Market Update: 2022 Q1
What’s going on in the stock market?
U.S. equity markets have gotten off to a rough start this year. As of this writing, the S&P 500, Nasdaq, and Russell 2000 are down roughly 10%, 16% and 18% respectively from their recent highs. While short term volatility is common (see JP Morgan slide below), this is the first 10% correction we have experienced since the beginning of the COVID pandemic in March 2020, almost two years ago.
The big story so far in 2022 has been the rapid move higher in interest rates based on upcoming Fed policy changes. Currently, the Fed is expected to end its pandemic-era quantitative easing (Fed has been purchasing $120b/month of Treasury and mortgage bonds) in the next month and begin to raise its Fed funds rate. The big unknown, and something we are watching closely, is what they will do with their balance sheet. It has grown from approximately $4.5 trillion pre-pandemic to roughly $9 trillion in size and the big question is whether they start to reduce the size of their balance sheet or maintain it. What they decide will likely be another catalyst for market direction in the near term. The Fed is meeting this week and the markets will be listening intently and parsing their language trying to decipher what their policies will be going forward. Bottom line, the Fed is starting its shift from an “easing” to a “tightening” policy to fight off inflation threats.
As we always remind our clients, the market is forward looking and it is currently trying to price in assumptions around how quickly and to what degree the Fed will move to combat inflation. This is prompting investors to reassess valuations for some of the most expensive segments of the market (growth) and rotate into more value stocks. If you look at the stock market internals, most companies are doing well; revenues are up, earnings are up, and free cash flow is up. What is getting hit are the multiples or what people are willing to pay for those earnings. Stock price = earnings (EPS) x multiple; earnings are up but multiples are getting cut.
Lastly, there may be some concern of the Ukraine conflict boiling over and the geopolitical risks that come with it. While we believe this is currently a small component of the recent volatility we’re seeing, the markets are facing headwinds on multiple fronts.
What’s our plan and what are we doing about it?
Heading into the end of last year, we started to shift some of our growth stocks to more of a value tilt which has worked well during this volatile period. Also, this past week we de-risked a portion of client portfolios by getting rid of our most growth-oriented position (albeit a very small position for our clients) into a market neutral investment. The markets are currently moving fast, and we are shifting allocations to protect as best we can while still following our prudent process. We still own some growth positions that are currently struggling, but we have strong conviction in how they will perform coming out the other side of this volatility. On the bond side, we have reduced duration (interest rate sensitivity) as best we can while still producing a reasonable yield. This should protect the principal value of our bond positions in a rising interest rate environment. As we have said for years, traditional fixed income is a tough area to find any real return, so we continue to reposition more into alternatives (assets that are not correlated to stocks or bonds) which should do well over the next 3-5 years with the low interest rate, high inflation world we live in.
What’s our outlook?
We believe the next few months will be volatile as the markets try to find their footing amidst the Fed’s changing policies, and we will continue working diligently to reduce that volatility in portfolios. However, we do expect 2022 will be a year where our economy continues to grow (positive GDP and no recession) and the underlying companies making up our stock market also grow (earnings). Keep in mind that economic momentum is strong right now and interest rates are at near zero. It will take quite a bit of Fed tightening before there is a noticeable impact on actual economic growth.
If you have any questions or want to discuss things in more detail, please do not hesitate to call or email us.