It’s clearly been a rough year for investors. A perfect storm of stubbornly high, white-hot inflation, large interest rate hikes, Russia’s brutal invasion of Ukraine, and China’s zero-Covid policy have all weighted heavily on global stock and bond markets.
These are indeed dark times for investors. The Fed—much to the surprise of market participants and economists—continues to threaten future rate hikes to combat inflation (and, by many accounts, is likely over doing it). Jerome Powell’s hawkish comments from Jackson Hole in late August effectively killed what was until then turning out to be a respectable market recovery. Since then, news of slowing GDP growth, escalating geopolitical tensions, and a surging U.S. dollar have all combined to paint a dark picture for investors.
But it’s precisely during such times that it’s critically important to step back, take a deep breath, and take stock of what we know about the present state of the economy and market.
Despite the Fed’s rhetoric, real-time data shows that inflation is indeed easing. It may not be coming down fast enough for the Fed, but there is evidence that it is indeed beginning to ease. Headline inflation peaked at 1.3% in June and has since fallen to 0.1% in August. Core Inflation, on the other hand, has remained stubbornly high, and indeed rose in August to 0.6% from 0.3% in July. It’s possible that August was just a fluke; but maybe it wasn’t. Regardless, real-time inflation data from the Cleveland Fed, as well as declines in home prices and new housing starts, suggest that core inflation may also be beginning to moderate. This shouldn’t come as a surprise. Rates have risen significantly from earlier this year—mortgage interest rates, for example, have doubled—and most measures show that U.S. GDP growth is virtually flat.
The Fed’s Supply Chain Pressure Index has declined (that’s good) from 3.41 in April to 1.47 in August and has been steadily improving throughout the year.1 Given that so much of our present inflation is due to supply side pressures (hence the relative ineffectiveness thus far of the Fed’s year-to-date rate hikes), improving supply chains should help relieve some pressure on prices. (For more, see this paper on inflation or click here for the section on the Fed’s policy implications.)
Equity markets valuations have significantly improved from where they were a year ago. The S&P 500, for example, closed last Friday at 15.8 times forward earnings—a roughly 6% discount to its 25-year average. Further, value stocks presently trade at 12.62 times forward earnings, a roughly 10.4% discount to their 25-year average. Non-U.S. stocks are even more attractive, with the MSCI ACWI Ex-US Index trading at 11.2 times forward earnings versus its historical average of 13.1 times—a discount of 14.5% relative to its long-term average.2
The market sell-off, despite all the rhetoric and pain, shows that diversification still works, perhaps not as well as we’d like, but it still nevertheless works. For example, while bonds are negative as a whole for the year, they’re down a lot less than equities. The Barclays U.S. Aggregate, for example, is down 13.8% versus 22.6% for the Russell 3000, year-to-date through Friday, September 23. As a result, diversifying across both in equal weights would’ve resulted in a year-to-date return of about -18%. Similarly for the year, value stocks helped diversified growth stocks, with growth returning -28.7% versus -15.8% for value stocks (all returns data are year-to-date through Friday, September 23, 2022).
No one gets excited about relative returns when absolute returns are negative. But that doesn’t mean diversification didn’t work to provide some relief to the undiversified alternative. Consider investors in such highly speculative assets as Bitcoin or the ARK Innovation ETF. Both are down over 60% for the year. Diversifying those risks would’ve been both prudent and wise.
None of this is to suggest that investors should feel better about market returns. No one like’s seeing red in their accounts; good relative returns and reams of economic data are of little solace during such times. But it would be shortsighted to look past the market’s silver linings. After all, we’ve been here before: March 2009, December 2018, and March 2020 to cite just a few recent historical antecedents. And the foremost takeaway from those dark times—and indeed all dark times—is that bull markets are born in the basement of investor despair.
2 JP Morgan, Guide to the Markets, Monday, September 26, 2022, slides 5, 10, & 49.
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