Capital markets, where to even begin? It has been a challenging ~12-months for stocks. Going back to summer 2021, we saw stocks trade in a tight range, taking one step forward, only to then take two steps back. Then, from November on global stocks fell more aggressively, hitting lows of more than 19% down. Several major stock market indices such as the Russell 2000, and the NASDAQ have crossed the -20% threshold into official bear market territory.
It remains to be seen if markets have hit bottom, or how much bleeding is still to come.
Currently, there is a crowded field of market drivers, investor sentiment which is always the paramount driver over the short-term, the fallout and potential escalation of the Ukraine vs. Russia War, INFLATION, Fed policy, lockdowns in China, and now economic recession.
Let’s start by looking at YTD performance (as of 5/18/22) of major capital market indices and a chart for global stocks.
- Global Stocks: -17.06%
- US Stocks: -17.24%
- International Developed Stocks: -15.26%
- US Aggregate Bonds: -9.52%
Investor Sentiment
When there are more buyers than sellers, stocks rise, and the converse is true. Investor outlook is influenced by all the other above-mentioned drivers, but ultimately it is the buying vs. selling sentiment that moves prices in the short-term. In an environment where all major drivers appear negative there are numerous opportunities for the story to shift positive and change the market direction.
Ukraine vs. Russia War
Initially when Russia invaded Ukraine, there was fear of escalation and the potential for a nuclear WWIII. While that risk remains, the probability is very low, and a more known quantity. The economic fallout from the conflict is complicated to calculate and predict. It is not as easy as subtracting the economic output of Ukraine and Russia from the world equation like one could remove a puzzle piece. The interconnectivity of global economies are vast, and the ripple effects of each action are essentially endless. That said, once the war broke out economies immediately started to adjust and adapt based on the new environment. Free economies are nimble, highly resilient and may adjust to this new environment better than initially expected.
A longer-term effect of the war might be a reduction in the use of US dollars as preferred reserve currency. If the US Gov. is willing to use the dollar as a means by which to manipulate and force the hand over foreign governments as it has with Russia, then other foreign governments (& entities) may explore alternative options. In theory, if the US dollar were to decrease in reserve currency status, it would weaken the dollar vs. foreign currencies. This could result in a positive effect for American workers and domestic production, while simultaneously increasing consumer costs (higher inflation), and decreasing available credit to individuals, businesses and government. For investors it would increase the attractiveness of international stocks.
Is war good for the economy?
No. There are beneficiaries in war, but as an aggregate war is an economic negative. It forcibly reallocates capital and resources. Additionally, war comes with destruction of property and human destruction. This means that capital and time that otherwise would have gone to some other new positive production, instead goes to rebuilding, and the dead are lost forever. Economists refer to this myth as the broken window falsely. Think about your home. If all the windows in your home were suddenly broken from vandalism or natural disaster and they needed to be replaced this would not be a positive economic development. Sure, the window company might benefit from the job, and the new windows might even be better than the old ones, but the money, time, and labor used to replace all the windows would have been better served elsewhere. Even if something is rebuilt/remade better than it was before the destruction, the cost of that destruction is always negative in real terms.
Inflation
Inflation numbers continue to come out, and the story mostly remains the same. Inflation is very high, and therefore, purchasing power continues to erode at a rapid pace. There is some recent evidence that the pace of inflation may be slowing. However, slowing inflation when the starting point is all-time highs is not much consolation for Americans in the grocery store or at the gas pump. For a more detailed take on inflation see my previous two newsletters: Will Prices Keep Going Up in 2022? & Inflation 2.0. In the short-term inflation is a negative force for stocks, bonds, consumers, companies, etc., etc. There are some beneficiaries of inflation though, namely commodity prices, and debtors. The biggest beneficiary of inflation is the Federal Gov., because it is the world’s greatest debtor. Over the longer-term stocks remain the best returning asset class after adjusting for inflation, even if prices are reset lower in the short. Value stocks, tend to outperform growth in inflationary environments.
Fed Policy
After spending 2021 denying the existence of inflation, then insisting it would be temporary, now the Fed insists it will fight and end inflation. They intend to raise the Fed Funds Rate by 0.25-0.5% incrementally, while also ending QE Treasury purchases. I read their intentions as hoping with time inflation will cool itself. Chairman Powell recently said that he admired Paul Volcker (Fed chairman 79-87) not because he aggressively raised rates and fought inflation, but “because he did what he thought was right.” It seems likely that chairman Powell might believe a different course of action is “right.”
A case for Bottom
If you believe as I do, that we are amid a recession, and the late-July report will only confirm it; then history would tell us that we are near a market bottom (if we haven’t hit it already). The stock market cycle tends to lead the economic cycle, whence why it is referred to as a ‘leading indicator.’ This is not to say that markets can’t fall an additional 10+% from current levels. The point is that if markets have not hit bottom yet, they likely will over the next ~40 days.
Theme Changes
When looking at history we find that market cycles tend to have sweeping macro characteristics that play out for long stretches, I refer to these as themes. There have been long periods of outperformance by Japanese stocks, US large growth, US tech, International DM, emerging markets, etc. vs. the relative market. Typically, those periods of outperformance are followed by relative underperformance and the emergence of a new leading category. I believe a transition to new leadership is taking place. Post 2008 US large/mega-cap growth stocks have had tremendous outperformance relative to the broader market. This has led to multiple expansion in those stocks, and big spread between other category multiples vs. US large growth. Below you will see the forward price-to-earnings ratios for these major categories of stocks, coming into this week.
- US Growth 23.5x earnings
- US Value 14x earnings
- International Developed 12.5x earnings
- International Emerging 11x earnings
The mean for US growth over the last 20-years is 18.5x earnings. This tells me growth may have further to fall, despite being -23% YTD already. By contrast US value stocks YTD performance is -6%.
When markets fall and the world appears to be in chaos our human nature works against our investor best interests. Our nature is emotional, and our emotions trigger our fight or flight instincts. In these times it is more important than ever to remain calm and revisit our investment policy. Lean on a clearly defined set of principles and process for making decisions.
Be well,
Wyatt Swartz
Financial Adviser, RIA
W. Swartz & Co.
(636) 667-5209 | www.wswartz.com