Market Update May 11, 2022
As we outlined in our early-year outlook commentary and presentations, we thought 2022 would be a “reset” year for equity markets. The extraordinary returns investors enjoyed over the previous three years left equity valuations high and markets susceptible to unforeseen outcomes – such as – more persistent inflationary pressures, surging bond yields, and aggressive hawkish policy shifts on the part of the Federal Reserve and other foreign central banks. Investors have also been forced to grapple with geopolitical uncertainties and a spike in commodity prices due to the Russia/Ukraine conflict as well as strict COVID-related shutdowns in China, which are adding to supply chain problems.
With the broad market (S&P 500 Index) down roughly 16% year-to-date as of Tuesday’s close, some of the reset process has taken place. Markets are in the process of adapting to the new reality where market liquidity and ultra-easy monetary policy are not the dominant drivers of stock market returns. Going forward, we expect fundamentals to matter a lot more than they have over the past decade.
As patient, long-term investors, we don’t proclaim to possess the ability to call market tops or bottoms. But with sentiment so negative, we feel there are a few positives worth mentioning. First, investor sentiment is so negative, which has historically served as a good contrarian indicator. In fact, sentiment readings are down to the abysmal levels that have historically signaled inflection points prior to market turnarounds. We were concerned with the euphoric investor attitudes and behavior last summer when SPACs, unprofitable tech IPOs, cryptocurrency, and non-fungible tokens were at the center of every investment conversation. That speculative froth has evaporated. Many of the hyper-growth pandemic darling stocks that soared in 2021 have plummeted by 60%-80% this year. Half of the stocks in Nasdaq Index are down more than 50% from their 52-week highs. We could outline a dozen other examples, but there are strong signs that investor attitudes have shifted from greed to fear.
Stocks have gotten cheaper. The broad market is now trading at a discount to the 5-year average valuation multiple and only slightly above the 10-year average. Looking under the hood, we see plenty of individual stocks we would categorize as being downright cheap. While valuation alone hasn’t been an extremely effective tool for identifying market bottoms, we do think it is an important determinant of future equity market returns.
The market is struggling with a range of near-term challenges. We put inflation firmly at the top of the list. Inflation remains in the driver’s seat and will dictate how aggressive the Fed needs to be in their path to normalizing interest rates. This path is likely to be the dominant driver of outcomes for both the economy and financial markets. The recently released April inflation report showed the first slight deceleration in monthly inflation readings in seven months. And we are now at the point where year-over-year inflation comparisons become more normalized. Going forward, the math makes it tougher for inflation to remain at such elevated levels. We haven’t seen enough evidence to call a definitive inflation peak but some small indications that we’re heading in that direction is a welcomed sign.