Markets in Review
After briefly touching record highs at the start of the year, markets gave investors a truly wild ride through the first quarter of 2022. Most indices chalked up their first quarterly loss in two years. Any positive sentiment that was carried into the new year got decimated by more sky-high inflation readings, clear indications that monetary policy must tighten faster than expected, and lingering concerns over additional COVID-19 variant surges. As if that wasn’t enough, Russia’s invasion of Ukraine brought a further surge in commodity prices along with huge spikes in market volatility as news and pictures of the horrors of a brutal war sent shockwaves around the globe.
Almost every market sector suffered during the first quarter as the Federal Reserve raised interest rates for the first time since 2018. Fixed income traders rapidly adjusted to tighter monetary policy which sent yields – which move in the opposite direction of prices – soaring and led to some Treasury yield curve inversions where long-dated rates fall below short-dated rates. During the quarter, the S&P 500 suffered a high-to-low decline of -13% at its worst but recovered somewhat to end down -4.95% so far this year. The tech-heavy NASDAQ entered a bear market (dropping more than 20% from its high) and finished out the quarter down -9.10%. The Dow Jones Industrial Average ended the first quarter down -4.57%.
The Russell 2000 Index, which includes 2000 of the smallest companies in the market, also dropped into bear-market territory while finishing out the quarter down -7.80%. Value-based investing, which focuses on buying companies that exhibit quality fundamentals but appear to be undervalued, exhibited relatively better returns this quarter (albeit still negative) even for the smaller capitalization companies. The Russell 3000 Value Index fell only -1.35% for the quarter and the Russell 2000 Value Index fell only -2.84% the quarter.
As previously discussed, mega-cap growth and technology stocks like Facebook (now Meta), Amazon, Apple, Netflix and Google are extremely rate sensitive and, as a group, continued their drop into bear market territory this quarter. Investors continue to turn away from most of these mega-cap growth stocks which were the market darlings for many years now. Instead, investors struggled to find safe-haven assets that would outperform in an inflationary environment which created inflows for cyclical and value sectors.
Due to tighter monetary policy, inflation and fears about future economic growth, fixed income offered no protection for investors looking for cover. The Bloomberg Barclays US Aggregate Index, which includes a broad cross-section of U.S. fixed income assets overall, sunk almost -7% during the quarter but recovered slightly to end down -5.93%. So, for the average investor who had passive exposure to either the broad equity market (like the S&P 500) or even exposure to the fixed income market this quarter, it seemed like losing -5% or more was almost inevitable.
Will the Fed Slam on the Brakes?
Historically, the Ides of March referred to the first new moon of March and typically signified a new year, which meant celebrations and rejoicing. The U.S. stock market apparently took a cue from the lunar calendar as, towards the end of a volatile first quarter, investors jumped on the “buy the dip” mentality that has been prevalent every time the market has declined over the past decade or so. After dropping -13% from its all-time-high at the beginning of the year as mentioned above, the S&P 500 rallied back over +8% during just the last half of March. Investors continue to show signs of irrational exuberance in the face of the war in Ukraine, the highest inflation rate in the past 40 years, and the likelihood the Federal Reserve will need to raise interest rates faster than in recent history.
With markets trading at or near all-time highs, it pays to be cautious as bear market rallies can fool investors into believing that risks have been fully priced in and the danger is now behind them. The past decade has conditioned investors to believe any market declines will quickly be followed by a persistent move higher as the Fed and Government poured monetary and fiscal stimulus into the economy to provide almost endless market support. It pays to remember that the “create wealth effect” policies to drive consumption have been dropped by the Fed with their new focus on fighting an inflationary surge that we have not seen since the late 1970’s.
The Fed is way behind the inflation fighting curve after wrongly judging that inflation was transitory. Government policy driven by liberal populism raised the national minimum wage dramatically and that wage increase alone provided the foundation for wage price pressure being felt today. Separately, during the pandemic the government provided exceptionally high unemployment compensation for millions of workers becoming a competitor to private industry trying to hire those workers back into full employment status. As the economy has recovered and accelerated post pandemic, these unemployment policies have created one of the largest misalignments in open jobs versus job seekers. Employers are increasing compensation across the board to compete for scarce employees. This wage melt-up is causing companies to broadly adjust prices for the first time in several decades and is reminiscent of the 1970’s wage-price spiral which led to stagflation as the economy faltered while prices continued to escalate.
Other frightening parallels exist in that the 1970’s oil embargo increased commodity price pressure and inflation in general due to a huge supply-demand imbalance. Over the past two years, pandemic related shutdowns created scarcity across most sectors of the economy leading to rapid price inflation due to another huge supply-demand imbalance. We were hoping the supply chain disruptions would quickly resolve themselves, but then another black swan event happened with Russia’s invasion of Ukraine. Extensive sanctions and the war itself will disrupt the normal flow of energy, commodities and other goods and services that are provided by both Russia and Ukraine. This will only exacerbate the inflation problem we already had due to the pandemic.
There is fervent hope that the Fed will be able to engineer a soft landing for the economy by avoiding a recession. If so, it would probably insulate investors from a significant bear market event. After successfully building up a “wealth effect” by supporting asset prices and consumer spending for years, the Fed would like to avoid the implementation of drastic monetary policy changes that would unravel its proverbial ball of twine.
Unfortunately, history shows that when the Fed launches a monetary tightening program to fight inflation, they have caused a recession and significant market event about 75% of the time. The Fed is currently prepared to aggressively raise rates but it also plans to drastically reduce their balance sheet holding of bonds built up over the past decade, otherwise known as quantitative tightening. Under these circumstances, it seems very unlikely we will avoid a recession and bear market.
The Fed has been the largest buyer of domestic treasury, corporate, and mortgage bonds in recent years. As of March 14, 2022, the Fed’s portfolio includes $8.96 trillion in assets which is an increase of about $4.24 trillion since March 18, 2020. As the Fed reduces their portfolio, they will become the largest seller of bonds in history. To consume this volume, market interest rates will need to adjust dramatically to attract enough buyer interest. In short, the combination of hiking interest rates while at the same time activating dramatic balance sheet run off would seem to raise the odds of economic recession further. The Fed took unprecedented action increasing their balance sheet by $8 trillion to avoid depression during the 2008 Financial Crisis and to fight the 2020-2021 pandemic shutdowns. As they begin to reverse this build-up, they will be attempting a balance sheet reduction program that is also unprecedented.
On the positive side, the economy is strong or even running hot so there is some room to raise interest rates before we see negative growth or recession. Even as the Fed raises rates, they are doing so from a historically low level. Consumer spending and demand for goods and services has remained strong and has even outstripped supply. So, a modest reduction in demand is not a bad thing. Corporate profits have been strong and rising and seem to also be resilient to a modest economic slow-down and higher financing costs.
The answer to the million-dollar questions seems to be squarely in the Fed’s hands. Will they or won’t they cause a recession and bear market as they adjust policy to curtail inflation? Up until now, investors have been handsomely rewarded to take risk and to chase return. Yet now we believe the risk/reward paradigm seems to favor protecting capital from large losses rather than chasing returns. Even if we don’t get an outright bear market, probabilities are strongly against healthy returns for the next year or so. Market history and return analysis shows that it never pays to take large losses and this is even more critical for investors who are either approaching or are in retirement. For the tens of millions of Baby Boomers out there, we think this is time to check your whole card.
WBI believes risk management and loss protection are key to long-term investing success. We developed a proprietary cash hedging process that has helped investors avoid large losses during bear market cycles over the past 30 years. The financial industry and media have conditioned investors to focus on returns relative to a market index over short time frames. It’s not the return you achieve in a day, week, month or year that really matters. What matters the most is the return you achieve over your lifetime of investing. Maintaining capital in bear markets tends to lead to higher returns over long periods of time. As Albert Einstein said, compounding is the 8th wonder of the world and the most powerful financial force in the universe. Efficient compounding depends on maintaining and growing capital in both good and bad market cycles.
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The views presented are those of Steven Van Solkema and Don Schreiber, Jr. and should not be construed as personalized investment advice or a solicitation to purchase or sell securities referenced in the Market Commentary. All economic and performance information is historical and not indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product referred to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI Investments or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with WBI Investments or the professional advisor of your choosing. All information, including that used to compile charts, is obtained from sources believed to be reliable, but WBI Investments does not guarantee its reliability. Sources for price and index information: Bloomberg (unless otherwise indicated). WBI Investments pays a subscription fee for the use of this and other investment and research tools. WBI Investments and Bloomberg are not affiliated companies.
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Annualized Rate of Return is the return on an investment over a period other than one year (such as one quarter or two years) multiplied or divided to give a comparable one-year return.
The Dow Jones Industrial Average (DJIA or “The Dow”) is a price-weighted average of 30 of the largest and most significant blue-chip U.S. companies.
The S&P 500 Index is a float-market-cap-weighted average of 500 large-cap U.S. companies in all major sectors.
The NASDAQ Composite Index (NASDAQ) is a market-value weighted index of all common stocks listed on NASDAQ. The Russell 3000 Index is a float-adjusted market-cap weighted index that includes 3,000 stocks and covers 98% of the U.S. equity investable universe.
The Russell 1000 Index is a float-adjusted market-cap weighted index that includes the largest 1,000 stocks by market-cap of the Russell 3000 Index.
The Russell 2000 Index is a float-adjusted market-cap weighted index that includes the smallest 2,000 stocks by market-cap of the Russell 3000 Index.
The Russell 3000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 3000.
The Russell 1000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 1000.
The Russell 2000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 2000.
The Barclays U.S. Aggregate TR Index is calculated based on the U.S. dollar denominated, investment grade fixed-rate taxable bond market including treasury, government-related, corporate, MBS, ABS and CMBS debt, and includes the performance effect of income earned by securities in the index.
The Barclays Global Aggregate TR Index is calculated based on global investment grade debt from twenty-four local currency markets including treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging market issuers and includes the performance effect of income earned by securities in the index.