The world’s stock markets have been volatile so far in 2022. The S&P 500, our preferred index to measure U.S. stocks, is down -13.3% as of April 29. The year started following the momentum of a strong fourth quarter of 2021, with the S&P 500 up on January 2nd and 3rd. But on January 4 the market started on a clear downward slope that led to an initial low point on January 27. The markets had a partial recovery over the next two weeks, then another clear drop to a low on March 8. Another partial recovery followed, only to lead to another decline with a low very close to, but not quite at, the March 8 low on March 26. April 29 then set a new YTD low down over 3.5% that day. In today’s Financially Speaking we want to look more closely at the markets, the volatility we are seeing, and try to put it all into some perspective. I don’t often write about market gyrations, but now being into a down year for a full four months I thought it appropriate. As always, the team at Barron Financial Group are only a phone call or email away if you have further questions or prefer a personal discussion.
How We Got Here
Getting some perspective, let me start by saying that the market as of April 29 was at a level last seen in May 2021. Volatility, yes, but not exactly a washout in our view. Technically, we are not yet in formal “correction” territory. Now let’s move on to some history. The S&P 500 has been the best performing stock market in the world for the last three years. In 2019 the return was almost 29%, in 2020 the return was over 16% and in 2021 it was just under 27%. This as, for at least the last two years, the U.S. and the rest of the world were dealing with the COVID pandemic. Those returns are impressive and were driven by companies that adjusted quickly and effectively to the pandemic conditions. Also, government support needs to get some of the credit. The U.S. government provided three stimulus payments along the way to help struggling citizens and businesses cope with the brief recession and pandemic effects. The first payment came in April of 2020, shortly after COVID had been labeled a global pandemic, at a cost of $292 billion. The second round of payments came in December 2020 at a cost of $164 billion. The third round of payments came in March 2021 at a cost of $411 billion.
These stimulus payments did, in fact, support the U.S. economy. Without this government support I am confident that the brief recession we experienced in 2020 would have been much more serious. People out of work were provided enhanced unemployment benefits that helped them maintain. Businesses had access to the PPP (Paycheck Protection Program) that helped them survive. And that personal/business stimulus combination resulted in a high level of demand for goods, and in particular goods associated with improving life at home, where so many were stuck during the pandemic. The problem started to form as demand was increasing at the same time that supply chain issues developed due to pandemic-induced labor shortages. As that demand/supply mismatch continued, and large amounts of stimulus money further pushed demand, inflation became the reality. Inflation got its first notice in April 2021 at 4.2%, well above the Federal Reserve (Fed) target of 2%. By March of 2022 inflation had increased to 8.5%. Theoretically, inflation happens whenever you have more demand than supply. Further, high levels of money in an economy create demand and if that demand exceeds supply, inflation will result. By the time we got to the third stimulus payment the M2 money supply, normally up 6% per year, was up almost 40% in a year. That is the definition of a high level of money in the economy. Now, to be fair, there was no good way to know that the three stimulus payments would cause this. But one analyst did say something to the effect that the U.S. had a $500 billion pandemic economic gap that the U.S. Congress filled with $1.9 trillion stimulus. It’s hard to say if that is true, but we think there is at least some evidence of its truth.
And this condition is exactly what we believe is driving our current market volatility. Inflation seems somewhat entrenched, and it will need to be addressed by the Federal Reserve (Fed) raising interest rates. And historically, raising rates to tame inflation has caused recessions. And recessions are not normally good for stock markets. So, we have three very good years in a row with very positive returns. Now, we enter the fourth year with increasing concerns about inflation, a possible recession, pandemic-induced labor and supply chain issues, rising interest rates and questions about what the Fed is going to do to help navigate this storm. And then, on top of it all, in February Russia invades Ukraine with potential NATO repercussions. For us, that is more than enough uncertainty to unleash market volatility.
From Here to Where?
In the big picture, and overlooking sometimes emotional day-to-day gyrations, the stock market sets prices using only three important points. The first is corporate earnings; where are they and where will they go looking ahead? The second is interest rates and how we discount corporate earnings into the future. The third is the confidence level we have regarding the answers to items #1 and #2. On the first point we have corporate earnings at all-time highs, and with a possible recession coming those future earnings are very much in doubt. On the second point we know interest rates are moving higher, perhaps aggressively so. How far will it go, no one knows. And to the third point the answers to items #1 and #2 are extremely uncertain. We may have our own opinions, but we have to be honest about how far off those opinions might be. So, the third point is that confidence levels about future earnings and interest rates are low. And this is the key to why we have the market volatility we have.
From here we offer our views on how this situation might evolve. We believe that the combined issues of labor and the supply chain are improving and will continue to do so. All of the M2 money floating around will take time to shrink, but the Fed can help with that. And as we continue to exit the pandemic, we believe these issues will gradually self-correct. We believe the markets can end the year at least back to breakeven, if not at a small gain. That’s not to say the volatility is over. No, we feel until the Fed increases rates enough to slow the economy and labor market investors won’t be satisfied that a degree of control is happening. We expect a ½% rate increase in May, then at least another ½%, or even ¾% rate increase, if not ½%, in June. By the July Fed meeting we expect some better sense of direction on inflation and with that a reduction in market volatility. We expect to be mostly past this volatility by August. Admittedly, we could be off by a month or two in this projection. In the end this means we are using this volatility as a buying opportunity.
I remain convinced that the three stimulus payments made by the U.S. government were done with the best of intentions. Is it possible that it went too far and caused inflation? Yes, but there’s no way to confidently know for sure. So, it is what it is. Now we have to hope that the other underlying conditions that we know were part of the inflation story can and will be addressed soon. And that we won’t need a recession to tame inflation. We believe the fundamental U.S. economy is strong and we feel that will become more obvious as the year proceeds.
My final point to consider is that like most market conditions there are a variety of ways to explain it. We’re giving you our point of view as best we see it, but no one knows for sure how this will all evolve. And, we still have the complete unknown of what will happen in Ukraine. We hope we’re right about things getting resolved by year end.
All the best,
Barron Financial Group, LLP is a fee-only Registered Investment Advisor regulated by the Connecticut Department of Banking.
This newsletter is for general information only and should not be considered investment advice. Investors should consult with a trained investment professional to discuss their particular situation.