Despite the Fed’s 50 basis point hike in early May, inflation data continues to run exceptionally hot. Headline inflation rose 8.6% over the past 12 months; Core inflation (ex-food and energy) rose 6% over the past 12 months. The ongoing war in Ukraine, COVID shutdowns in China, the summer driving season, and ongoing disruptions to global supply chains (among many other things) are all highly cited reasons for the continued upward march in prices. U.S. equity markets recoiled on the news with U.S. stocks falling nearly 3% on Friday and are now down 18.5% for the year (through Friday’s close).
The market is now pricing in an additional rate hike at this week’s FOMC meeting of somewhere between 75 – 100 bps based on Friday’s data. That’s a big hike, one that’s probably needed to tame inflation. But a word of caution is in order; we should remind ourselves that the Fed raised interest rates 50 bps on May 6—meaning that Friday’s May inflation data (data that represents the changes in consumer prices for the month of May) likely doesn’t reflect the full impact just yet of the Fed’s May 6 rate hike. Further, “QT” (Quantitative Tightening, whereby the Fed allows bonds to roll off its balance sheet) is only now beginning, the economic effects of which will likely take some time to manifest. The good news is that Fed is doing what it must to combat inflation. The bad news is that the Fed doesn’t control the global economy and many of today’s causes of inflation have their roots far beyond our shores (e.g., COVID shutdowns in China, the war in Ukraine, and global supply chain disruptions). Finally, while more rate hikes are certainly needed, we should prepare ourselves for the very real possibility the Fed may overshoot based on incomplete data.
It’s during difficult markets when our mettle is most tested. But it’s precisely in times like now when resisting the urge to make long-term investment decisions based on short-term data is paramount. How then should we think about our portfolios given U.S. stocks are down so much?
First, diversification matters. This is why we avoid fad investments, exotic strategies, and heavy sector bets and instead choose to maintain a highly disciplined and planning-centered approach to investing—one that focuses on supporting your financial planning objectives by pursuing broad diversification across and within major global asset classes (e.g., U.S. stocks, non-U.S. stocks, etc.) and style factors (value, quality, etc.). Such diversification has paid off YTD despite an exceptionally difficult market. For example, values stocks (-9.34%), non-U.S. stocks (-15.49%), emerging market stock (-13.48%), and U.S. bonds (-10.65%) have all delivered diversification benefits this year beyond U.S. stocks (-18.49%) and certainly beyond the darlings of the past decade: U.S. growth stocks (-26.67%) and Bitcoin (-58%).1
Second, while inflation, recession, and rising interest rates continue to rightly dominate the minds of investors, it would be wise to keep in mind some of the positive data. For example, corporate earnings continue to grow (up about 6.4% YTD), despite serious economic headwinds. According to FactSet Earnings Insight (June 10, 2022), consensus estimates are for full 2022 calendar year earnings and revenue growth of 10.4% and 10.5%, respectively. Said differently, profits are up while stock prices are down. The S&P 500 Index, for example, now trades at slightly less than its 25-year average (currently, 16.3 times earnings versus a 25-year average of 16.85 times earnings). As stocks become less expensive and more profitable, their future expected returns increase. For long-term investors, that’s good news despite the short-term impact to our portfolios.
Finally, history tells us that market returns have been quite strong after market declines. Since 1926, U.S. stocks delivered an average 1-year return of 12.5% after a 10% market decline and an eye-popping 22.2% after a 20% decline (see below exhibit). If one does the math, it means markets have, at least historically, tended to recover within about 12 months of large market declines. The takeaway for investors is the best way to recover from losses is to maintain a long-term perspective and remain invested in properly diversified portfolio.
No one likes negative returns or volatile markets. And they’re particularly painful after such a long period of high, positive returns for investors. But they’re an ever-present, random, and recurring aspect of investing, one that can’t be simply wished away or avoided through fad investments or exotic investment strategies. Instead, we take a different approach. We seek to understand, plan for, and manage the risks and uncertainty that comes with investing—through things like sound financial planning, broad diversification, and a disciplined, long-term perspective.
Fama/French Total US Market Research Index Returns, July 1926 – December 20212
1 JP Morgan Guide to the Markets, Monday, June 13, 2022. Indices: Value stocks – Russell 3000 Value Index. Non-U.S. stocks – MSCI EAFE Index. Emerging market stocks – MSCI Emerging Markets Index. U.S. bonds – Barclays US Aggregate Index. U.S. stocks – Russell 3000. U.S. growth stocks – Russell 3000 Growth Index.
2 “History Shows That Stock Gains Can Add Up after Big Declines”, https://www.dimensional.com/us-en/insights/history-shows-that-stock-gains-can-add-up-after-big-declines. Data in chart is from Fama/French Total US Market Research Index Returns, July 1926 – December 2021.
All data is as of Friday, June 10, 2022 unless otherwise noted.
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Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals may materially alter the performance and results of your portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. Diversification does not ensure a profit or guarantee against loss. Historical performance results for investment indexes and/or categories, generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark. Indexes are not available for direct investment.