Recessions and significant market drops are usually unexpected. And that is what makes the current environment so distinctive and unusual – suddenly everyone sees a recession on the horizon. A Deutsche Bank survey of over 400 global investors showed that 71% expect an economic recession within the next 18 months compared to only 29% back in February. Google searches for recession are as high as they were in March 2020[1]. Headlines are grim and would make anyone assume we are in a recession already, or that one is just around the corner.
The prospect of recession isn’t unwarranted based on the circumstances. The Fed is raising interest rates to slow economic growth and fight inflation that is the highest in 40 years at over 9% year-over-year. The concern is that the Fed will raise interest rates too far and too fast and tip the economy into recession. The runway for an economic “soft landing” is now shorter and less anticipated as interest rates have risen and growth has slowed.
We would agree that economic growth is clearly slowing due to the Fed’s tightening cycle. But, a recession is not inevitable, and any recession could be rather mild, as they usually are, due to the underlying strength of the current economy. Employment growth is about as strong as it has ever been with the unemployment rate at 3.6% and hiring demand still strong with 11.3 million job openings in May[2]. There are still nearly two jobs available for every unemployed individual in the U.S. Despite high inflation and gas prices, consumers and businesses are still spending. Corporations are flush with cash and have less debt. Towns and municipalities are also in solid position with solid cash flow and excess cash. The data does not reflect a deep and drawn-out contraction.
Inflation and corporate earnings are the key
Inflation should remain high in coming months, but asset prices have already repriced lower. Stocks, bonds, real estate, metals, energy and cryptocurrencies have fallen considerably in recent months. Gasoline futures are down more than 22% since June, raising the hopes that high gas prices across the country will continue to fall. The price of oil is down nearly 20% off the peak in early June[3]. Even the housing market is cooling due to mortgage rates that have more than doubled at close to 6% and rising inventories.
These are all disinflationary conditions, but a surging U.S. Dollar, which is the strongest versus most currencies since 2002, may be the clearest signal that consumer demand is slowing and that inflation should follow eventually. Commodities are mostly priced in dollars and a strong dollar pressures commodity prices lower. A strong dollar also makes goods sold overseas by U.S. companies more expensive. Apparently, the Fed’s message has been heard, but it will take some time for price increases to slow. Slowing or pausing the Fed’s hiking cycle later this year would be beneficial for most risk assets.
Perhaps the most supportive would be continued strength of corporate earnings in the second quarter and beyond. First quarter earnings growth was expected to be 5% and ended up growing by approximately 10% year-over-year. For the second quarter, investors and analysts have penciled in 4.1% earnings growth[4]. Hitting this target, and, perhaps most importantly, satisfying forward earnings guidance for the remainder of the year will be critical. Continued earnings growth would reinforce market valuations, which are reasonable and in-line with the median valuation of the last 20 years. Material deterioration in earnings could lead to another leg down for markets. Corporations have managed inflation quite well so far, but there will surely be those that struggle with rising costs and some that are in position to excel. The key for stock price stability is not whether the economy falls into recession, but whether earnings can continue to expand, or at least hold steady.
Growth and technology lead stocks lower in the second quarter
The broad market, as defined by the S&P 500 Index, declined 16.1% during the quarter and fell 20.0% during the first six months of the year[5]. This is the worst first half of a year for the Index since 1970. However, growth stocks and other more speculative and overvalued corners of the market, led by the technology sector, were responsible for the most damage. The tech-heavy Nasdaq Composite Index declined 22.4% during the quarter and was down 29.2% during the first half of the year. Highly-valued and less profitable companies with earnings forecasted many years into the future can suffer when interest rates rise. Instead, investors favored more profitable and higher quality companies.
The Russell 2000 Small Cap Index fell 17.2% during the quarter and was down 23.4% through June 30th. As expected, smaller companies do carry more risk in general and fell more than the broad market, but not by much – perhaps due to valuation. Surprisingly, international markets held up better than most people realize given the war in Ukraine and China’s zero-Covid policies. The MSCI Developed Market Index and the MSCI Emerging Markets Index declined 14.5% and 11.5% during the quarter, and 19.6% and 17.6% for the year, respectively.
Finally, bonds turned in their worst six month stretch to start a year based on data going back to 1975. The U.S. Aggregate Bond Index declined 4.7% during the quarter and 10.4% for the first six months. The sudden, incredible rise in interest rates has crushed most types of bonds. But, yields are now much higher – and expected returns are higher as well.
Global Asset Allocation Strategy
The strategy ended 2021 with high levels of equity exposure, as we favored stocks over bonds and allowed risk assets to run. On January 3rd, as the S&P 500 peaked, we reduced equity exposure back to neutral across all accounts, raised cash levels, reduced bonds, and introduced bond alternatives to mitigate losses from bonds due to rising interest rates. The persistent inflation and the Fed’s pivot to rising interest rates were signals that could not be ignored.
Some excess cash was dripped back into domestic equities on the eve of the Fed’s first rate hike in mid-March. At this point, the broad market was down close to 15% from the January 3rd all-time high. Some cash was also added to bond alternatives. Aside from select tax-loss harvesting in some accounts, there were no transactions made during the second quarter. Market weakness bottomed out in mid-June, but we would need to see further weakness to be opportunistic at this point. Earnings season is just around the corner and there could be more volatility ahead if forward guidance disappoints.
The strategy has mitigated the bond carnage from rising interest rates in two ways. First, as has been the case in recent years, the bond portfolio has had shorter duration. Shorter-term bonds generally outperform longer-term bonds in rising interest rate environments because bonds mature sooner and can be reinvested at higher yields. The duration of the bond portfolio is roughly 3 years versus the US Aggregate Bond Index duration of approximately 7 years. This means that, on average, bonds are maturing in about 3 years. Second, the four new bond alternatives are capital preservation investments that are not correlated to bonds and interest rates. These investments include strategies such as equity and fixed income market neutral, event-driven and merger/acquisition arbitrage. Performance of these investments has handily beaten the U.S. Aggregate Bond Index halfway through the year.
The strategy remains flexible and continues to hold dry powder to be opportunistic should we see further near-term weakness in risk assets. The strategy invests with a 3-5 year time horizon and will proactively take advantage of temporary lower asset pricing to enhance long-term returns.
Focused Equity Strategy
In the second quarter, equity markets continued to favor value stocks over growth stocks. Value stocks, as measured by the S&P 500 Value Index, declined 11.4%, whereas growth stocks, using the S&P 500 Growth Index fell 20.9%. For the first six months of the year, the value was down 11.5% versus a decline of 27.5% for growth. This represents a sharp turnaround from the last few years, where it looked like growth stocks would grow to the sky.
The sell-off hit a few sectors harder than others. The worse-hit sectors year-to-date were Consumer Discretionary (-33%), Communications (-30%), and Technology (-27%). All other sectors performed better than the S&P 500 Index, with the standout being Energy gaining 31% due to price spikes, and utilities declining only 1%[6]. Each of these sectors represents a basket of stocks intended to be grouped together by similarity, but some of the sectors had significant divergence among the constituents.
Our positioning in Focused Equity doesn’t change a lot from quarter to quarter, as we emphasize long-term intrinsic value of companies we expect will flourish across most conceivable economic and market cycles. That includes an overweight in financial stocks, telecommunications, energy, gold, and health care. While telecommunications is classified in the communications sector, it acts as a substitute for, and better tracks the utilities sector. We remain underweight technology, consumer discretionary, and consumer staples. The portfolio also has a little extra cash, which helps when the market is down.
In April, we trimmed Pfizer and McKesson, while adding Merck and Medtronic. We still like Pfizer and McKesson, but the position sizes had grown too large and we felt it was a good time to introduce the other two names. Like Pfizer, Merck is a large pharmaceutical company that specializes in oncology, animal health and vaccines, along with drugs in hospital, neurology, immunology, virology, cardiovascular, and diabetes. The company has a healthy pipeline, with recently approved and promising phase III compounds. Medtronic is a medical device company with strong franchises in cardiology, neuroscience, surgical, and diabetes. We believe both companies offer a compelling value at these prices, and we liked the defensive nature of health care in the midst of heightened market uncertainty at the time of these purchases.
Also in April, we sold Meta (formerly known as Facebook), and added to Nvidia and VMware. While our timing on Meta was less than ideal, we became increasingly concerned about the future of the company due to a number of negative headwinds. This includes a large source of revenue that was under pressure from privacy changes in Apple’s iOS software – revenue that we felt had not been adequately disclosed and classified in their 10K. In addition, Facebook faces intensifying regulatory and business model challenges. WMware is a company that we already owned and felt it represented an uncommon value, so we added to it. Apparently, the managers at Broadcom agreed with us, and in May announced the acquisition of the company. The merger still needs to go through regulatory approvals and may take many months to complete. Nvidia is a semiconductor company that specializes in graphics chips used in computers, workstations, and increasingly AI and other specialized server applications. The stock price has fallen considerably and valuation is solid.
In this market turmoil, we find ourselves in a shifted landscape. Companies that previously were expensive are now not so much. It is impossible to know where the market will go in the short term, but we believe a sensible long-term investment strategy is the best approach in a chaotic world.
Bear markets make for favorable expected returns
A decline of 20% is known as a bear market and our June newsletter touched on what to expect in terms of downside and duration before markets rebound based on the prior 26 bear markets since 1928. Once markets drop by 20%, it generally takes 52 trading days, or about 10 weeks, to bottom out, which would be around September[7]. Not all bear markets are the same, some are shorter and some longer.
While it is frustrating to see account values down, there are two main points to remember. First, market losses are temporary. The market is a bull market, which is when markets go up, about 78% of the time over the last 92 years[8]. Therefore, staying fully invested in anticipation of a market rebound is the best course of action. The second point is that once markets are down 20%, forward-returns should be substantially greater. A study of the Nasdaq since 1970 shows that investing after the index has been down 20% has resulted in returns averaging 22.2%, 52.3%, 86.6%, and 328.1% over the following 1, 3, 5, and 10-year periods, respectively[9]. This includes periods where the market initially fell substantially more than 20% before rebounding.
There is a chance that we could see more volatility ahead, especially if inflation or earnings disappoint. However, predicting short-term market moves is nearly impossible. This is why it is important to stay the course and selectively add to risk assets if we do see more downside. Expecting to peg the bottom of the market is unrealistic. But, now that the market is down 20%, we can expect long-term returns to be much better than average – even without hitting the absolute bottom of the market.
As always, please call or email with any questions. We would be happy to discuss our thoughts in greater detail at any time!
The APW Team
[1] “Marketweek” by Nicholas Jasinski; Barrons; July 4, 2022.
[2] “Hiring Demand Remained Strong in May” by Bryan Mena and Rina Torchinsky; WSJ; July 6, 2022.
[3] Factset data as of July 6, 2022.
[4] “Earnings Insight”; Factset; July 1, 2022.
[5] All index performance data from Commonwealth Investor360.
[6] Sector returns referenced are the State Street sector ETF performance.
[7] Ned Davis Research as of December 15, 2021.
[8] Ned Davis Research as of December 15, 2021.
[9] “What Happens When You Buy Stocks in a Bear Market” by Ben Carlson; A Wealth of Common Sense Blog; March 20, 2022.
Alliance Private Wealth is a Limited Liability Company. Advisory services offered through Commonwealth Financial Network®, a Registered Investment Adviser.