May 18, 2022
Market volatility is a part of investing, and increased choppiness was one of our themes for 2022, as we entered a new era of rising interest rates and higher inflation. But its relentlessness has been especially unnerving. Almost half of this year’s equity trading days have suffered intra-day swings of more than 2% on the S&P 500 index, and 88% have experienced at least 1% moves. The S&P 500 has trended down and has lost 16% year-to-date.1 The technology-heavy Nasdaq Composite, meanwhile, has descended into bear market territory. Bonds have been just as volatile. Fixed income markets have suffered their worst start to the year in over four decades, with yields spiking on fears that the Federal Reserve will have to hike rates aggressively to fight inflation.
When will the volatility end? It will take clear signs that inflation, now at 40-year highs, is declining, or has at least peaked. That, unfortunately, could be some months away, and our clients and other investors should prepare for further market gyrations as we move into the summer.
But we remind clients that the environment could look very different in six to nine months, which is why it’s important to stay true to your long-term investment plan. We have been decreasing equity exposure this year to ensure we are appropriately positioned for this environment, but also poised to take advantage of opportunities once they occur.
We are also watching the market closely for signs that it has reached a bottom, so we can then take advantage of dislocations. This is a time when opportunities are starting to develop. The tide has gone out and taken a lot of boats with it, and we already see several attractive opportunities developing on an individual stock basis.
Let’s look at what’s driving market volatility, what will signal markets are bottoming and how we are positioning portfolios in this environment of volatility.
What’s Fueling the Volatility
The biggest fear roiling markets is that the Fed won’t be able to tame inflation, now over 8%, without tipping the country into recession.
A host of unexpected headwinds have plagued the market this year, starting with the sharp pivot in the Fed’s expectations for inflation. It was clear from its December Federal Open Market Committee meeting minutes, released in the first week of January, that the Fed was caught off-guard with the persistence of inflationary pressures. They announced a more aggressive-than-expected plan for rate hikes and balance sheet reduction. Just as the market was in the process of finding a new floor after this announcement, the war in Ukraine broke out, sending energy prices soaring, and considerably complicating the Fed’s ability to orchestrate a soft landing. China’s zero Covid policy has also added to the Fed’s woes, by perpetuating supply chain bottlenecks and slowing economic activity.
In a matter of months, the market went from last December’s expectations of only two or three increases in the federal funds rate this year, to pricing in rate hikes at every FOMC meeting, including three 50 basis point moves in May, June, and July.
The result has been a resetting of equity markets. Investors are re-assessing what they are willing to pay for future earnings in an environment where inflation stays higher for longer, and higher rates choke off corporate and consumer access to capital.
As we’ve noted in previous commentaries, stocks can do well when there’s some inflation – even inflation between 4%-6% – because many companies can pass along higher costs to consumers. However, with March and April’s Consumer Price Index (CPI) growing more than 8% from a year ago, markets are trying to determine what earnings multiple is justified.
Exhibit 1: Risk Assets Are Vulnerable
In Exhibit 2, we can see that the price-to-earnings multiple for the S&P 500 has fallen from its peak of 23x in August 2020, to 16.9x.2 Up until the fall of last year, investors were willing to pay up for growth stocks that benefited from the pandemic (as we can see from the premium the S&P 500 Growth Index commanded over its Value counterpart). But as we moved into 2022, growth stocks, particularly those technology and e-commerce high-fliers of the pandemic, have fallen precipitously. The market is instead preferring value stocks, which have fared comparatively better in a volatile market. One of the reasons why the S&P 500 has been on a downtrend all year is because technology, a growth sector, accounts for nearly 30% of the index.
Exhibit 2: PEs Have Quickly Compressed, Driven By Growth Stocks
When will Markets Find a Bottom?
Investor sentiment hasn’t been this pessimistic in over 20 years. Given that sentiment is often viewed as a contrary indicator, does this suggest that equity markets have bottomed? History does tell us that when sentiment is this extreme, it offers a buying opportunity for medium and long-term investors. You can see from Exhibit 3 that when the AAII Survey – measuring investor expectations for stock prices over the next six months – has been this pessimistic, the S&P 500 is higher 12 months later.
Exhibit 3: Markets Higher After Extreme Bearishness
Even so, we haven’t seen traditional signs of investor capitulation, which might be an even stronger indication a market bottom may have been reached. We are also watching a subset of measures to get more evidence of a bottoming process. They include the level of volatility, trading volume, the ratio between the number of puts (options to sell stock) sold versus calls (options to buy stock) and market breadth, or the number of companies participating in a market’s attempted advance. Although we won’t hear a bell when a true bottom has been reached, taken together these measures aren’t yet strong enough to declare that better times are ahead. But perhaps the bottoming process may have, at least, begun.
Investors often ask whether it’s right to stay the course when markets are volatile. In short, the answer is yes. Staying disciplined and adhering to a well-thought-out investment plan aligned to your long-term goals and time horizon is the right course of action.
Our recommended model portfolios are constructed to withstand different conditions that play out over an economic cycle. With that kind of foundation in place, changes can be made at the margin to ensure our portfolios are appropriately positioned for an environment of increased volatility, higher inflation, and rising rates, yet also poised to take advantage of opportunities once they arise. Our Investment Strategy Committee has recommended three changes to reduce risk in portfolios since the start of the year. We decreased our exposure to stocks, recommending a neutral stance in equities, with an emphasis on high-quality, U.S. large cap stocks. We increased exposure to private equity for its low correlation to public markets and more attractive long-term return potential, and we reduced exposure to high yield credit, a riskier fixed income sector.
Staying invested and aligned with your investment plan doesn’t preclude active, bottom-up decisions at the sector and company level in different asset classes. For instance, our large cap equity team emphasized company quality (those with strong balance sheets) early in the year and shifted to more defensive sectors like energy, health care and industrials. They have also taken advantage of dislocations at a stock level, which are now beginning to emerge.
Structured notes are another tool for clients with additional cash to put to work. These securities use options that enable the owner to participate in a potential market rebound, while also offering a downside buffer.
Harvesting tax losses has also been recommended, so clients have a good store of losses to offset capital gains this year or in years to come.
Volatility will likely persist until we start to get clear evidence that the Fed’s efforts are taming inflation. But history teaches us that a neutral position in equities within a diversified portfolio is the right place to be. With patience and resolve to stick to an investment plan, investors will get through this period and then be poised to take advantage of the opportunities that have always followed difficult times like these.