Market Review: The stock market posted some of its worst returns on record in the second quarter. The Standard and Poor’s 500 Index declined 16.1%, the Nasdaq Composite fell 22.3%, the Russell 2000 Small Cap Index dropped 17.2%, and the MSCI All World ex-U.S. International Index fell 13.5%. None of the 11 S&P industry sectors posted a positive return nor was there protection provided by other asset classes as the Bloomberg Barclay’s Aggregate Bond Market Index lost 4.7%, the Bloomberg Commodity Index dropped 5.6% and Gold fell 6.7%. The scorecard for the first six months of the year reveals even more dismal historical comparisons. The 20% decline for the S&P 500 was the worst first half of a year since 1970 and the fourth worst on record. The 10.4% loss for the Bloomberg Aggregate Bond Index was the worst on record since the data started in 1981. This correlated meltdown in both stocks and bonds assured one of the most painful environments for balanced portfolios in history.
Inflation and the Fed: In retrospect, at year end 2021 the market was at peak liquidity, peak valuations, and peak earnings after the S&P 500 had posted a ten-year annualized return of 16.5%. The Federal Reserve Board had yet to recognize the persistence of inflation pressures and the Fed Funds rate remained near 0%. The Fed was also adding liquidity through open market bond purchases and the money supply (M2) had increased at a torrid 16% rate since the beginning of 2020. After a cursory 0.25% rate hike in March, the highest inflation readings in over 40 years forced the Fed into a stunning about face. They increased their Fed Funds target by 0.5% in May and 0.75% in June and announced their inflation fighting resolve. The extraordinary volatility in the bond market highlighted how the markets were whipsawed. The yield of the 10-Year U.S. Treasury moved from 1.5% at the beginning of the year to almost 3.5% in mid-June. This provided a holder of the Ten- Year note with a loss in that short period of 15.2%. As for the equity market, valuations have corrected to a higher rate environment as the 12-month forward Price to Earnings ratio of the S&P 500 dropped from 21 to a more manageable 16 currently, although the denominator (earnings) will be dropping in concert with a slowing economy.
In the Fed’s defense, we are functioning in an extremely complex environment that encompasses pandemic issues such as supply chain dislocations and China’s zero Covid policy as well as Russia’s invasion of Ukraine and the pressure it has placed on agriculture and energy markets. The future remains murky but there is no doubt that in the short term the Federal Reserve will seek to regain their credibility. Expectations are for another 0.75% rate increase in late July and another hike of at least 0.50% in September. October feels like a lifetime away and it is worth noting that there has already been a significant tightening of monetary conditions through a recent contraction in M2, sharply higher mortgage rates and, not insignificantly, the US dollar index moving to a twenty-year high.
Our Process: It is impossible to know how market scenarios will play out and, perhaps more importantly, what scenarios have been priced in. Our first line of defense in down markets is to manage your assets to your specific profile, goals, and time horizon. We consider your near-term liquidity needs and your longer- term growth goals while ensuring the two distinct objectives are balanced to protect you from selling long-term risk assets at inopportune times. We hold your liquidity and safety in cash vehicles and short-term bonds, as we have believed longer-term bonds carry too much price risk as indicated by the Ten-year Treasury example above. You are invested in dynamic blue-chip companies that are proactively managing their products and brands to this environment and that will survive this economic cycle. You are diversified across styles and industries and, as appropriate, alternatives to hedge inflation. You hold numerous positions showing fundamental value at current prices, there is just no way of knowing when that value will be realized. That is why they are a part of your long-term bucket.
We thank you for your trust and support in another challenging part of the investment cycle and we are always available to discuss your portfolio.