As anticipated, volatility remained elevated during the quarter, and during the month of June in particular. As recession fears gripped the financial markets on the heels of the Fed raising rates by .75% in June, areas of the market that had previously held up better than the broad market succumbed to selling pressure, resulting in very few safe havens. At its most recent low, the S&P 500 declined by over 12% in the first half of June but then attempted to rally at the end of the month, ending a challenging month with declines close to 9%. Bonds declined 1.5%
For the second quarter, the S&P shed 16%, the bond market 5%, NADSAQ 100 (QQQ) 20% and small caps (IWM) 16%. YTD, the S&P officially entered a bear market, declining 20%, bonds down close to 11% and QQQ down close to 30%. This was the worst first six months of the year for stocks since 1970, and only the first time that both stocks and bonds declined to start the year since 1980. Cash was the only safe haven during the quarter, as even value/cyclical stocks, and energy, which had been one of the few places that was appreciating, declined significantly during the quarter. These are truly unprecedented times.
WHAT’S DRIVING THE MARKET
At the risk of sounding repetitive, inflation and rising rates continue to be the primary driver of the financial markets price discovery. So far this year, the Fed has raised the Fed Funds rate three times – .25%, .50% and most recently .75%. There is expectation that we will see another .75% rate increase during the July Fed meeting, with a brief pause until the September meeting. Inflation is still running hot, adding to the likelihood that additional rate increases will be necessary to stabilize prices. The labor market continues to be strong, which is arguably a silver lining in an environment where the consumer is still “hanging in there.” How long excess savings will support consumption considering higher food and energy prices is an important metric to evaluate. Eventually, consumers excess cash cushion that was built up during the pandemic will be depleted, which is a concern if inflation has not cooled down by that time.
Recession fears are also running rampant, and consumer sentiment printed a fresh low in June. Sentiment often leads market action, and perhaps the overly negative backdrop may result in an inevitable recession. In our view, a recession in 2022 may be less damaging to the economy (and sentiment) than a recession in 2023, simply as a function of time – the longer this challenging backdrop persists, the less optimistic market participants will likely become, which could end up being a self-fulfilling prophecy, making a recession more likely to arise. Since the labor market is still so strong, our base case is that if we technically enter a recession (two consecutive quarters of negative GDP) it will likely be short and shallow and should also aid in demand destruction which should naturally offer some relief on the inflation front.
ADJUSTMENTS TO PORTFOLIOS
As expressed in our May note, Value stocks had been holding up quite well on a relative basis. Unfortunately, during the month of June, almost everything sold off, leaving very few places to hide from the worst month of the year. During the second week of June, the Energy sector began to sell off, which spilled over to other value-oriented areas of the market, including consumer staples and financials. RPV declined 12% over the next nine days, and energy collapsed over 25% in the following four weeks. As such, the models that held RPV recommended going to cash. We also sold FAB, a multi cap value fund that we have owned for more than 14 months. Losses in these two positions were contained to reasonable levels, with those sales capturing an 8% loss in FAB and a 12% loss in RPV. At the end of the month, we also trimmed exposure to our S&P equal weight position, RSP.
It is important to understand that the magnitude of declines has a far greater adverse impact than the extent of gains, and it is imperative for long term wealth accumulation that participation in drawdowns be limited to not require an inordinate amount of time to recoup. With the S&P down 20%, and the bond market down 10%, our declines in the 15% range are not too deep to be able to recoup in reasonably short order once the market bottoms. A 15% decline (from 100 to 85) requires a 17% advance to break even. However a 25% decline (from 100 to 75) requires a 33% advance to do so. These deep, long, drawn out market declines is exactly what our process attempts to avoid. The current backdrop of economic challenges is creating an unprecedented environment, and no one can know how much more the market can drop – or when the selling has concluded. Only by looking in the rear-view mirror can one call the bottom with any degree of certainty, and we are of the belief that the path of least resistance is down. Thus, extreme caution is warranted, and our sizable cash position (at least 40%) will help mitigate further declines that could be even more damaging and take longer to recover from.
There are likely to be additional bear market rallies like we saw in mid-March, May and June. However, the overall trend is still down. Should the worst be behind us, our process will be much quicker to put cash back into the market than it is to pull exposure out of the market. If the market takes another leg down, then our participation will be limited given the current cash position.
LOOKING AHEAD
This upcoming earnings season will be extremely important in determining the future direction of stocks. Currently, earnings have not been materially revised downward, which we feel is warranted. If corporate earnings announcements reveal lower earnings, and even more critical, lower margins (due to higher costs of just about everything – from labor to energy to raw materials and excess inventory –) then we anticipate stocks will need to be re-priced in light of lower current and expected earnings. This scenario could likely result in another leg down in the market, for which we are well positioned to mitigate full participation. Forward guidance by corporations will also be scrutinized to better understand the fiscal challenges companies are having in the current environment. If guidance becomes more cautious, that may also likely require stocks to re-price to the downside given that current earnings multiples may still be too high to justify current stock prices.
Also, in July we will get the June inflation reading. Obviously, this needs to indicate some marked softening on the inflation front for the market to anticipate peak inflation is behind us, which would give the Fed some reason to take pause in continuing to raise rates. If inflation starts rolling over, then the Fed can claim their policy decisions have helped bring price stability back to targeted levels. However, if inflation does not show signs of cooling, then the Fed will be more pressured to continue to raise rates, which would likely cause stocks to be re-rated in light of more fiscal tightening.
Finally, the July Fed meeting will take center stage. Probably no surprises here, as the Fed is widely expected to raise rates another .75% as it has clearly communicated that it is dedicated to bringing inflation down.
One potential positive “green shoot” stems from the recent declines in the energy and commodity sectors. On one hand, lower energy and commodity prices should positively impact inflation – bringing it down. However, a collapse in commodities and energy, along with lower bond yields, often signal anticipation of a recession. We will be closely monitoring how these data points play out and impact the markets.
All in all, the current environment is wrought with uncertainty, which is keeping volatility at elevated levels. Anticipate more choppiness and an ongoing up and down market. Ultimately, the market will settle down when inflation starts to soften, which will lead the Fed to stop raising rates and perhaps start to be more accommodative in the upcoming years. The road will be bumpy and uneven, but in the end, the market is not going to zero. We will stay focused on prudently managing your investments and will likely stay defensive until there are clear signals that inflation is abating, and the Fed is closer to the end of their path to rate normalization and price stability than the beginning.
We wish you well.
