*Bitcoin performance tracked over a 7-day period ending 21st August 2022
The three major indexes ended lower this week, snapping their longest weekly winning streak since November.
After notching its worst first half since 1970, the S&P 500 had bounced some 16% from its mid-June low, fueled by stronger-than-expected corporate earnings and hopes the economy can avoid a recession.
This week, however, it seems like investors remembered that the Fed is planning to continue hiking interest rates in an effort to cool down the economy even more.
S&P 500 Year-To-Date Performance
Inflation vs The Economy
Unfortunately, this economic contraction is a necessary evil and the most obvious way out of the current inflationary environment.
While recent inflationary data has been positive and pricing pressure has been on a downward trend, we are not out of the woods just yet. As we move forward, the focus will likely shift from rising inflation to softening economic data and the negative effects this may have on company earnings.
For now, we are likely in the interlude between inflation peaking and economic data slowing significantly, somewhat of a momentary sweet spot.
Remember, there will always be risk. The particular risk that we are most preoccupied with just changes over time.
I’m not bearish, but I do think that return expectations need to be modified.
We have just ended a period of unprecedented liquidity. Money was free. The Fed Funds Rate sat at 0.3%. The 10-year Treasury was 0.72%. The federal reserve doubled its balance sheet from $4.5 Billion to $9 Billion.
These were not normal conditions, and these conditions gave rise to unadulterated risk-taking.
The market is now resetting to more ‘normal’ market conditions where the Fed is no longer willing to remove any and all downside risk.
It seems like every time something bad happens in the economy we decide we need policies to keep it from ever happening again.
But growth, or sustainable growth, and risk go together. And if you try to remove risk, you either get stagnation or, more likely, huge distortions that cause even more trouble,
Sustaining growth requires innovation, and that does not happen without risk
Moving forward, the market recovery is more likely to be more U-shaped than V-shaped this time around, as the liquidity and support that fueled previous reversals get stripped out of markets.
The below chart shows the growth of the Fed’s balance sheet (white line) relative to the growth in the S&P 500 (blue line).
Fed Balance Sheet vs the S&P 500
You can see the strong correlation. (with a lagged effect) between the two. As the Fed pumped money into the system over the last ten years, stocks have moved in tandem. The removal of this liquidity will likely act as a drag on future stock prices.
That’s not to say that upside doesn’t exist. There is still an abundance of companies with the ability to generate consistently strong earnings over time. Still, the general upward trend of the market may be slower relative to what we have experienced in recent years. Liquidity pulled forward a lot of the expected returns, and that will take time to reset.
Not For Profit Companies
Be warned; while I think stock prices can increase, the market will be more selective with who it rewards.
Some of the over-exuberance in the market is still being stripped out. We have seen multiple companies fall by 75% or more, but many of these were built on a narrative that no longer exists.
If you are still clinging onto multi-year non-profitable growth stocks with the hopes of a mean reversion, think again. Many of these companies are not and never were viable operations.
Not everything is ‘Buy-and-Hold.’ You need to know the difference between a market-induced drawdown in a company’s stock price and a drawdown caused by growing idiosyncratic risk and material changes in the outlook of the underlying business itself.
Conviction in any company you invest in is important but don’t blindly hold that conviction over time without understanding how the business and the environment in which it operates change over time.
More than 40% of all companies that were ever in the Russell 3000 Index experienced a “catastrophic stock price loss”, which we define as a 70% decline from peak levels which is not recovered.
Don’t just assume these stocks will come back. Many of them don’t.
Chart of the Week
The World Economic Forum Published a Chart this week showing house Price-To-Income ratios around the world.
Some surprising names at the top of the leader board.
Now is the time to take advantage of the current market conditions. To learn how we can help, simply follow the link below.