Stephen M. Mills, CIMA®
Partner
Chief Investment Strategist
Brad Bays, CIMA®
Partner
PIM Portfolio Manager
Highlights:
- The S&P 500 Index has fallen approximated 22% as of the date of this letter.
- The “bear market” for equities is now nine months old.
- The U.S. Federal Reserve continues to tighten monetary conditions by hiking the fed funds rate and reducing balance sheet holdings in an effort to fight inflation.
- Inflation has shown modest declines recently but remains well above the Fed 2% target.
- U.S. economic growth is slowing and the risks for a recession have risen.
Commentary
2022 has thus far been a difficult year for investors. As of the end of the third quarter, stocks, as measured by the S&P 500 Index, have recorded a negative return of 23.9% including dividends for the year. 1 The Nasdaq Index, which is made up of primarily higher growth stocks, has suffered an even worse decline of 32.4% for the same time period.1 Both indices entered what is often referred to as a “bear market” (a decline of 20% from a previous high) in June of this year.1 The Dow Jones Industrial Average hit the negative 20% level in late September, officially confirming the bear market in stocks.1 We mark the beginning of this bear market from the January 3rd high for the S&P 500.
Bond prices have also fallen this year as rising interest rates have driven most bond indices down by double digits. As of September 30, intermediate government bonds, as measured by the Ishares 7–10-year Treasury Bond ETF (IEF), have recorded a negative return of approximately 13% for the year while corporate bonds, as measured by the Bloomberg US Aggregate Index, have fallen 11.5% in value.1 Thus far, 2022 has been one of the worst years in the past 40 years for fixed income investments. In addition, it is rare that both stocks and bonds experience such negative returns at the same time. Typically, when one of these asset classes is down the other is up but that has not been the case this year. This challenging environment has certainly tested investor patience and increased investor anxiety.
We believe the losses for both stocks and bonds are directly attributable to the aggressive monetary tightening by the U.S Federal Reserve (Fed) and other central banks around the world this year. Since March, the Fed has hiked the federal funds several times, bringing the rate to the 3-3.25% range as of the last Federal Open Markets Committee (FOMC) meeting on September 21 when the committee increased the fed funds rate by .75%.2 That rate increase was the Fed’s third straight .75% rate hike.2 Federal Reserve chairman Jerome Powell, speaking on behalf of the FOMC, has consistently emphasized the committee’s resolve to bring the rate of inflation back down to the Fed’s long-term target of 2%. Chairman Powell stated at the news conference following the September 21 rate announcement: “We have got to get inflation behind us. I wish there were a painless way to do that but there isn’t.”4 The monthly inflation statistics, as measured by the Consumer Price Index (CPI), have shown inflation rising by over 8% on a year-over-year basis since early this year. The latest inflation report issued by the Bureau of Labor Statistics for August showed CPI rising by 8.3% over the previous 12 months. That level is well above the Fed’s 2% target rate which is why the majority of FOMC members see the fed funds rate rising to between 4% and 4.5% by the end of the year. That may happen at the next two FOMC meetings in November and December.
The Fed’s aggressive monetary tightening will likely throw the U.S. economy into a recession, in our view. Higher interest rates tend to depress both business and consumer demand for goods and services. We are already seeing evidence of this in the housing market as mortgage rates jumped to the 6.5% for a 30-year conventional mortgage as of September 28, the highest level since mid-2008. 5 The U.S. housing market slowed for the seventh month in a row as reflected in the monthly existing home sales report issued by the National Association of Realtor. Sales of previously owned homes fell .4% in August from July to the lowest level since May 2020. 6 August sales were lower by 19.9% from the year earlier level. 6 A combination of high home prices and rising mortgage rates have made purchasing a home much less affordable. Housing is a major component of our economy and one of the reasons for the strong GDP growth over the past couple of years.
There are other data points that indicate the economy is slowing. One in particular, is the Conference Board’s Leading Economic Index (LEI), which tracks ten economic components whose changes tend to precede changes to the overall economy. As of the latest August reading, the LEI has declined for six consecutive months potentially signaling a recession according to Ataman Ozyildirim, Senior Director of Economics at The Conference Board. 7 The adjacent chart indicates three other times since 2000 that the LEI correctly signaled a recession.
Scott Wren, Senior Global Market Strategist with Wells Fargo Investment Institute, stated in a recent report: “Based on our work, the U.S. economy is likely to fall into recession late this year. We expect the recession to last into the middle portion of 2023. We see a mild to moderate recession for the U.S. economy developing in the fourth quarter of this year and extending into the first half of 2023.” 8 We concur with that forecast.
We believe recession fears are the primary reason stock prices have fallen so much this year, particularly since mid-August when Chairman Powell spoke at the Jackson Hole conference and reiterated the Fed’s resolve to tighten monetary policy to bring inflation under control. Stocks had staged on impressive rally off the June lows to mid-August with the S&P 500 Index rising 17% from its June 17 closing low for the year. This market rally subsequently faded after Powell’s Jackson hole comments. The major averages are testing the June lows as we pen this letter.
The chart on the next page, which we included in our July letter (a link to access the letter is included in footnote 9) shows the last 11 bear markets dating back to 1946 using the S&P 500 Index. The average length of these 11 bear markets is 16 months. The average price decline is 35.1%. As of the date of this letter, the current bear market has lasted about nine months and with the S&P 500 Index falling nearly 25% from its January 3rd high so we may have a bit further to go before the bear market ends. But here’s the good news: notice the two columns labeled 6-month and 12-month returns after the bear end. The overall average return for the S&P 500 after six months is a positive 27.3% and after 12 months it is plus 43.4%. We don’t know when this current bear market will end nor how much stocks will ultimately decline. However, what we do know is that historically, bear markets are followed by bull markets. Although we may see stocks fall further from current levels, we feel that the bear market is closer to the end than the beginning and we could begin to see a more durable recovery beginning as early as the fourth quarter of this year or in the first quarter of next year.
The current high degree of uncertainty concerning inflation, the Federal Reserve’s future monetary policy actions, and the potential of a recession beginning later this year, make predicting the end of the bear market very difficult. Eventually, we feel the outlook will become clearer and investor attitudes will change. But until then, we expect the stock market will remain volatile.
Some investors may be tempted to sell their equity holdings and wait for fundaments to improve before getting back into stocks. However, in our experience, by the time the fundamentals start to improve, the stock market has already bottomed and has risen significantly off the lows. Case in point, at the onset of the coronavirus pandemic in February 2020, the S&P 500 Index began falling, declining by 35% from its February 14 high to its low on March 20. The global pandemic was just getting started and counties around the world, including the U.S., were shutting down their economies. Over the course of the next three months, U.S. economic activity fell off a cliff with Gross Domestic product falling an astonishing 9.6 for the second quarter. 10 However, the S&P began to recover in late March and had regained most of its losses by the beginning of June, well before the economy began to recover. By the beginning of August, the S&P had fully retraced its 35% first quarter decline. We believe this is typical of a bear market pattern where stocks begin their recovery before economic fundaments start to improve.
We continue to focus primarily on holding high quality stocks and equity funds in our client’s portfolio. We favor U.S. large and mid-size company stocks and funds. Our bias toward quality means holding companies with strong financials, consistent sales and earnings growth and that pay current dividends with a history of increasing future dividend payments. We believe these types of stocks can better weather economic downturns while at the same time giving the investor a consistent stream of cash flow. We remain underweight international stocks due to our view that the economies in Europe and Asia may experience deeper recessions that in the U.S. We still favor commodity related stocks especially those in the oil and gas sector. Many commodity related stocks have experiences significant declines recently and could go lower if the economy falls into a recession. However, we believe the current valuations for many of these stocks are attractive, especially for those that pay dividends. We see long-term structural supply deficits in commodities like copper, oil, and lithium, supporting the prices of these resources and increasing the earnings and dividends of the companies that produce them.
We are beginning to favor high quality intermediate fixed income securities. We believe current interest rates for Treasury securities, high-grade corporate bonds and municipal bonds have become attractive at current levels. Short to intermediate Treasuries are now yielding close to 4% while intermediate corporate bond yields are approaching 5%. 1 Tax-free municipal bonds with maturities between 5 to 10 years are now yielding in the 4% range. 1 A 4% tax-free yield is equivalent to a 6.1% taxable yield for an investor that is in the 35% tax bracket. Even money market yields have risen to about 3% recently and are expected to go even higher as the Fed raises rates. 1 These yields are substantially higher than at the beginning of this year when yields for most maturities ranged between .1% and 2% for most fixed income securities. We believe this rising rate environment has presented an attractive opportunity for yield-hungry investors to put idle cash to work.
While we may have more downside left in stocks before a durable bottom is made, we believe we are getting close the end of the bear market. We feel many stocks are at an attractive entry point for those who have a time horizon of two years or longer. We believe there are three primary drivers of stock prices: earnings, interest rates and investor sentiment. We see each of these drivers beginning to show improvement by the first quarter of 2023. We believe the Fed will pause its rate hike cycle by the end of the year or at the latest, the first quarter of 2023. We believe the economy can withstand interest rates in the 4-5% range. We see an earnings recovery for stocks beginning in the first or second quarter of 2023. Currently, investor sentiment regarding the outlook for stocks, is at some of the worst levels in history. In addition, according to the most recent AAII Investor Sentiment Survey, individual investors are at the highest level of pessimism since March of 2009 which marked the beginning of a multi-year bull market in stocks.11 There are other sentiment indicators that show similar levels of investor pessimism. Whether the current sentiment readings will mark the beginning of a new bull market remains to be seen. However, historically, bear markets often end at such extreme levels of pessimism, in our view.
In summary, we understand that the volatility in the financial markets is very stressful for most investors who have exposure to stocks and bonds in their portfolios. Our recommendation is to remain patient and hold current allocations. We believe the key to navigating through highly uncertain and volatile investment environments, like the one we are in, is to be diversified through prudent asset allocation. Tactical portfolio adjustments can be made depending on circumstances. This may be a good opportunity to use any further downside volatility to add cash reserves to both stocks and bonds where appropriate. We encourage investors to evaluate current asset allocations to ensure portfolios are in line with 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 trust and confidence in us. 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
1 Thompson Charts
2 https://www.federalreserve.gov/monetarypolicy/openmarket.htm
3 https://www.bls.gov/cpi/
4 Wall Street Journal, “Fed Raises Interest Rates by .75% for Third Straight meeting, September 21, 2022.
5 https://www.reuters.com/markets/us/us-mortgage-interest-rates-jump-652-highest-since-mid-2008-2022-09-28/
6 Wall Street Journal, U.S. Home Sales and Prices Fell in August as Mortgage Rates Rise, September 21, 2022.
7 https://www.conference-board.org/topics/us-leading-indicators
8 Wells Fargo Investment Institute, Market Commentary by Scott Wren, September 28. 2022.
9 https://www.tcmtx.com/blog/post/tcm-market-outlook-and-strategy-july-6-2022
10 https://www.bea.gov/news/2020/gross-domestic-product-2nd-quarter-2020-advance-estimate-and-annual-update
11 https://www.aaii.com/sentimentsurvey
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U.S. Treasuries: Bloomberg Barclays Global U.S. Treasury Index; U.S. Municipals: Bloomberg Barclays U.S. Municipal Index; U.S. TIPS: Bloomberg Barclays U.S. TIPS Index; U.S. Corporates: Bloomberg Barclays U.S. Aggregate Corporate Bond Index; U.S. High Yield: Bloomberg Barclays U.S. Corporate High Yield Index; Emerging Market: JPMorgan Emerging Markets Bond Index. Index return information is provided for illustrative purposes only. Index returns do not represent investment performance or the results of actual trading. Index returns reflect general market results, assume the reinvestment of dividends and other distributions and do not reflect deduction for fees, expenses or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment.
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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