After three straight years of double digit returns for stocks, the S&P 500 is off to its fifth worst start in history. The low for the year so far was on January 24th. Over the last three months, the Federal Reserve made it clear that it is going to accelerate the pace of interest rate increases. Russia invaded Ukraine, destabilizing Europe more than any other crisis since the end of the cold war. Russia’s invasion of Ukraine is causing the price of energy to spike, further complicating efforts to slow the pace of inflation. China, the second largest economy in the world, is imposing its most stringent lockdown since the beginning of the pandemic.
Given the chaotic start to 2022, this volatility shouldn’t surprise anyone. Even in the best of times, the market often struggles to advance after three straight years of above average returns. The real pain is in the bond market where bonds just got through their worst quarter in forty years. There was truly no place to hide in the first quarter of 2022. Small-cap value stocks had the best performance within the U.S. market, but this was after severely lagging the rest of the market during the recovery from the COVID bear market of 2020.
The second year of a new presidential administration is typically challenging. The honeymoon is over, and the focus is generally on whether the president faces a backlash from disappointed voters. This often translates into a flip in control of congress. Historically, the first nine months of the second year of an administration is challenging for the market.
The market is processing the impact of an increasingly aggressive Federal Reserve. Federal Reserve governors are going out of their way to make their intentions clear to investors. The logic is, if everyone knows where they are heading, the fixed income market will rapidly make the adjustment as fixed income investors adjust their expectations. Federal Reserve governors are signaling that they are going to consistently move interest rates higher until inflation subsides. The consensus is that 3% interest rates should wring inflation out of the economy without creating a recession.
Two-year U.S. Treasury securities have rapidly moved up towards the level that the Federal Reserve anticipates will contain inflation. The market predicts that the Fed will raise 50 basis points at the next meeting on May 4th. So, even though the central bank will continue to raise interest rates through the rest of 2022, the market has already done a lot of the Fed’s heavy lifting. Two-year yields reflect the market’s expectations for how high interest rates will go between now and 2024—most likely the entirety of the Fed tightening cycle.
Another way to look at this is that investors expect that the Fed will be able to subdue inflation with interest rates at a lower level than at any point over the last fifty years. During the expansion that ended in 2008, two-year rates peaked at 5%. During the expansion that ended in 2001, rates peaked at more than 7.5%. After the Fed stopped raising interest rates in 1994, the bull market continued until spring of 2000, another six years. In the summer of 1984, rates peaked at more than 13%. The bull market again continued for another six years, through 1990.
I am very confident that the market is currently undervalued if peak two-year yields stay under 5%. The most pessimistic Fed governor thinks that 3% will be the peak for two-year yields.
The stock market doesn’t deal in subtleties. Risk taking is either on or off. The U.S. stock market is one of the most liquid, efficient markets in the world. It has a massive share of global savings. When people need to raise money, the stock market is one of the most attractive options. Investors can sell quickly.
Clients ask me if this is a good time to buy and while I can claim no special insight into how the markets will behave over the next few months, if the economy is reasonably strong, and corporate earnings are healthy, I anticipate that the market will eventually make new all-time highs. This implies that any significant sell-off is a reasonably appealing buying opportunity.
Historically, once midterm results clear-up the market tends to rally. This rally can be significant, especially if the change in control leads to gridlock in D.C., which seems to be the markets’ first choice. Six months from now, we will have a very good idea of how the mid-term elections will turn out, and the Federal Reserve will likely be done raising interest rates. Assuming the earnings outlook continues to look healthy into 2023, I think the market has a good chance of trading near all-time highs later this year.
Fixed income investments face a different set of challenges. The fixed income market has become much less liquid over the last twenty-five years. The Dodd-Frank Wall Street Reform Act constrains the investment activities of the largest banks. Prior to this legislation, banks were more active in trading their own portfolios, often taking the opposite side of the trade relative to retail investors. Without this depth of fixed income dealers, bond markets have become more volatile.
When we build fixed income portfolios, we take our clients’ time horizons into consideration. Generally, our fixed income portfolios own securities that mature in less than ten years on average. If we own bonds that are high quality, we have a high degree of certainty about the ultimate return on the bond.
We know that when the bond matures, our client will receive the face amount of the bond. In the meantime, our clients will receive semi-annual payments—one-half of the coupon amount every six months. So, a $1,000 bond with a 5% coupon will pay $25 twice a year over the life of the bond.
If we were a bank, we would classify these assets as “hold to maturity” in which case we would not have to re-value or mark-to-market the value of the security. As a registered investment advisor, with a third-party custodian like Schwab, the SEC requires us to value these securities on an ongoing basis. So, even if the last trade of the bond was for a small amount at an absurdly low price, we are forced to value that security at a price that may not reflect the current market or the intrinsic value of the security.
It’s a little too complicated to go into all the details in this quarterly letter, but if you would like more information about the usefulness of current prices for bonds that are to be held to maturity, please contact me and I will be happy to walk you through the challenges and limitations of valuing fixed income securities.
Thank you for your trust, especially during these times of uncertainty. I find reassurance in the fact that no matter how unusual current events seem, there are historic examples of pretty much everything we are processing today. Eventually, we always seem to muddle our way through.