There's more to today's headwinds than just the conflict in the Ukraine
We woke up yesterday morning to shocking news in Europe as it looks like Russia brought a full-on invasion to the Ukraine border. What seemed like a relatively minor conflict is potentially turning into something much greater. In situations like these we hope and pray for the innocent bystanders who will undoubtedly be thrown into the middle of the situation. It’s unfortunate and hopefully it’s a brief encounter with few casualties.
It’s hard transitioning from the human toll war can take while looking at our own financial lives. But there is a lot of fear and concern all around the world, especially in times of substantial market volatility. In times like these, it's important to take a step back and try to make sense of what’s going on in the markets and how yesterday's current events can be viewed whilst making investment decisions.
I want to try and make sense of what we’ve seen the last few days while also looking at the big picture. Stock market analysis is always easier in hindsight. 2021 is certainly no exception. Looking back at last year, there’s obviously more clarity in the markets as we continue to see major Covid recovery trades take a back seat. Putting it all into perspective, it feels like a correction was due for some time, but trying to time it is unfortunately nearly impossible.
This morning as the markets opened up down 2-3%, I was reminded of the following quote from Morgan Housel in his book The Psychology of Money:
“Your success as an investor will be determined by how you respond to punctuated moments of terror, not the years spent on cruise control”
Timely advice in a time of global uncertainty.
Where are we today
As markets come to a close, the major indexes are at the current levels YTD:
S&P 500 - (10%)
Nasdaq - (17%)
Russell 2000 - (11%) - but down 19% from highs in November
It’s amazing to think of the reversal we saw yesterday into today, since the Nasdaq started down over 3% and finished up 3% on the day. It entered bear market territory (20%) by definition, along with the small-cap index Russell 2000. The S&P continues to outperform both, as it isn’t experiencing the same pullbacks that growth (Nasdaq) and small-caps are seeing.
When looking at a few data points from last year, the party had to slow down at some point. As the Covid sell-off first began in February of 2020, the losses were dramatic and they were steep. But given the nature of the type of sell-off it was, there were predictions we could see a snap-back recovery, which is exactly what happened. The markets bottomed out in March, and fully regained their losses by June of that year. And then the market continued to soar, never looking back.
I don’t like to measure the return of the market from the Covid lows, as I think its a more accurate measure to look at stock market returns just prior to the Covid sell-off. In just under two years time, from February 2020 thru the end of 2021, the market grew over 41% and averaged an annual rate of return of just over 20%. While we’ve seen strong corporate earnings, solid fundamentals, and a robust U.S. consumer and economy, this type of growth is generally unsustainable. The problem is knowing when it will end.
Even as the market continued to rip through the end of 2021, there were some Covid winners that began to have major sell-offs below the surface. However the companies keeping the market afloat, the Apple’s, Amazon’s, Googles of the world which make up large segments of the major indices kept these losses somewhat shielded.
Zoom for example peaked in August of 2021, and fell 54% to close the year. Peloton, which is making headlines now, fell over 70% during this time. Roku was down 44%, Paypal down 33%. ARKK, which was a darling ETF coming out of Covid, was down 24% over that time and is down almost 60% from its highs a year ago. Take into account the various SPAC’s that went public and your looking at a long list of stocks that were hit incredibly hard even as the markets continued to rise.
Enter 2022 and the headwinds started to effect the overall markets. Take into account the steady rise of inflation, which no longer appears transient. Threat of looming interest rates has not been kind to overall market sentiment. And now we deal with geopolitical unrest overseas and the market has subsequently headed to correction / bear market territory. Let’s look at how these headwinds may effect markets moving forward.
Russian Geopolitical Uncertainty
The events in Ukraine overnight were unsettling. I’m no geopolitical expert, but I certainly didn’t expect a full on invasion by Russian forces. Given the scope and lack of any fighting in Europe for so long, I expected much of the fighting to take place in the Eastern most territories. But as we found out yesterday morning, that wasn’t the case.
Where the invasion and future of Ukraine lies, it's hard to say. I tend to fall back on historical context to help determine the outcome as it relates to the stock market. For some context, here is a history of international war and conflicts over the past 90 years and their effect on the markets.
It’s also critical to remember the impact that a conflict between Russia and Ukraine will have on the rest of the world. The combined GDP between the two countries is approximately $1.5 trillion. We have three states (CA, TX & NY) that individually have larger GDP’s than the two countries combined. It’s not to make light of the casualties of war or the uncertainty that this brings to the global markets, however when the volatility settles it shouldn’t have major impacts to U.S. companies like Apple and Amazon. Russia isn’t the same global and economic power it once was and their standing in the world has a far lesser impact than it once did. This type of volatility is typically short-lived.
Inflation is a real threat today. The latest CPI reading was over 7% on a year over year basis ending in January. For perspective, one of the Fed’s “dual-mandates” is to keep the inflation rate around 2%. We’re obviously well above that right now.
As we’ve shared in past, there seems to be a few main drivers of the inflationary environment at the moment. The two major ones seem to be the unraveling of Covid through the supply chain. We continue to see major disruptions overall, from the semiconductor chip shortage impacting cars, to furniture and raw materials and anything in between. While this inflation is certainly real, this feels like it could have a shorter impact on overall cost of goods and services. On the other hand, we’ve seen tremendous wage growth over the last two years as businesses work to keep up with hiring and due to the strength of the labor market. This is the type of inflationary pressure you can’t just “put back in to the bottle.” This will be here to stay. While I do not believe we’ll continue to see 7% CPI readings, it feels like this could keep inflation above the 2% mandate for some time and is less transitory. I do expect to see downward movement in the CPI index as we move forward and stabilize coming out of Covid lockdowns.
Why is inflation so bad for stocks? Simply put, it comes back to math and calculating future cash flows to put a current price on stocks. When you insert a higher inflation multiple, your discounted cash flow from future earnings is lower. This is part of the reason why we are seeing lower stock prices from inflation concerns. Your seeing the biggest impact on the Nasdaq since its made up of mostly growth stocks which are typically priced for future growth potential. When inflation impacts that future earnings potential, you tend to see the biggest negative impact on these types of investments.
Federal Reserve Rate Hikes
The last major headwind we’ve been fighting over the past few months has been the Fed and the approaching fiscal policy we all expect. Given where inflation is today, the Fed has no choice but to raise rates moving forward. While the goal of rate hikes isn’t necessarily to cause a bear market / recession, the end goal of a rising interest rate environment tends to lead to a slowing economy which could cause a bear market. So the prospect of interest rate hikes are a concern.
But taking a step back and looking at the big picture, rising interest rates doesn’t need to be a threat for a continued bull market. The overall economy is strong right now, very strong in fact. We have unemployment at 4% and still adding considerable jobs on a month over month basis. Consumers are still spending on goods and services, and they’ve seen their overall balance sheet in the best shape, both through additional savings as well as the rise of home prices. Let’s not forget that it is most people's largest assets and can play a role in the overall strength of our economy.
Finally corporate America is in a place where they can withstand an immediate increase of interest rates. We’ve been in a low-rate environment for so long that we saw reserves and borrowing increase to the point where if we see an upward trend in rates moving forward they should be able to handle it in the immediate future. Lastly, we are starting at ZERO. We only have one way to go and that’s up. We can’t keep rates at zero forever, and past rate hikes from this current level did not stop the bull market in 2015 - 2018 when the Fed funds rate moved from zero to 2.5%.
While we expect this to cause shorter term volatility, it doesn’t need to signal the end to the bull market. We take many different angles when it comes to looking at the market and portfolios, and the fundamentals of corporate America and our economy are still relatively strong to support future stock market strength.
Big Picture Takeaway
It’s never easy watching the markets go through a pullback, and we’ll never make light of that. The headwinds we are experiencing between Russia, inflation and interest rates are real and we’ve seen the impact they’ve had during this latest market correction.
As discussed above, the rate of return and seemingly everyday surge in the stock market we saw from March 2020 through the end of 2021 was not sustainable. There was no predicting when it would peak, I would say that the headwinds above gave investors an opportunity to reassess their positions and provided the “excuse” to maybe unwind some trades that were getting far overvalued.
After the current markdown, the market overall is much better positioned moving forward. Forward P/E’s are now more in-line with historical averages, still over the last 25-year averages, but well within a comfortable range. With the added strength of the U.S. consumer and strength within corporate America, this bull market doesn’t need to come to an end. Volatility is expected, and it’s been a while since we’ve really felt it. Over the last 40-years, the S&P has average a 14% annual drawdown, while still ending the year positive 80% of the time. I don’t want to diminish the impact of the recent selloff, but we’re still in the range of a normal market selloff.
If you are unsure of what to do in today's market environment, feel free to schedule an initial consultation to learn more about our investment philosophy and process.
Written by: Ryan Bouchey