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Stephen M. Mills, CIMA®Partner

Chief Investment Strategist

Brad Bays, CIMA®   Partner

PIM Portfolio Manager

Highlights:

  • The first half of 2022 was the worst year for stocks since 1970.
  • The S&P 500 Index officially entered a “bear market” in June.
  • The U.S. Federal Reserve continues to hike interest rates and reduce liquidity in an effort to fight persistently high inflation. . 
  • Inflation continues to show no signs of abating
  • Although the U.S. economy remains resilient, rising interest rates and high inflation are putting downward pressure on growth.    

Commentary

The first six months of 2022 have been one of the worst starts in history for U.S. stock markets.  We have to go back to 1970 when the S&P 500 Index lost 21% to find a six-month start worse than this year’s performance.1  As of June 30, the S&P 500 Index is down 20.5% in value since the beginning of the year reaching Wall Street’s technical definition of a “bear market” which is a decline of 20% from a previous high.2 The Dow Jones Industrial Average faired a little better but still lost 15.3% of its value over the same time period while the Nasdaq Index declined by a whopping 29.5%.2  Needless to say, many investors find themselves somewhat shell-shocked and frustrated by the severity of the stock market decline so far this year. 

While we have been warning of the possibility of a correction in stock prices since the first of the year coming off a very strong 2021 when the S&P 500 Index rose 28.7%, we have been surprised by the severity and volatility of the decline in stocks this year.   In the TCM 2022 Market Outlook & Strategy letter that we wrote in early January, we believed the U.S. stock market was vulnerable to a correction of as much as 10-15% during 2022 due to a number of risk factors.  However, we were also optimistic about the prospects of the stock market for 2022 and believed we would see positive returns for the year in the S&P 500 Index based on continued strong economic and earnings fundamentals.  Our forecast began to unravel in February when Russia invaded Ukraine sending oil and natural gas prices dramatically higher.  The price of oil, as measured by West Texas Intermediate Crude (WTI), surged from the mid $70’s per barrel at the beginning of the year to nearly $120.2   In addition, in March, the U.S. Bureau of Labor Statistics (BLS) reported that the Consumer Price Index (CPI) surged 7.9% for the previous 12 months ending February 28, a 40-year high.3  The S&P 500 Index responded to these negative developments by falling nearly 14% by March 15 from its January 4 high.2 

The stock market staged a strong rebound over the next few weeks but then turned lower again as it became apparent to investors that the Federal Reserve (Fed) was going to have to get much more aggressive with its actions to fight inflation. This narrative of higher interest rates and persistently high inflation has been in control of the market for the past several months sending stock prices on a downward path.  In mid-June, the Fed surprised markets with a higher than expected .75% rate increase in the Fed fund rate and cemented the concerns about higher short-term interests rates this year.4  The Fed has now raised the Fed funds rate to 1.5% from 0% at the beginning of this year and it appears they will continue to hike rates for the remainder of 2022.4  This has raised the probability of a recession for the U.S. economy over the next few quarters which we believe is one of the contributing factors for the sharp selloff in the S&P 500 Index in late June. The S&P 500 Index officially fell into bear market territory on June 17, closing the day down 24% from its January 4 high.  

We have not experienced a bear market in stocks since the first quarter of 2020 when the S&P 500 index fell 35% over a 5 week stretch on fears the Covid-19 pandemic would throw the global economy into a severe recession.  By mid-August, the S&P had fully recovered all of its losses.  We are not anticipating that large of a decline in stocks this time around but we are also not anticipating as quick of a recovery.  The chart below shows the last 11 bear markets dating back to 1946.  The average length of these bear markets is 16 months with the shortest being about 1 month and the longest just over 30 months.  Thus far, the current bear market has lasted about six months so based on history we may have a little ways to go before it ends. We believe that the current  downturn in stock prices may not end until it becomes evident that either inflation is subsiding and/or the Fed is nearing the end of its rate hike cycle.  That could happen as early as sometime in the third quarter of this year or as late as the first quarter of 2023, in our view. 
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From our 40 plus years of observing financial markets, the stock market typically trades differently in a bear market as compared to a bull market.  In a bull market, stocks are generally in an uptrend with shallow corrections in prices that are quickly met with buying as investors seek to put cash to work on stocks.  Investor psychology is generally positive and the outlook for the economy and corporate earnings is optimistic.  However, in bear markets, investor psychology changes.  Investor attitudes generally become more pessimistic about the stock market and future economic activity.  The R word, recession, is often bandied about in the news media and among investment analysts.  In a typical bear market, stocks generally trend downward.  There are often sharp countertrend rallies in the market that are quickly met with selling that takes the market to new lows. 

In looking back over the past six months we can see this typical bear market pattern in the major stock market averages.  During the recent market downturn, we have experienced several sharp rallies that were met with more selling taking the market to new lows.  In our view, this pattern was firmly established in June when the S&P 500 Index rallied about 8% from its May lows to only turn back down and make new lows on June 17.   Again, the S&P 500 index rallied almost about 8% off the June lows over the next several trading sessions.  This countertrend rally was again met with more selling.  As of the date of this letter, we are currently in the process of testing the June lows for the major stock market averages. This bear market pattern will most likely persist until the market can establish a firm bottom.   We may be there right now or it could be months away.  There is really no way of knowing when a bear market will end especially with today’s high degree of uncertainty concerning inflation, the aggressive Fed policy actions to reign in inflation, and the cloudy outlook for economy over the next few quarters.  Eventually, the outlook will become clearer and investor attitudes will change.  But until then, we expect the primary trend for stocks will be sideways to downward. 

This begs the question: Should we simply get out of stocks to avoid further losses until the economic clouds begin to clear and things look better?  This strategy sounds prudent and reasonable.  The main problem with this strategy in our view, is that by the time we see the economic storm clouds clearing, the stock market has typically bottomed and is well on the way to a recovery.  Trying to time market movements is very difficult because essentially, you have to make two right decisions,  one decision to sell and then a second decision as to when to buy back.  You have to have the timing right for both decisions to benefit from such a strategy.  Catching the bottom of a bear market is tricky because it is typically at that point the economic outlook often looks the bleakest.  The old adage, “It is darkest before the dawn” can be applied to investing.  Even seasoned investors have a difficult time buying when the outlook looks bleakest. But that is what we feel would best benefit you when timing market moves.

The big issue now facing investors is the prospect of a recession in the U.S. economy.  Recession talk has increased lately with the reality that the Fed will likely have to raise rates further in order to reign in inflation.  The market is now anticipating that the Fed will raise the Fed funds rate to around 3-3.5% by the end of 2022.  That would mean several more rate hikes over the remaining course of 2022 with the possibility of another .75% hike in July.  Investors have grown more worried that these higher rates, along with inflationary pressures, could potentially lead to an economic contraction in the second half of this year.  The technical definition of a recession is two consecutive quarters of negative GDP.  Based on recent economic data, we believe the probability of a recession developing this year has definitely risen.  Wells Fargo Investment Institute believes that it is more likely than not, the economy will enter a mild recession this year and early next year.5 We feel the stock market is in the process of discounting such a probability.  Stocks tend to anticipated an economic downturn well in advance of it actually occurring. 

While recessions and bear markets are no fun, they are normal part of the economic and investment cycle.  They occur for a variety of reasons including geopolitical crisis, the bursting of a financial bubble, natural disasters, excessive inflationary pressures, and government and central bank policies.  It is important to remind ourselves when we are in the midst of a downturn, that historically, the U.S. stock market has shown remarkable resilience.  The chart below illustrates the track record for the S&P 500 index going back to 1965.  As you can see, there have been many significant market disruptions during this time period but the overall trend is upward.

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We believe the current market volatility and downturn will eventually subside and stocks will recover.  That’s why we are encouraging our clients, where appropriate, to stay the course and avoid panic selling.  We believe a lot of negativity has already been priced into stocks.  Instead of reducing equities at this point in the market cycle, we recommend where appropriate, using cash to slowly add to high quality stocks that have durable business models and strong financials.  These types of stocks can weather most economic storms.  We feel that many stocks in this category have sold off and have become very attractive bargains during this bear market and possibly present an excellent long-term buying opportunity.  There is another old Wall Street adage attributed to the 18th century banker and investor Baron Rothchild that we believe applies today, “Buy stocks when there is blood on the streets, even if it's your own.”  This contrarian approach can produce some very nice profits for the long-term investor. 

As far as fixed income is concerned, 2022 has been a very difficult year for the bond market.  The 10-year U.S. Treasury Note has risen from 1.5% to about 3% as of June 30.2  That translates into about a 12% decline in the principal value of the 10-year U.S. Treasury Note.2  While normally bonds provide some cushion in a declining stock market, that has not been the case this year. There has been little downside protection from market losses for fixed income investors from their bond portfolios this year.  We have been somewhat negative on bonds for the past two years as we felt yields were unattractive.  However, we believe rising interest rates since the first of the year have made both high grade taxable bonds and municipal bonds more attractive.  We are seeing yields in the 3-5% range for short-term and intermediate bonds.2  Even money market yields have risen to about 1.5% recently and are expected to go even higher as the Fed raising rates.We believe this rising rate environment has presented an attractive opportunity for yield hungry investors to put idle cash to work. 

In summary, while we may have more downside left in stocks before a durable bottom is made, based on our positive outlook for corporate earnings for 2023, we believe the stock market is at an attractive entry point for those who have an investment time horizon of three years or longer. We believe the main driver of stock prices is corporate earnings.  While earnings may weaken somewhat for the remainder of this year if the economy enters a recession, we believe corporate managements will respond to any weakness by making the necessary adjustments to weather the storm and grow their businesses in the future.   As a whole, we believe corporate managements successfully navigated the coronavirus pandemic and paved the way for record earnings results for the S&P 500 in 2021. We have faith they can successfully navigate through this period of high inflation and rising interest rates. 

We recognize that the current situation in the financial markets can be frustrating and very stressful for investors. As we have stated before, we feel the key to navigating these highly uncertain and volatile investment environments is diversification through prudent asset allocation.  We believe this is a good time to assess your current asset allocation to ensure your portfolio is in line with your long-term goals and objectives.  This could also be a good time to rebalance portfolios back to long-term target allocations particularly if equity allocations have dropped below targeted levels. 

As always, we greatly appreciate your continued trust and confidence in us and we will continue to work to keep you informed of economic and market developments. 


Your Trinity Capital Management Team

Trinity Capital Management, 821 ESE Loop 323, Suite 100, Tyler, Texas 75701.  903-747-3960.  www.tcmtx.com

Footnotes

  • Reuters, S&P 500 Ends Brutal First Half ’22 With Largest Percentage Loss Since 1970, June 30, 2022.   
  • Thompson Charts
  • CNBC.com, “Inflation rose 7.9% in February, as food and energy costs push prices to highest in more than 40 years” March 10, 2022
  • Yahoo.com, Federal Reserve raises interest rates by 0.75%, most since 1994, amid effort to slow inflation, June 15, 2022
  • Wells Fargo Investment Institute, 2022 Midyear Outlook, June 2022. 

The indices presented in this material are to provide you with an understanding of their historic performance and are not presented to illustrate the performance of any security.  Investors cannot directly purchase any index.

Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments.  An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.  Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility.

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S&P 500 Index: The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock's weight in the Index proportionate to its market value. 

Dow Jones Industrial Average: The Dow Jones Industrial Average is an unweighted index of 30 "blue-chip" industrial U.S. stocks.

NASDAQ Composite Index: The NASDAQ Composite Index measures the market value of all domestic and foreign common stocks, representing a wide array of more than 5,000 companies, listed on the NASDAQ Stock Market. 

The Consumer Price Index (CPI) is a measure of the cost of goods purchased by average U.S. household. It is calculated by the U.S. government's Bureau of Labor Statistics.

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