John Gorlow
| May 14, 2022
Stocks saw a sharp pullback in May as the Federal Reserve made it clear that it would aggressively fight inflation by approving the biggest interest rate increase since 2000. The Fed plans to shrink its massive bond holdings, and signaled that it will work to cool the economy and tamp down the fastest rise in prices seen since the early 1980s.
The speed of inflation’s rise has deeply unsettled markets and investors. But there may be other factors behind the recent surge in market volatility, such as the unwinding of leveraged trades or the possible liquidation of funds following big wrong-way bets.
The two-year Treasury Note yield, which tends to lead the Federal Funds Rate, has soared from just 0.16% a year ago to 2.73% on 3-May 2022.
The ten-year US Treasury yield rose sharply from a record low of 0.51% on 31-July 2021 to 3.12% on 6-May 2022. The thirty-year mortgage rate jumped from 3.29% at the start of this year to 5.45% last week.
The Nasdaq Composite entered a bear market, falling 29.58% from its record high on 19-November 2021 through 12-May 2022. The S&P 500 is down 19.92% from its record high on 4-January 2022. For April, the S&P 500 plunged nearly 9%, its worst monthly decline since the Covid shutdown of March 2020.
According to the American Association of Individual Investors, the share of people who believe the stock market will continue to fall over the next six months is at its highest level since March 5, 2009, just days before the S&P 500 hit its closing low during the Global Financial Crisis.
Deep investor pessimism is also reflected in the ratio of price to forecasted earnings of the S&P 500, which has fallen from 21.5 to 17.5 since November 2021. This decline reflects the drop in the S&P 500, as well as a rise in the expected earnings per share of the underlying components.
Market strategist Edward Yardeni (Financial Times, 05/10/2022) believes this data indicates that investors are much more concerned about a possible recession than industry analysts are. This pessimism may not be warranted, he writes, noting that despite concerns about inflation, US consumers are in good shape with significant savings, and the labor market is healthy.
Yardeni also points out that non-financial corporations have refinanced their debts and still have plenty of cash on their balance sheets after raising $2.3 trillion in the bond market over the past 24 months.
He adds that most of the drop in the S&P 500 valuation multiple so far this year has been attributable to eight mega-cap stocks including Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla. Currently these stocks account for 23% of the market capitalization of the index. Between them, the five biggest names among these eight stocks have shed nearly $2.6 trillion. This fast decline follows a rapid, steep rise. Collectively, the forward P/E of these stocks soared during the first year of the pandemic to about 35. It is now down to 25.
Are we likely to see a recession? We don’t have a crystal ball to know the answer. But Yardeni is in the correction camp for now, and expects to see the S&P 500 in record-high territory again next year. He predicts inflation will peak this summer between 6% and 7%, then fall to 3% to 4% next year without triggering a recession. One can hope his outlook is correct.
What the Data Reveals About Bond Performance
Rising interest rates have caused bond prices to fall, producing negative returns across most segments of the US fixed income market in 2022. The Bloomberg US Aggregate Bond Index is down -9.44% year-to-date. Short-term fixed income has fared better given its lower sensitivity to changing rates, but it is still down -3.93% since the start of the year. Bond losses of this magnitude haven’t been seen since the early 1980s, presenting investors with tax-loss harvesting opportunities that are typically reserved for riskier equity allocations.
When will fortunes reverse? Should one hold on to bonds or switch to cash? Perhaps surprisingly, research shows that previous bond bear markets have been met with new highs in as little as two months.
Consider the chart below. Before today, the period of the greatest bond drawdown in modern history was from August 1979 to February 1980. The drawdown lasted seven months, and it took another three months for bonds to recover. The forward-looking three-year return was 7.13%.
|
Drawdowns for Bloomberg U.S. Aggregate Bond Index (worst 10)
|
|
Rank
|
Start
|
End
|
Length
|
Recovery
By
|
Recovery
Time
|
Underwater
Period
|
Drawdown
|
*Forward
3YR Ret
|
|
1
|
Aug-79
|
Feb-80
|
7 months
|
May-80
|
3 months
|
10 months
|
-12.50%
|
7.13%
|
|
2
|
20-Aug
|
22-Apr
|
21 months
|
|
|
?
|
-11.08%
|
|
|
3
|
Jul-80
|
Sep-81
|
15 months
|
Nov-81
|
2 months
|
17 months
|
-9.02%
|
11.75%
|
|
4
|
Feb-94
|
Jun-94
|
5 months
|
Feb-95
|
8 months
|
13 months
|
-5.14%
|
6.37%
|
|
5
|
Mar-87
|
Sep-87
|
7 months
|
Dec-87
|
3 months
|
10 months
|
-4.90%
|
7.40%
|
|
6
|
Feb-84
|
May-84
|
4 months
|
Jul-84
|
2 months
|
6 months
|
-4.88%
|
17.69%
|
|
7
|
8-Apr
|
8-Oct
|
7 months
|
8-Dec
|
2 months
|
9 months
|
-3.83%
|
5.81%
|
|
8
|
Dec-81
|
Dec-81
|
1 month
|
Mar-82
|
3 months
|
4 months
|
-3.74%
|
18.28%
|
|
9
|
13-May
|
13-Aug
|
4 months
|
14-May
|
9 months
|
13 months
|
-3.67%
|
2.91%
|
|
10
|
3-Jun
|
3-Jul
|
2 months
|
4-Jan
|
6 months
|
8 months
|
-3.55%
|
2.05%
|
|
*Annualized
|
When considering bond performance from a broader perspective, what the chart reveals is that annualized returns are strongly positive over the subsequent 36 months across all observations. In other words, yesterday’s rising rates do not guarantee lousy bond returns tomorrow.
Since the earliest days of bond investing, it has been challenging for researchers and investors to accurately predict whether bond yields will go up or down, or how fast and long a trend might continue. For the average investor, anxiety over current yields may be counterproductive if it forces a change in strategy. Was your fixed-income allocation appropriate just a few months ago? Is it somehow less appropriate now that bonds generally have higher yields? Higher yields represent lower prices today, but higher returns later since bonds must still mature at their par values.
For most investors, the exposure and duration of bonds held in a portfolio before rates began to rise is still a reasonable default position unless life circumstances have changed in some fundamental way. Jumping out of fixed income and into cash, or making a large shift in duration today based on what’s happened over the past few months, will not necessarily lead to a better outcome. As Avantis Investors recently framed it, “Trying to avoid the worst of times today might just mean you miss out on the best of times to come.”
Without doubt, bringing down inflation is likely to cause further pain. Fed Chairman Powell said so quite bluntly in an interview with Marketplace yesterday. A great deal of pessimism is already priced into the market. While some believe the market has over-reacted, there’s no way to know.
As investors seek safety, other losses could create more volatility. For instance, crypto assets recently went on a steep downward spiral, with Bitcoin losing 60% of its value since November 2021. Broader financial markets have so far seen little spillover effect, but that could change. The open question is whether what happens in crypto stays in crypto or forces the sale of other asset classes that affect stock and bond performance.
As always, the best defense during turbulent times is a well-built strategy and the willpower to stick to it. Making changes based on fear is unwise. Markets are resilient and will always find a way back to equilibrium. It may take longer than feels comfortable, but the alternative is to lock in avoidable losses and risk missing the recovery when prices rebound.
If you have questions or concerns about your asset allocation, please contact me. I am here to help.
Regards
John Gorlow
President
Cardiff Park Advisors
888.332.2238 Toll Free
760.635.7526 Direct
760.271.6311 Cell
760.284.5550 Fax
jgorlow@cardiffpark.com