What’s Going on in the Markets February 27, 2022

Since our last post on What’s Going on in the Markets on January 30, 2022, the market has seen a flurry of volatility trying to come to grips with higher than expected inflation, the Russian invasion of Ukraine, and the coming interest rate increases by the Federal Reserve. Our hearts go out to those suffering in Ukraine because of yet another unnecessary war. Since the beginning of the year, while the S&P 500 Index has seen a maximum decline of approximately 11% on a daily closing basis, the carnage under the surface in many stocks and sectors of the markets has been far worse with some stocks down more than 75% on the year. In this post, we’ll look at the factors that may call for further declines or for a coming rally.

The Good

We’ve previously written about how markets undergo a pullback greater than 10% on average every 10-12 months, also called a correction. Therefore, the current correction, which was long overdue by the time it arrived in January, is part of the normal course of ebbs and flows in the stock markets. No one really knows if a correction will devolve into a full-blown bear market until after the fact (a bear market is a decline of 20% or more from the last market peak). While bear markets tend to be harbingers of coming recessions, they don’t always forecast them with 100% accuracy (nothing does). Historically speaking there are no bells rung at the start of a bear market. In fact, market tops are notoriously difficult to identify except in hindsight, as they are often quite volatile and take months to unfold. The good news is that we’ve been preemptively defensive in our portfolio decisions. The bad news is that a few bear market warning flags are starting to sequentially wave and resemble some of the ones we’ve seen in the most significant bull market tops in history. But it’s not yet a sign to sell everything. Corporate earnings are the primary driver of the stock market. Simply put, the better the earnings, the higher the market can go. Towards that end, the corporate earnings reports for the 4th quarter of 2021 were better than expected from a revenue and net income perspective, and corporate guidance (forecasting) relating to 1st quarter 2022 earnings were equally positive. Earnings guidance for the rest of 2022 tended to be even more positive and points to a reacceleration of the economy in the back half of the year. That tends to indicate that a recession is off the table, which is consistent with my beliefs and would stave off a bear market. From a COVID-19 standpoint, since we’ve tamed the Omicron variant, the country is starting to plan for a return to a bit of normalcy with the relaxing of masking requirements around the country and less onerous vaccination mandates. This alone ought to put a bid into the travel, entertainment and leisure industry, as pent-up demand picks up steam and drives further spending. This also adds to the “no recession on the horizon” narrative. The joblessness and employment figures are surprisingly to the good side, with unemployment levels lower and jobs numbers steadily improving. And employees and new hires are seeing higher wages, which again, will drive higher spending that will stave off a recession (but unfortunately, also drive inflation higher). While the effects of the Russian invasion of Ukraine may have some impact on the delivery timeline of various goods and services, the supply chain constraints that plagued the economy in 2021 seem to be subsiding, removing some inflationary pressure, and allowing more deliveries of materials and finished goods to factories and consumers respectively.

The Bad

With one trading day left in the month, the S&P 500 Index is down about 3% for the month and down 8% from the year-end 2021 close. While totally within the realm of normal expected volatility, especially for a mid-cycle election year, it’s never fun to experience that kind of decline. That’s because, as mentioned above, many sectors and stocks have been hit far harder. Fortunately, the last couple of days saw a robust bounce in the markets from the depths of fear at the start of the invasion of Ukraine. Inflation continues its domination of headlines as the last consumer price index clocked in at an annualized rate of 7.5% for January. Energy prices continue to rage higher as we saw oil a touch above $100 a barrel overnight last Thursday as news of the Ukraine invasion started to hit the headlines (the price of oil settled slightly under $92 at Friday’s close, but is spiking again in the Sunday overnight futures market). Food and commodity prices don’t seem to have found a ceiling yet. While some easing of inflationary pressures is expected as supply chains get back to normal and as jobs get filled, it won’t be enough to stave off interest rate hikes by the federal reserve, which are needed to keep inflation in check. I believe that we may have seen the worst of the inflation fears in January. Speaking of interest rate hikes, estimates vary widely as to how many hikes the federal reserve will have to implement to tame the inflation beast (economists estimate between three and nine 0.25% hikes in 2021 alone). Even if we get eight 0.25% hikes this year, which I consider unlikely, we’ll still be at a 2% federal funds rate, which is quite accommodative for the economy and is generally still quite favorable for the stock market. Unfortunately, higher interest rates have a negative impact on bond prices, which have not yet found a footing this year either (but haven’t collapsed either). Investor sentiment/psychology (feelings about the stock market) and consumer confidence are somewhat worrisome as they continue to remain moribund in the face of an economy that’s firing on all cylinders and a job seekers’ market that puts them somewhat in control (versus employers) and favors continued robust spending. Highly confident consumers tend to spend more, which drives the economy. There is convincing evidence today that housing prices are in bubble territory. This carries strong implications for financial markets and the economy given the importance of housing to consumers’ views of their personal balance sheets. Unlike the 2005 Housing Bubble, which was largely predicated on subprime lending and credit default risk, today’s bubble has far more to do with affordability and interest rate risk. Mortgage rates have been suppressed over the past decade by the Federal Reserve’s ultra-accommodative monetary policies, including direct purchases of trillions of dollars in mortgage-backed securities and near-zero interest rates. Mortgage rates dropped to a record low of 2.7% in early 2021 after the Fed threw the proverbial kitchen sink at the economy in response to the pandemic. However, the recent rise in long-term interest rates, along with the Federal Reserve’s decision to taper their asset purchases, have caused mortgage rates to spike back to 3.7% – the highest level in nearly two years. The combination of rising rates and rising prices has made the average mortgage payment on the same property approximately 30% more expensive than just a year ago. Monitoring the state of the housing market will be crucial in the months ahead as the Federal Reserve is due to begin tightening monetary policy as discussed above.

The Ugly

The Russian invasion of Ukraine is without a doubt an ugly, if not a well telegraphed development. If there was a wild card for the world economic recovery from the pandemic, it’s this–which has the possibility of derailing the recovery by disrupting supply chains and the flow of essential commodities from the region. Economic sanctions unfortunately tend to affect citizens more than the leaders they target, and also have an indirect adverse effect on the countries imposing them. Wars are of course unpredictable, so predicting the outcomes or effects is crystal ball type of speculation. As the war stakes are raised, so too are the risks to the markets. If calmer heads prevail and escalation to the unthinkable can be avoided, then this should be another one of those bricks in the proverbial walls of worry of the stock markets. A protracted war that draws in other countries will lead to a market that no doubt will sell first and asks questions later. However, one important historical insight is that most geopolitical crises or regional conflicts do not have a negative long-term impact on the stock market. In the few instances where geopolitical events have weighed on the market, it has been a result of either a broad-based global military conflict or a rise in energy prices (inflation) that puts upward pressure on U.S. interest rates (monetary policy). Of the last eleven crises/conflicts leading to war, only four of them led to a decline of 20% or more in the S&P 500 Index. The current Russia-Ukraine conflict is likely to cause even higher energy prices, yet at the same time, might reduce the possibility of a full 0.50% rate hike from a concerned Federal Reserve in March. The biggest concern from fighting a protracted war is a possible global slowdown, which forces us into a recession. Should that happen, I imagine it will be mitigated by a slowing of interest rate hikes and perhaps monetary stimulus. I consider this scenario unlikely at this time.

Now What?

We continue to expect volatility during this mid-term election year and remain cautious and defensive in our positioning. A deeply oversold market resulted in a big bounce on Thursday and Friday of last week, but the escalation in the rhetoric, a worsening of war tactics and increasing economic sanctions over the weekend are likely to trump any oversold markets, and we could see a big give-back of the gains of the last two days come Monday, the last trading day of February. The futures markets on Sunday night portend a very weak open for Monday morning. There is no doubt that there is a higher-than-normal degree of risk in the market today, and there has already been a significant amount of damage under the surface.  While the S&P 500 Index is currently only 8% off its January high, virtually half of all S&P 500 stocks (and an estimated 80% of NASDAQ stocks) are already down over 20% from their highs. The jury is out on whether this will be a protracted correction or a major bear market. However, we know that every bear market started out as a pullback, some pullbacks led to a correction, some corrections led to a small bear market, and every big bear market started out as a small bear market. And that makes the next 60-90 days perhaps the most critical in this market cycle stretching back to its start in 2009 (excluding the COVID-19 crash). Like everything else in life, there is no crystal ball when it comes to navigating the eventual end of a market cycle. Rather, a disciplined assessment of the weight of the evidence allows us to proactively position client portfolios to be defensive when it really matters. Going forward, we are prepared to further increase portfolio defenses depending on how the events in the market unfold. Using options, inverse funds, reducing under-performing positions and harvesting profits are all ways we can reduce client portfolio risk without necessarily exiting the markets (Disclaimer: none of this is a recommendation to buy or sell any securities). “In the end, navigating a [probable] bear market is not about putting your money under a mattress and waiting for the sky to fall. Instead, the focus should be on proactively managing risk to carefully navigate a wide range of outcomes and positioning oneself for that next great buying opportunity.”-James Stack, InvesTech Research No doubt these can be scary times for your hard-earned nest egg, and no one enjoys giving back a chunk of market gains. But as we’ve said before, the best way to profit from the stock market is to not get scared out of it. Enduring volatility is the price we pay for the outsized gains we get from investing in the stock market, but if you find yourself losing sleep over your portfolio, talk to your financial adviser (or contact us) so you’re invested in a portfolio that has the right amount of risk for your personal temperament. If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives. Source: InvesTech Research

About the author

Sam Fawaz, CPA, CFP®

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