The stock market has started 2022 with renewed volatility, much of it to the downside. At this writing, the S&P 500 is down 7.78% since the beginning of the year. Indexes that are heavier in technology, such as the NASDAQ, are down more, although it would be a mistake to infer that all technology is doing poorly in this environment. What is clear is that some of the excessive valuations visible in the market prior to the beginning of this year are being washed out. Some of those higher valuations were concentrated in high-tech stocks. The current price-earnings ratio of the S&P 500 is 25.2, still well above the long-term average of 16, but also below the ratio of 35.9 seen at the beginning of 2021. Still, many companies are reporting strong earnings and increasing their outlook for the next twelve months. S&P 500 earnings are up over 78% from their depressed state at the depth of the COVID recession, and overall earnings are ahead of what was being reported prior to COVID. However, investors are having to evaluate securities in an environment where interest rates are rising, and the very generous liquidity provided by the monetary and fiscal stimulus is being withdrawn. If the value of a security is equal to the present value of a future income stream, then increases in the applicable discount rate would produce lower valuations, all else equal. And some meaningful part of last year’s bull market was liquidity-driven.
Complicating the investment picture further is the fact that bond investors are facing a rising interest rate environment. Historically, bonds have been favored by conservative investors for their relative stability, their ability to preserve capital, and their income generation. Much of our recent history in the bond markets has been characterized by declining rates, which make fixed-income securities more valuable. In a rising rate environment, the market value of bonds goes down. Bonds still occupy a unique place in the spectrum of investments – barring default, they pay an amount certain on a date certain and that is their principal appeal to the conservative investor. However, in a rising rate environment, they lose market value and struggle to maintain purchasing power in the face of higher inflation. All is not lost for the bond investor; the impact of rising rates can be mitigated by managing duration in a portfolio, and diversified portfolios can include income-producing assets that may be less directly impacted by rising rates. These can include dividend-paying stocks, REITS, MLPs, and Business Development Corporations. The risks associated with such investments should not be confounded with a bond portfolio, but they can play a role in a broader investment strategy.
Committed bond investors should not entirely despair of this market. For many years now, bond investors have had to accept unusually low interest payments. The path to higher rates, though painful in the short term, is also the path to higher yields for bond investors. Well-structured bond portfolios typically have maturities distributed across many years, thereby producing cash flow from both coupon payments and maturities. In a rising rate environment, that cash flow can be used to reinvest at higher rates.
Source: S&P Dow Jones Indices LLC, fred.stlouisfed.org
As always, if we can be of assistance to you in navigating these challenges, please do not hesitate to contact us.