Markets in Review
Let’s start by highlighting that the S&P 500 Index has just posted its worst first-half performance since 1970. Most indices are firmly in a bear market now. There are a few key, interrelated causes for this horrible second quarter. One is rocketing inflation, which has led the Federal Reserve and other central banks to hike rates at a faster pace than previously expected. The Fed earlier this month hiked rates by 75 basis points, which was the biggest increase since 1994. This has led to the second cause, which is increasing fears that the economy will fall into a recession if it hasn’t already. Furthermore, lingering COVID-19 variant surges and the war in Ukraine helped further destroy any positive sentiment that was left..
Virtually every market sector suffered this quarter. Fixed income traders continued to rapidly adjust to tighter monetary policy which sent yields – which move in the opposite direction of prices – soaring and led to more Treasury yield curve inversions where long-dated rates fall below short-dated rates. During the quarter itself, the S&P 500 suffered a high-to-low decline of -20% at its worst but recovered somewhat to end down -20.58% so far this year. The tech-heavy NASDAQ fell further into its bear market and finished out the quarter down -29.51% for the year. The Dow Jones Industrial Average ended the first half of the year down -15.31%.
The Russell 2000 Index, which includes 2000 of the smallest companies in the market, also continued its plunge into bear-market territory while finishing out the quarter down -23.93% for the year. Value-based investing, which focuses on buying companies that exhibit quality fundamentals but appear to be undervalued, exhibited slightly better returns on a relative basis this quarter (albeit still very negative) even for the smaller capitalization companies. The Russell 3000 Value Index fell -14.07% year to date and the Russell 2000 Value Index dropped -18.12% year to date.
Throughout the quarter, week after week of predictions about the intensity of inflation and the likelihood of a recession prevented markets from finding any equilibrium. Any temporary rallies were soon squashed and all we read are increasingly worse forecasts for when and where the volatility will cease. Due to tighter monetary policy, inflation and fears about future economic growth, fixed income continued to offer little protection for investors looking for cover. The Bloomberg Barclays US Aggregate Index, which includes a broad cross-section of U.S. fixed income assets overall, has dropped -10.35% year to date, so for the average investor who had passive exposure to the broad equity and fixed income markets in a “60/40” equity/fixed income portfolio, it seems like losing -15% or more was almost inevitable.
Historic Inflation Cycles and Markets
You may have noticed that the market cycle has changed along with the Fed’s monetary policy shift to fight inflation. With inflation soaring, it is clear that the Fed is way behind the curve on raising interest rates. They will likely stomp on the proverbial breaks in an attempt to rapidly slow the overheated economy and inflation. When the Fed moves into this type of posture, they have caused a recession about three-quarters of the time. And recessions are typically correlated with bear markets.
In a bull market, it pays to focus on capturing as much upside return as possible. Bull markets typically become entirely dependent on the Fed maintaining an accommodative monetary policy. As we’ve explained previously, growth, momentum, and technology stocks typically do very well during bull markets due to the low cost of capital among other reasons. In a negative market cycle, it pays to shift your primary focus to protecting capital. Historically the beginning of the year provides strong positive performance, but certainly not this year as mentioned above.
With dire warnings from blue chip financial leaders indicating we are heading for an economic hurricane, it is time to sit up and take notice. Furthermore, with record inflation numbers driven by wage-price pressures not seen since the 1970’s, it might pay to analyze the 70’s inflation cycle to see what happened to markets. Buckle up folks because it is not pretty!
After the end of World War II, the US entered a period of Goldilocks economic growth and prosperity. Market indexes soared in what became known as the “Happy Days”. But the growth engine and low inflationary environment started to turn by 1965 into an overheated inflation bubble driven first by wage-price inflation and then by the 1973 oil embargo. The price of oil jumped fourfold and shocked the US economy. The country was in the grips of “Stagflation”, which is often defined as a period of high inflation that occurs at the same time as slowing economic growth. With a 6.23% average inflation rate over these 15 years, it’s no surprise that investment markets suffered one of the worst performance periods on record. From 1965-1979 the S&P 500 index generated an average rate of return of just 1.12% per year for a cumulative price change of 16.78%. Each time inflation spiked the market took a nosedive. During this period the market posted 3 brutal bear markets – which are defined as -20.00% or more from the previous market high – and came very close a fourth time.
The reason we are walking down memory lane is to help investors understand what is likely ahead for markets. The cause of inflation in the 60-70’s was somewhat different than what we are experiencing today. Yet the outcome is strikingly similar with wage-price inflation caused by government policy errors combined with an adverse energy price cycle with the oil price once again spiking by almost 400%.
Against this backdrop the markets are going to struggle to produce positive returns until the Fed can break the back of the current inflation spiral. So far this year the markets are off to a bad start and inflation is not abating. The Fed is just starting their war on inflation and investors should beware. You might want to note that the previous bear market cycle lasted a very long time and there were some very powerful “bear market rallies” that fooled investors into taking more risk only to end up losing more capital.
The compounding effect of serial rate hikes on the economy is like pumping the brakes harder and harder on a car to slow down. Each hike slows the economy until the combined effect stops growth altogether. And if the economy is not growing it will likely be contracting.
The robust consumer spending and economy we have enjoyed over the past 10 years has been built on the back of zero interest rate monetary policy. It has been cheap to borrow, but as rates now rise the cost to borrow becomes harder to justify and many companies will suffer immensely.
In addition, the Fed and the government have pumped cash into consumers’ pockets with Quantitative Easing (“QE”) and fiscal stimulus. Not only is the Fed taking away the zero interest rate punch bowl but they are putting a hard stop to the other easy monetary policy party favors markets have relished including QE balance sheet expansion, all at the same time. The net effect will be a constrained consumer who normally drives 70% or more of our economy.
It seems pretty obvious the direction the markets will take as the Fed shifts from policy accommodation to tightening. Just in case you are still wondering, and missed the first page of this commentary, that market direction would be down.
The Fed is way behind on keeping inflation under control and they will respond by playing catch up. We expect another 75-basis point rate hike in July with more to follow. The Q2 Gross Domestic Product print is likely to be negative, projected at -2.00% according to the Atlanta Fed. This would put us in a technical recession providing confirmation that the U.S. consumer has been adversely affected by high gas prices at the pump, rising mortgage rates, a loss of wealth in their investment accounts, as well as fears surrounding the war in Ukraine, COVID and social divisiveness in our country. The divisiveness seems eerily reminiscent with what we experienced in the 60’s and 70’s is therefore another reason we fear that history might be repeating itself and we must prepare for another turbulent time in our nation’s markets, economy, and society as a whole.
Investors have already started to react by selling the most overvalued growth stocks with many of the technology “darlings” down by 70% or more. Investors have instead been rotating to value stocks that are more reasonably priced. We have found investors preference high yielding dividend stocks even more under these conditions. In the dot.com bear market, higher yielding dividend stocks defied the harsh 50% or 80% correction experienced by the S&P 500 and NASDAQ respectively by posting positive returns. Yes, that’s not a typo … certain types of high dividend value stocks produced positive returns during one of the worst bear markets this century.
The Time for Risk Management
WBI’s active risk managed strategies using our proprietary cash hedging software seeks to help investors navigate the ups and downs of the markets without taking huge portfolio crushing losses. Our first priority is aiming to protect your capital from large losses. With many Baby Boomer clients retired and taking income, large losses are not only toxic to their ability to generate income but can lead to compound liquidation of assets. Passive indexing has worked great up until now in the Fed fueled bull market, but when you look at this passive index over full market cycles that include downturns it’s not such a pretty picture.
Investor psychology and greed causes people to take excessive risk chasing high octane bull market returns. They fail to notice the warning signs of a change in monetary policy, government policy, inflation, and other warning signs the bull market may have run its course. Unfortunately, this leads investors out on the cliff’s edge of risk and can lead to large bear market losses. Investors who are nearing or entering retirement can’t afford to take large losses of capital. Our research shows that losses greater than 20% are very difficult to recover from and still generate a reasonable level of retirement income. Protecting capital when you are in the income mode is critical to avoiding portfolio failure.
With the U.S. equity markets and bond markets both registering one of the worst first half’s on record, it surprises us every day how investors continue to buy the dips assuming a nascent rally will turn into the next long term bull market run. As we can see in Figure 3 above, bear market rallies can be powerful but typically lead to greater losses of capital without proper risk management. Curtailing losses is also an imperative for investors trying to build capital.
As Albert Einstein said, “Compounding is the eighth wonder of the world and the most powerful financial force in the universe”. Maintaining the largest capital base possible through a bear market cycle is the most powerful way to unleash capital growth and compounding in bull market recoveries. As markets recover, relatively smaller losses are quickly overcome and the miracle of compounding on a larger capital base starts to quickly generate positive growth. At WBI we are also the “Dividend Guys”. We actually wrote the book on dividend investing for McGraw Hill (check out All About Dividend Investing: The Easy Way to Get Started if you’re interested). Dividends and capital protection are winning combinations to allow investors to have the dry powder (a.k.a. “cash”) to reinvest when the next bull market trend emerges. At WBI we take our risk management role seriously because investors have told us for over four decades that they are trusting us with money they can’t afford to lose.
Unless otherwise indicated, the source for all price and index data used in charts, tables and commentary is Bloomberg.
IMPORTANT INFORMATION
Past performance is not a guarantee of future results. The views presented are those of Steven Van Solkema and Don Schreiber, Jr. and should not be construed as personalized investment advice or a solicitation to purchase or sell securities referenced in the Market Commentary. All economic and performance information is historical and not indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product referred to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI Investments or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with WBI Investments or the professional advisor of your choosing. All information, including that used to compile charts, is obtained from sources believed to be reliable, but WBI Investments does not guarantee its reliability. Sources for price and index information: Bloomberg (unless otherwise indicated). WBI Investments pays a subscription fee for the use of this and other investment and research tools. WBI Investments and Bloomberg are not affiliated companies. Our current disclosure statement as set forth on Form ADV Part 2 is available for your review upon request. WBI managed accounts may own assets and follow investment strategies which cause them to differ materially from the composition and performance of the indices or benchmarks shown on performance or other reports. Because the strategies used in the accounts or portfolios involve active management of a potentially wide range of assets, no widely recognized benchmark is likely to be representative of the performance of any managed account. Widely known indices and/or market indices are shown simply as a reference to familiar investment benchmarks, not because they are, or are likely to become, representative of past or expected managed account performance. Additional risk is associated with international investing, such as currency fluctuation, political and economic uncertainty. Annualized Rate of Return is the return on an investment over a period other than one year (such as one quarter or two years) multiplied or divided to give a comparable one-year return. The Dow Jones Industrial Average (DJIA or “The Dow”) is a price-weighted average of 30 of the largest and most significant blue-chip U.S. companies. The S&P 500 Index is a float-market-cap-weighted average of 500 large-cap U.S. companies in all major sectors. The NASDAQ Composite Index (NASDAQ) is a market-value weighted index of all common stocks listed on NASDAQ. The Russell 3000 Index is a float-adjusted market-cap weighted index that includes 3,000 stocks and covers 98% of the U.S. equity investable universe. The Russell 1000 Index is a float-adjusted market-cap weighted index that includes the largest 1,000 stocks by market-cap of the Russell 3000 Index. The Russell 2000 Index is a float-adjusted market-cap weighted index that includes the smallest 2,000 stocks by market-cap of the Russell 3000 Index. The Russell 3000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 3000. The Russell 1000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 1000. The Russell 2000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 2000. The Barclays U.S. Aggregate TR Index is calculated based on the U.S. dollar denominated, investment grade fixed-rate taxable bond market including treasury, government-related, corporate, MBS, ABS and CMBS debt, and includes the performance effect of income earned by securities in the index. The Barclays Global Aggregate TR Index is calculated based on global investment grade debt from twenty-four local currency markets including treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging market issuers and includes the performance effect of income earned by securities in the index.