned today. How much less depends on interest rates at the time. Lower rates mean less time-value of money impact, resulting in a willingness to pay more for future earnings (result: higher valuations). Higher rates mean greater time-value of money impact, resulting in a willingness to pay less for future earnings (result: lower valuations).
From a fundamental perspective, what we’ve experienced this year has been this exact math at play. Coming into the year, the S&P 500 was valued at more than 20 times estimated forward earnings, which is relatively expensive from an historical perspective. At the same time, the 10-year Treasury yield was around 1.5%, which is on the low end historically. Over the past 6 months, the 10-year Treasury yield has jumped to over 3%, and the S&P 500’s valuation has fallen to around 16 times forward earnings (more than a 20% decline from its valuation to start the year). During that time, for the most part, earnings have held up to estimates. Therefore, the current market decline has been almost entirely due to multiple contraction (shrinking valuations), as opposed to reduced earnings. On a stock-specific basis, some have been affected much more so than others, as the further the rubber band was stretched (think early-stage tech companies with little to no current earnings), the harder it’s snapped back.
I realize that explanation may be elementary to some, but when scary headlines abound and emotions are high, it can be a valuable exercise to review something as unemotional as math.
Now that we’ve covered the fundamentals, what about the macroeconomic environment? Since we’ve discussed the macro challenges in more detail in prior newsletters, and not much has changed, I’ll focus here on the newer developments of the second quarter.
Let’s start with the Federal Reserve. The Fed met twice during the quarter: once in May and once in June. At the May meeting, the Fed raised the federal funds rate by 50 basis points and Chair Powell indicated that a future 75-basis-point hike was not currently being considered. The market loved that comment during the afternoon of his press conference, then decided it hated it the next day (a great indication of the type of market we’re in). At the June meeting, the Fed actually did hike 75 basis points, which the market initially loved, then hated the next day.
The decision to hike by 75 basis points during the June meeting surely was influenced by the CPI print a few days earlier, showing an inflation rate of 8.6% for the prior 12 months, hotter than the 8.3% expected and the hottest since 1981. This was not welcome news, as inflation is the primary concern on the minds of investors and the primary driver of monetary policy. With inflation running hotter than expected, the Fed decided it needed to move faster, hence the 75-basis-point hike a month after saying a hike of that size wasn’t on the table. It’s also important to understand that not only is the Fed raising rates, but it is also reducing the size of its balance sheet. What does that mean? When the Fed sells assets it holds (primarily Treasury bonds), it effectively takes money out of circulation, reducing the supply of money in the economy. This practice, paired with setting the fed funds rate, are the primary inflation-fighting tools that the Fed has.
Another major macro headline was the initial read on first quarter GDP, which showed a decline of 1.6%. If we were to post another decline in GDP for the second quarter, we’d meet the technical definition of a recession. Notably, few economists are expecting this to be the case; rather, a 2023 recession is the concern being widely considered. But I wouldn’t rule out a negative second quarter GDP print.
On a geopolitical level, hope for near-term resolution to the war in Ukraine has remained elusive. Sadly, no good news on this front, so the economic effects have continued, needless to say the human suffering.
In short, most of the headwinds that picked up steam in the beginning of the year have continued, leading to persistent inflation, higher rates, slower (or negative) growth, and recession concerns. Acting rationally, the financial markets have reflected this.
What comes next?
Over time, short-term market predictions from “experts” have proven about as worthwhile as astrology, so I avoid joining those ranks. Fundamentals drive the market over the long term, but sentiment tends to drive short-term moves, and sentiment is driven by human feelings. For that reason, there’s little value in attempting to predict what will happen in the next week, month, or quarter.
Instead, let’s look backward and forward on a multi-year (or even longer) basis to understand the factors that are likely to influence what comes next. From a valuation perspective, with the reduction in the S&P 500’s forward multiple from over 20 to start the year down to around 16 currently, we’re roughly in line with the average of the past 25 years. And with the 10-year Treasury yield in the 3% range, the current valuation seems reasonable in looking at past valuations when interest rates were at this level.
So far, we’ve had a valuation reset in the market, as opposed to an earnings decline. But that could change in the coming weeks. If earnings estimates come down as companies begin reporting second quarter results in the coming weeks, stock prices would have to follow suit in order to maintain the current market valuation. If inflationary pressures are proving to affect consumer spending, earnings reductions seem likely. However, if earnings hold up (as they have so far), and companies indicate an easing of inflationary pressures on the cost side, it’s reasonable that the current valuation could hold. And as earnings grow going forward, so should stock prices.
There will be other headlines and events in the coming months that will surely cause market reactions, but it really comes down to which shoe will drop first? Will inflation moderate, earnings hold up, and consumer confidence strengthen? Or will inflation destroy consumer demand, compress corporate margins, reduce earnings, and spawn a recession?
The answer to those questions will likely determine whether this bear market gets significantly worse and stays much longer, or whether most of the damage has been done and the recovery path comes sooner. In either scenario, know that bear markets of the past have come and gone, and the periods that followed have brought substantial gains for investors with patience. Even the greatest long-term investments sometimes yield poor short-term results.
Remember that good financial planning takes bad markets into account. Portfolio management is a subset of financial planning. Positioning investment risk appropriately within a portfolio and maintaining diversification are prerequisites to favorable long-term outcomes. Building a financial plan and a portfolio to match can allow you to live comfortably with bear markets, which inevitably come and go many times over.
Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser.
Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results.