With inflation and recession fears dominating headlines, both stocks and bonds continued their fall in the second quarter of 2022.
At times, it useful to put short term market conditions in the context of longer market cycles. If we go back to the January 1, 2009, we observe that the S&P 500 (with dividends reinvested) compounded at an 16% annual rate through the end of 2021[1]. In other words, the Index began 2022 approximately six times higher than what it was just 12 years ago. Furthermore, during the period 1/1/2019 through 12/31/2021, a period which included a global pandemic, the S&P 500 produced an annualized rate of return of more than 26%!
When inflation began to soar late last year, it became evident that some of these recent returns may have been fueled by excess fiscal and monetary stimulus. As the market adjusted to this new reality of higher prices, higher interest rates, and the prospect of an aggressive Fed “tightening”, both stocks and bonds declined in value, forcing long term investors to “give back” a portion of the extraordinary market gains of the last twelve years. While it may not feel good in the moment, the effort to get inflation under control is crucial, even if it means some short-term pain.
The market is responding as we would expect, enticing investors with better valuations, improved bond yields and the prospect of higher returns going forward. Consider that:
Bond yields have increased significantly since the beginning of the year implying higher expected returns going forward. For much of the last decade, the real yield (the nominal rate less inflation[2]”) on 5-Year Treasury Securities has been negative or close to zero. At the beginning of 2022, the real yield was negative .5%. Today it is positive 0.5%.
Similarly, the broader investment grade bond market, as represented by the Barclays Aggregate Bond Index, has experienced a similar surge in yields, from below 2% at the beginning of the year to almost 4% now.
Inflation expectations are moderating. Although it was recently announced that the annual inflation rate, as measured by the change in CPI over the last 12 months, exceeded 9%, it is important to remember that this is a backward-looking measure. Using the “breakeven inflation rate”, we observe that the 5-year market-based measure of inflation peaked at the end of March at more than 3.5% and has since moderated to about 2.5%.
Valuations are much better than they were at beginning of the year. At the beginning of 2022, the forward Price to Earnings ratio[3] “P/E” on the S&P 500 was about 21, well above its historical average of 15.5. Today that number is 16.1.
Value stocks are making a comeback. The outperformance of growth over value was a defining trend of the last decade, and that trend accelerated in 2020 and 2021. 2022 finally saw that trend reverse, with value stocks outperforming growth stocks by 15% during the first six months (as measured by the Russell 3000 Growth Index and the Russell 3000 Value Index). Portfolios diversified across and weighted toward value stocks, including our client portfolios, help dampen the declines and outperform the traditional market weighted indices.
Many react to a stock market decline with the desire to retreat to safety by abandoning their long-term investment strategy and going to “cash”. Perhaps it is an evolutionary instinct to want to protect “what we have left” at all costs.
But if we observe market history, and we understand how markets reward risk with higher returns, we know that bear markets are necessary. Without bear markets, we would get low, savings account like returns, and inflation would slowly and perniciously erode the value of our accumulated wealth.
So instead of abandoning a well thought out investment plan, now is the time to stay the course, opportunistically rebalance when appropriate, revisit your financial plan, and remember that this is part of the process. And if the volatility of the stock market makes you nervous, remember that investing is ultimately about the long-term value of companies – large, well-financed, well managed companies whose value is not defined by short term stock prices.
