Quarterly Market Review and Outlook
2022 Q3 Market Re-Cap
The challenges of the first six months of 2022 did not subside during the third quarter. Although, there was a brief respite during July, inflation data remained high and growing fears of a Federal Reserve induced recession caused the U.S. stock market to retest the year to date low. At this point, market participants are viewing almost all data through a negative lens.
Through the 3rd Quarter, U.S. stocks are down this year between 17%-33% depending upon the index.iii
International stocks performance is mostly in line with U.S. stocks.iii
As we have continuously said, the U.S. bond market is having its worst year in 50 years. Typically, bonds are held in portfolios to offer stability during stock market declines and to provide an income stream. Unfortunately, bonds haven’t been able to play this role in 2022. Year to date, the U.S. bond market is down over 14%.iv International bonds have fared only slightly better.v
2022 Q4 Outlook & Beyond
U.S. Stock & Bond Market Situation
Unless someone has been living under a rock, everyone sees the pain that has hit financial markets. We want to be honest in our assessment of the situation, but hopefully provide a bit of perspective and encouragement.
First, we think that the prospects of avoiding a recession are slim over the next year or so. By the traditional definition (i.e., two consecutive quarters of negative GDP), we are already in recession. However, the Atlanta Fed projects 3rd Quarter GDP to be around 2%vi and companies continue to look to hire. Our sense is that we are not in a recession now but could slip into one in 2023.
Second, if the U.S. does go through a deep recession that includes higher unemployment, increased default rates, lower corporate earnings, and decreased home values, then it would be reasonable to expect more stock market pain. From a historical perspective, an average Bear market stock decline (i.e., at least a 20% drop from a recent high) is approximately 40% and lasts 20 months.vii The S&P500 index is already down 23% year to date—the NASDAQ is down 33%. So, there could be a bit more pain in the stock market in the coming months and quarters. Obviously, we don’t have a perfect crystal
ball, so this is just looking at possibilities through a historical lens.
Third, it is quite common for people to assume that the current, or next, recession will be remarkably similar to the previous recessions. At this stage, we would suggest that the landscape is different than pre-2008. Lending practices have been much stricter over the last ten or so years when compared to pre-2008. Also, so many people refinanced in 2020 and 2021 that interest rates servicing mortgages should be very supportive.
Additionally, while the primary inflation problem is due to the abundance of liquidity within the financial system, people and businesses generally speaking have cash. It is our hope that these excess cash reserves will serve as a bit of a safety net if the economy continues a downward turn. Currently, the M2 money supply in the U.S. (i.e., almost all the liquidity in the financial system) is at, or near an all-time high.viii This is a double-edged sword—the M2 supply explains the 40-year record inflation but is also the source of cash that will help provide liquidity when times get hard.
Finally, other asset classes that have not been viable options in many years are starting to look attractive. For instance, certificate of deposit rates are higher than we have seen in 15 years. We have begun to add CDs to accounts, where appropriate, and plan to continue.
Recession Investment Management Strategy
First, our strategy this year has been to under allocate to risk assets. In most cases, we have lowered allocation to stocks and raised allocation to cash. That has helped more than any other single factor this year.
Second, we want to absolutely adhere to our client’s unique investment objectives, financial goals, and timeframe. As we have said time-and-again, if you have a tolerance for investment risk and have a timeframe of greater than 10 years, taking dramatic action like going to 100% cash may not be prudent. When we say 10 years, we mean 10 years from your life expectancy. A person aged 60 has a life expectancy of approximately 20+ years—we view that as the real timeframe. Getting to retirement is not the finish line. When you draw your last breath is the real finish line.
Third, as we mentioned above, we have added and look to continue to add CDs to accounts, where appropriate. When we can find 6-month CD rates that approach 4%, we believe that is a great alternative to money markets and a good place to store “safe” money. We are mostly keeping maturities short, so it allows us flexibility to reinvest elsewhere if market conditions change. We also anticipate the Federal Reserve to continue to raise interest rates in the months ahead—that could boost yields even higher.
Finally, we would caution against a complete selling of all stocks. As said earlier, we don’t have a perfect crystal ball. We like dividend payers and certain sectors like energy. We think selection is critical, but also think it’s prudent to continue to have some selective allocation here. The stock market will start to recover long before the economy turns—oftentimes it’s when the economy seems at its worst that the stock market starts to rise. Remember how terrible the economy was in 2009? It turns out 2009 was the best time to buy stocks in our lifetime.
Politics and Economic Policy
As the mid-term elections are less than a month away, many will be paying close attention to tight races in the House and Senate. Currently, the Democrats have an 8-seat advantage in the House of Representatives and the Senate is tied, 50-50. We will only focus on the potential economic impacts of the election and leave the social impacts to another forum.
As we stated above, a significant reason for the elevated levels of inflation is due to record liquidity within the financial system. If you look at the M2 graph over the last 10 years, you will notice a huge spike during and after COVID.ix This directly relates to governmental payments of all kinds during and following COVID. In short, the primary reason for the highest inflation in 40 years is due to government spending during and after COVID. The necessity of this spending can be debated, but its impact should not be up for debate.
The relevance, as we see it, is that we would expect higher governmental spending should Democrats control Congress and the White House versus a split Congress. Republicans are not without sin here. Democrats, however, proposed a $10 trillion dollar spending bill.x Democrats argue that higher government spending won’t produce additional inflationary pressure. We think that’s obviously not the case.
A split Congress or a Republican controlled Congress with a Democrat controlled White House should result in little to no NEW spending. xi In this case, we view dividend government as a good thing.
The website maintained by Real Clear Politics predicts the Republicans will control fifty-two seats in the Senate after the November election. They project Republicans to take control of the House and to send Nancy Pelosi to Italy (it’s rumored that she is lobbying to be the U.S. Ambassador to Italy should she lose her Speakership).
These are frustrating times. The last two years has seen a lot of unprecedented upheaval, controversy, unnecessary government spending, and emotion. We encourage people to remain optimistic. We still live in the greatest country in the history of the World—that is a simple fact.
Clients hire us to give them financial advice and to manage, in many cases, their life’s work. We do that without fear and emotion, with great patience, and with a long view. There are plenty of reasons to be optimistic about 2023—albeit perhaps mid to late next year.
Some of our most trusted economists and forecasters feel that markets are beginning to reach levels of value not seen in several years.
Bob Brinker: “Combined with our estimated price/earnings ratio range of 18 to 20 times forward earnings, we expect the S&P 500 Index to challenge its record high by the second-half of 2023.”xii
Kiplinger: “After a brutal first half of the year, bonds are starting to look a bit better…”xiii
Brian Wesbury: “If you’re a very long-term investor who doesn’t want to time the market…just maintain your normal allocations to stocks and don’t be shy about continuing to buy stocks at your normal intervals.”xiv
J.P. Morgan: “Forward P/E 25-year average = 16.84. Current forward P/E = 15.15. Shiller’s P/E 25-year average = 27.97. Current Shiller P/E = 27.15.”xv ***Lower P/E ratios generally represent greater value.***
We are looking to be cautious and prudent, but open to opportunities. We encourage clients to adopt a similar mindset.
It’s worth saying that we are looking to grow and expand our business. We appreciate referrals to your family members, friends, and colleagues who may not be blessed with a good financial advisor! Many thanks to you that have kindly sent people our way.
As always, should you have questions or need to update us on your situation, please do not hesitate to contact us. Thank you for your continued trust and confidence. We hope that you and your family have a blessed Fall and Holiday season!
vii “Market Insights: Guide to the Markets®.” J.P. Morgan Asset Management. U.S. 4Q 2022. September 30, 2022. Page 16.
xii Brinker, Bob. “Bob Brinker’s Marketimer.” October 2022. Volume 37. Number 10.
xiii “The Kiplinger Letter: Forecasts for Executives and Investors.” August 18, 2022. Volume 99, Number 33.
xiv Wesbury, Brian S. & Stein, Robert. “Monday Morning Outlook: More Trouble Ahead.” First Trust. September 26, 2022.
xv “Market Insights: Guide to the Markets®.” J.P. Morgan Asset Management. U.S. 4Q 2022. September 30, 2022. Page 5
Securities offered through First Heartland Capital ®, Inc., member FINRA/SIPC. Advisory Services offered through First Heartland ® Consultants, Inc. Walker, Higgins & Associates, LLC and Walker, Higgins & Associates Wealth Management, LLC are independent of First Heartland Capital ®, Inc. and First Heartland ® Consultants, Inc.