The second quarter was a difficult one for stocks, as the S&P 500 plunged -16.1%. In fact, we’d have to go back to the first quarter of 2020 to find a worse quarter (-20.0%). Beyond that, we’d have to go to the fourth quarter of 2008, so you can see that quarters this bad tend to occur very infrequently. That this quarter’s loss followed a -5.5% first quarter decline makes it all the more painful. That it didn’t occur as a result of a recession makes it somewhat unusual. It is probably more analogous to a speculative bubble being burst, like in 2000, than anything that happened in 2008 or 2020. I’ll have thoughts on where we go from here later on in this report.
From a stock standpoint, things were either bad, not that bad, or really bad. Technology was right in the crosshairs of the decline as unrealistic future growth expectations ran headlong into rising inflation. This sector shed -19.8% last quarter, bringing its year-to-date return to -26.6%. Technology is the largest sector of the market, especially for ESG portfolios, so losses there had an impact that one could hardly avoid. Technology stocks had been the best performers prior to Covid and the best performers during the Covid recovery period. While emerging tech peaked in February 2021, the big names – Apple, Microsoft, Nvidia, etc. – were still making new highs in the 4th quarter of last year. Those stocks had been close to “bullet-proof” for many years, so they were over-represented in mutual fund and ETF portfolios even though they had become quite expensive. In the first quarter of 2022, energy and materials stocks picked up the slack from the tech sector. Through the middle of May energy stocks rose more than 40%. Then they corrected viciously, falling more than -17% in June.
Neither developed markets outside the U.S. nor emerging markets provided any relief either. Europe lost -14.6%. Asia ex-Japan lost -16.3%. Japan dropped over -20% in dollar terms, as the yen nosedived against the U.S. currency. Wherever one went outside the U.S., the inflationary effects of a very strong dollar depressed economic activity. China has picked up the slack in the past, but China’s ineffective vaccine and draconian quarantining policy has prevented them from being an economic stimulus for the world this time.
Bonds didn’t provide any shelter either. The Bloomberg Aggregate Bond Index was off another -4.7% last quarter, bring the year-to-date decline to -10.4%. Inflation continues to be a headwind for the bond market; with current yields below the rate of inflation, bond investors lose purchasing power even if interest rate don’t rise any further. Some bonds have value as “ballast” because long duration, high quality bonds often rise when stocks fall. This is more common in deflationary environments than inflationary ones, however, since high quality bond price gains are a signal that the Federal Reserve is likely to address economic weakness by cutting interest rates. Today inflation is high, so the Fed cannot cut rates even if the economy stalls.
Finally, there is gold. The perfect environment for gold, theoretically, is a situation where the central bank (Federal Reserve) creates too much credit, fails to tighten credit when inflation begins to get established, and forces investors to accept steeply negative returns on their savings. Therefore, this should have been a fantastic year for gold. Instead, it has managed to lose about -6%. Truly, this has been a difficult environment for investors. That said, One Thing That Cannot be Stressed Enough…
Consumer Sentiment Index and Subsequent 12-month S&P 500 Returns
Source: JPMorgan Guide to the Markets – US, Slide 25. Data are as of June 30,2022
Peak is defined as the highest index value before a series of lower lows, while a trough is defined as the lowest index value before a series of higher highs. Subsequent 12-month S&P 500 returns are price returns only, which exclude dividends. Past performance is not a reliable indicator of current and future results.
The graphic above shows consumer sentiment over the past 50 years with 8 distinct peaks and troughs noted and how much the S&P 500 gained or lost in the 12 months following. On average, buying at a confidence peak returned 4.1% while buying at a trough returned 24.9%. Such an outcome may be counter intuitive, but it highlights the fact that investors tend to extrapolate the most recent trend into the future.
This is not to suggest that U.S. stocks will return anything like 24.9% in the year ahead, as many other factors will determine that outcome. However, it does suggest that investors should focus on things they can control, like maintaining a long-term perspective to avoid reactive selling, rather than investing based on how they feel about the world. The point is, you CANNOT outperform by selling after the market has made a major decline, and you rarely outperform by getting aggressive late into a bull market. JP Morgan is widely reported to have said “In bear markets, stocks return to their rightful owners”. His point was that most people make money during bull markets but give back most, all, or all-and-then-some during the bear phases. I have to believe that at today’s low sentiment levels, were he here, Mr. Morgan would be a buyer.
The first thing to remember is that stock prices reflect current liquidation value of a company plus all the future cash flow that the company is expected to generate over its lifetime, discounted by future expected inflation rates. The higher inflation is, the more you have to discount a dollar you expect to earn in the future. Many companies in the airline, utility, mining, real estate, and financial services industries grow at sub-5% rates, so most of their value is in what you could liquidate them for. On the other hand, companies in biotechnology, clean energy, cybersecurity, and the like are expected to earn far more in the future than they do today. These stocks are therefore far more sensitive to expected future inflation rates. They are the ones that have been hurt the most this year, but they are also the ones that stand to gain the most once the market believes that inflation has peaked.
Up to the end of May, we believed that we were in a rising inflation environment, so we made changes to increase the exposure to companies in the former group while trimming the latter. Recently, the market seems to feel that it might be time to “bottom-fish” those high growth companies as inflation moderates. Our feeling is that we’d like to be neutral on this question. We cannot predict future inflation, and we’ve not met anyone else who has shown consistently that they can.
During down markets, one tends look at returns in an absolute sense as opposed to a relative one. For example, a stock fund that lost only -11% last quarter would have been a big winner relative to the market’s -16%, but it still reduced one’s wealth in an uncomfortable way. In a bear market we look for absolute winners – funds that are able to hold or modestly improve their value – as relative wins become less appetizing. To that end we increased exposure to private real estate, long dollar, and merger arbitrage funds. We also held a little more cash in portfolios. At some point, higher inflation will lead to higher money market rates.
For several years I have written reports that explained the strong stock market performance with the caveat that stocks were overvalued versus historical measures, and therefore future returns would not be as strong. Of course, I didn’t know when stocks would sell off or by how much, because that is unknowable.
Let’s play a thought experiment. Think of annual stock returns as individual marbles in a bag of forty total marbles, representing forty years. In the bag are black and grey marbles, representing large and small gains, respectively. Also present are red and pink marbles, representing large and small losses. In the bag, black and grey marbles outnumber red and pink marbles by a two to one margin which is roughly equivalent to the ratio of up to down years in the stock market. 2008 was the last red marble year. Going thirteen years without drawing a red one kind of makes one overdue. The “red marble” year could have been 2020 when Covid ravaged the world, but unprecedented fiscal action (otherwise known as stimulus checks) reversed the first quarter decline. It could have been 2021 when stimulus ran out, inflation started to accelerate, and high-flying work-from-home stocks came crashing down to earth, but thanks to an incomprehensibly accommodative Federal Reserve, prices for the market leaders managed to stay in the black (elevated) to the end of the year.
Many investors are sure that we have drawn a red marble here this year. Our feeling is that forward stock multiples have now contracted to a level that would allow for decent future returns if corporate earnings expectations can remain around current levels. A moderation in inflation to the 4-5% range and less Fed policy uncertainty could very well turn 2022 from a red to a pink marble year.
Commentary – How Did We Get Here?
I will discuss how the U.S. got into the inflationary mess that it is in right now, with the hope that understanding it will help lead to better outcomes. In doing so, it is important to separate systematic mistakes (which are foreseeable, avoidable, and correctable) from shocks (which are unexpected crises which central banks and political leaders cannot anticipate and therefore must react to the best they can). Here is how we got here:
- Federal Reserve Overstimulation – Going back to the end of the Great Financial Crisis in 2009, prominent economists warned about “secular stagnation”. Stated simply, this was the idea that because of the massive amount of debt that we took on to emerge from that crisis, America was going to experience very low growth and deflationary pressures until we could pay down that debt. Fearful of falling back into a recession, the Federal Reserve opted to keep rates near zero to generate modestly positive economic growth. Inflation flared a tiny bit in 2013, 2015, and 2018, but each time a small amount of tightening snuffed it out. Key results:
- The Fed began to believe it could successfully manage inflation, so it didn’t take it seriously.
- During periods in which economic growth is expected to be modest, investors tended to avoid cyclical industries (energy, materials) preferring to allocate capital to areas with stronger growth prospects (technology, biotech, green energy).
- Underinvestment in Energy – The energy sector was a terrible investment for much of the 2010s. Overinvestment in prior years led to subpar returns as supply surged in excess of demand. In the middle of the decade many energy companies faced bankruptcy as the revenue generated on $45 per barrel of oil could not service debt incurred at $90/barrel. CAPEX investment then shifted to green energy because interest rates were low enough to tolerate short term losses on the expectation of large long term gains. Many thought oil in the ground might never be exploited because green energy costs would fall enough to make it obsolete, so oil companies focused on efficiency and profitability, not additional production capacity. Europe went so far as to shutter most of its nuclear capacity, and Germany’s former Prime Minister Angela Merkel made a fateful natural gas pipeline pact with Russia. The key result is that the world was dreadfully unprepared for an oil shock.
- China tensions get worse – As result of Chinese efforts to project more influence upon the world and counter the power of the United States, China begins to exert itself more in the South Asia Sea and in Asia more broadly. The U.S. has been unhappy for more than two decades about Chinese theft of American technology and intellectual property, but as China has grown it has become more of a direct rival. Both countries begin to feel that what benefits one hurts the other, so they increasingly use trade sanctions to punish one another. The result is that the U.S. starts to emphasize domestic re-shoring of manufacturing, which is inflationary because labor costs are higher here.
That was the background as 2020 began. Now the shocks:
- Covid strikes – The global pandemic takes a large human and economic toll, but it also affects labor supply and manufacturing patterns. China locks down, attempting to stamp out the disease once and for all. The Chinese vaccine has very low efficacy, however, and the virus is still able to spread and mutate. More than two years later the Chinese population is still subject to rolling lockdowns, and Chinese economic growth has slowed to the lowest level in decades. They can’t supply many of the things the world needs, or if they can, it is late, less than requested, and more expensive. The United States COVID lockdowns are far less severe than China’s, and its vaccines are much more effective. Even so, American workers begin to ask themselves tough questions about the way they are living and working. Many chose to work from home or leave the labor force altogether, leaving Corporate America to deal with a historic worker shortage. In the past, this could have been met by being more open at the borders, but over the past five years this country has scaled back both legal and illegal immigration dramatically. Key results:
- Empty shelves, higher labor costs, and reduced service hours due to the shortage of workers.
- Massive economic stimulus in 2020, as U.S. unemployment briefly approached 30%.
- Federal Reserve blunders – It may well have been very necessary to flood the economy with liquidity in April 2020, and perhaps for several months thereafter. That said, once it was apparent that the checks were fueling a massive consumer spending boom, the Fed should have tried to rein it in by raising interest rates. Instead, the Fed declared the burst of inflation in 2020 “transitory” and continued to pump money into the economy. Unable to go anywhere, people spent their money on their homes or they put it into the stock market, fueling a mania for “stay-at-home” stocks like Zoom Video and Peloton. Initially, this extra demand was great for retailers, but soon they were hard-pressed to meet it given Chinese under-production and American inability to get goods off container ships and into trucks at the port of entry. Retailers raised prices and consumers paid them, so they upped their orders knowing they might not get all they asked for. By the middle of 2021, however, consumers had enough goods. Freed by relatively successful vaccines, they wanted to travel instead. Stay at home stocks began to crater, but with the Fed inexplicably still in expansion mode, excess funds found their way into a narrower group of stocks – technology leaders such as Apple, Microsoft, Amazon, and Nvidia. Key results:
- Supply chain problems, overly easy monetary policy, and rapidly changing consumer preferences lead to a massive misallocation of capital. Now, goods retailers suddenly have too much inventory as spending moderates toward pre-pandemic patterns.
- Russia Attacks Ukraine – This touched off #2, the under-investment in energy. With Russian energy effectively off the market in the developed world, this has led to a large gap between supply and demand. Energy prices are off now their highest levels, but it is hard to see prices going much lower as it is difficult to increase production over the short term (and many providers aren’t even sure they want to, fearing a plunge in prices if the war ends). The situation is particularly acute in Europe, which depends on Russian natural gas. The war also affects the global food situation, as Russian and Ukrainian wheat is exported around the world. Rising prices for food in the developing world are leading to political crises; Sri Lanka is the first but unlikely to be the last country that spirals out of control as people vent their frustrations on the government. Key results:
- War is inflationary. Money is spent on munitions, which are consumed without any benefit to the economy. Even in an economic slowdown, national debt grows.
So here we are. We got away with two decades of an incoherent China policy, overly expansive money policy for a decade, several years of underinvestment in energy, and a poorly thought-out immigration policy throughout several administrations until suddenly the chickens came home to roost.
All of that said, we have the ability to make use of this economic downturn. Almost every economist has written in some manner about the cleansing function of recessions. In fact, it can be argued that times of difficulty are the ONLY times that people are willing to make sacrifices for the long term good. Europe is beginning the painful process of weaning itself off Russian energy. America has an opportunity to address the causes of this downturn on a bipartisan basis precisely because both parties and multiple Federal Reserve Governors have their fingerprints all over the failures. America’s tough financial decisions in the wake of the Great Depression set it up to be the pre-eminent economic power of the 20th century (which enabled it to also be the pre-eminent military power). I hope we will rise to meet this challenge as well. If we can, I would be very bullish on us in the coming decades.
 S&P 500 with dividends included, per Morningstar Workstation
 Technology sector ETF, per Morningstar Workstation
 Energy sector ETF, per Morningstar Workstation
 MSCI Europe, Asia Ex Japan, Japan Total return in US dollars, per Morningstar Workstation
 Bloomberg Aggregate Bond Index, per Morningstar Workstation
 Through July 22nd.
 Each dollar earned in 2028 is worth 88.6 cents at a 2% inflation rate; at 6% it is worth only 69 cents
 40 was chosen because the drawing out a particular color does change the odds modestly. A bag of 40 might have 10 pink and 3 red marbles, so as you draw out black, grey, and pink marbles the odds of red increases (much like a long period of high stock returns makes the market more and more expensive, setting the stage for a disappointing year or two). If the bag is infinite, the drawing of any color marble doesn’t change the odds.
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