The stock market declined over 9% in the month of April and is now down over 13% year to date. If all security pricing is, at a basic level, an effort to value a future stream of earnings or income, then higher rates will produce lower valuations, all else equal. Lower rates produce a higher present value calculation, and higher rates push present values down. The price-earnings multiple of the S&P 500 is now 20.88, well down from a recent high above 39, but still above its long-term average of 16. Reported corporate earnings have been reasonably strong in the first quarter; 80% of companies have reported earnings above estimates, but the margin has been tight. On average, the earnings have beaten estimates by 3.4%; the five-year average is over 8%. Many CEOs are expressing a cautious outlook, given headwinds from rising costs and supply disruptions.
Bonds, which decline as rates rise, have also come under pressure. Broad bond indexes are down over 8% year-to-date at this writing, so balanced portfolios made up primarily of stocks and bonds are under greater pressure now than at any time in recent memory. It is very unusual for both asset classes to produce negative returns over a full calendar year.
These are discouraging results for diversified investors; however, a lot of bad news may already be priced into these markets. Stocks have had to digest war in Europe, an ongoing pandemic, extraordinary energy and commodity prices, and a general inability to secure materials, even at elevated prices. The bond market has priced in seven or more rate increases between now and year-end. The two-year treasury is already above what the Fed has indicated is their “neutral rate”–neither stimulative nor constrictive. None of this is to suggest that stocks can’t go lower or rates can’t go higher. If inflation proves to be persistently high, the Fed may have to push rates substantially higher in order to quell demand. If doing so precipitates a recession, negative market conditions will be with us for a while.
So why stay in? It is impossible to accurately forecast something as complex and as dynamic as the global economy. Yet markets are forward-looking, so we cannot know when all the bad news has been priced in. What we do know is that stocks are cheaper than they were at the beginning of the year. Market timing fails because it assumes we can know in advance the right times to buy and sell securities. Planning works because it leverages time and discipline to tap into the long-term returns available to diversified portfolios. Longer-term, the odds favor the patient investor. It is part of a natural dynamic that economies and markets expand over time. They just don’t do it in a straight line. Problems get resolved, inventions come online, and new markets are developed. Human innovation does not stand still.
These markets are not easy. If we can be of assistance to you through these times, please reach out to us. Thank you.
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.