September has historically been the equity market’s weakest month of the year, and the current month is following this pattern with the S&P 500 down 6% for the month as of Friday, September 23rd. The market is now only 1% above the June lows, and 12% off the peak of this summer’s rally.
The principal cause for the current weakness is clear. Inflation is declining at a slower pace than either the Fed or markets expected. Hence, the Fed has felt compelled to ramp their hawkishness. The July rally was triggered by a combination of modestly favorable inflation data and evidence of a slowing economy, giving life to a narrative that the Fed might “pivot” to lower rates as soon as the first half of 2023. In August, disappointing inflation data led the Fed to effectively quash this narrative, communicating their belief that higher rates would be appropriate for longer than markets were expecting. This view was hammered home last week with the Fed statement and Powell’s comments.
With a Fed pivot likely off the table for at least the next six months, what is the outlook for equity markets? Given the uncertainty around inflation and how the economy will respond to higher rates, the most confident forecast we can offer is elevated volatility as investors react to incoming data. Due to the effect on Fed policy, bad economic news in the period ahead will tend to be good for equities and vice versa, adding to the volatility risk.
Next to inflation data, markets will be most sensitive to corporate earnings. To date this year, earnings have been resilient with consumers continuing to spend and companies generally able to pass along their higher costs. During earnings season (which begins next week) stocks tend to rise as most companies manage earnings expectations to a level that they can exceed, and companies are freed to do share buybacks after their earnings report.
While the odds of recession have risen with the Fed’s hawkish policy tilt, the tight labor market and strong consumer balance sheets argue for any recession being mild. Bear markets accompanying mild recessions have also tended to be less severe than average bears. As shown in the chart in the accompanying document, the current bear market has thus far been one of the mildest of the 13 bear markets since WWII1. Bear markets have historically occurred in about one of every six years. However, periodic bear markets have not prevented the S&P 500 from averaging an 11.8% annualized return since its inception in 1928 (see S&P 500 history chart in attached document).
Second, it is important that each investor has an asset allocation appropriate to their risk tolerance and investment time horizon. This has been harder to accomplish this year than usual in that fixed income has experienced its greatest loss in history. With rates having risen, higher yields and lower interest rate risk have better positioned fixed income to serve its traditional role in balancing portfolio risks.
While recent market news flow has been negative, there are some bright spots on the horizon. Mid-term election years have tended to see three quarters of a flat to down market followed by strong performance in the fourth quarter. Additionally, investor sentiment has become exceptionally negative which augurs bullish in that forward market returns are inversely correlated with investor sentiment. Markets are moved by developments that differ from investor expectations. When expectations are extremely negative, even news that is “less bad” than expected move a market higher. To illustrate, the chart in the attached document shows the “Lefkovich Index” (formerly called the “Panic/Euphoria index).2 Historically, forward returns from the current near-panic index reading have been positive 95% of the time.
While portfolio declines are an unavoidable and unpleasant aspect of equity investing, we are pleased with how our portfolios have been weathering this downturn. We do not anticipate any significant shift in portfolio strategy. Trades that clients will see in their accounts during this period will mostly be rebalancing for tax-loss harvesting, and some reduction in our non-U.S. exposure which we are decreasing below what was already a low level.
As usual, please call or email with any questions on market conditions or your portfolio.
Kevin Barlow and Kevin O’Grady
1 AWealthofCommonSense.com, September 22, 2022
2 Bloomberg.com, John Authers, September 11, 2022
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