“In bear markets, stocks return to their rightful owners.” – J.P Morgan
As we’re all aware, 2022 was the most challenging year for investors since 2008, the beginning of the Financial Crisis. In an effort to bring down soaring inflation, which hit a 40 year high last summer, the Federal Reserve (the Fed), beginning in March, initiated a series of interest rate hikes at the fastest pace seen in decades. These higher rates and the presumption of slowing economic growth and weaker corporate earnings resulted in falling equity prices (the S&P 500 index finished the year down 18.9% on a total return basis) with growth stocks being the most negatively impacted, primarily technology companies. Those same rate hikes also resulted in the worst calendar year return for bonds since the 1930s, with the Barclays Aggregate Bond Index down over 13%.
Fortunately, Q1 of 2023 brought a “relief rally” as indicated below:
This rally seems to seems to be driven by a combination of factors, including: belief that the Fed has either finished raising rates or, at worst, might hike once more in May; that inflation, while still high, continues to ease; that corporate earnings have generally been better than expected and, finally, a grudging acknowledgment among economists and Wall Street participants that while the consensus view still calls for a recession this year or next, a “soft landing” scenario is still very possible. Further, if we do experience a recession this year or next, it may not be as severe as was once anticipated. Naturally all of this is conjecture and opinion. From the standpoint of market dynamics, one encouraging sign for equity investors is the high level of market pessimism and negativity from both retail and institutional investors. Negative market sentiment has historically been a contra-indictor of market performance. In other words, high levels of pessimism have more frequently been associated with market bottoms, oversold conditions and the end of bear markets and/or the early stages of bull markets. Although the “yield curve” is still inverted (a frequent precursor to recession) the spread between yields on 2 year and 10 year Treasuries has recently narrowed, another encouraging sign. In summary, while discussing current economic and market conditions has some usefulness, none of this information should impact an investor’s decision to own stocks as long-term investments. Whether we do or do not experience recession this year or next, and whether stocks do or do not perform well over the next quarter or even the next year should be largely irrelevant to long term, disciplined, patient investors. Investors who own equities do so – or should do so – for long term wealth creation, preservation of purchasing power and potentially increasing income over time through rising dividends.
Headwinds and Tailwinds – Our View
Over the next few quarters stocks should benefit from stabilized and, eventually, falling interest rates as well as declining inflation. These two factors have historically been “tailwinds” for equities for two reasons. First, price/earnings multiples often expand in lower interest rate environments. The price/earnings multiple refers to the price investors are willing to pay for every dollar of earnings. Second, corporate earnings often improve due to lower inflation, lower interest rates and lower operating costs in general, resulting in higher profit margins. The primary “headwind” for stocks going forward will likely be slower economic growth which could put downward pressure on corporate earnings and possibly stock prices. The reality is that no one – regardless of who they are or what they might claim – can accurately or dependably predict how stocks will perform over the short term. Further, economists and market strategists have shown little ability to accurately predict recessions, and the timing and severity of any recession. This is why it’s so important to understand that owning equities requires a multi-year time commitment and the ability to ignore short term price volatility, even when that volatility creates anxiety and psychological pain. The ability and willingness to remain patient and disciplined is often the primary difference between long-term investing success and failure.
Beware the Lure of Short-Term Yields
One of the most dramatic changes in the investment landscape in recent months is that investors, after a dozen years of earning virtually nothing on cash and minimal interest from bonds, can finally earn a reasonable, mid-single digit return from those investments. Today one can earn 4% plus yields from money market mutual funds, short-term Treasuries and other short-term investment grade credit. While these higher yields are clearly a positive for investors, one should be careful to use these investments appropriately – as short-term “parking places” for dollars or as a modest percentage of a balanced portfolio – not as a replacement for long-term investments, including stocks. If you’re investing in money market funds and bonds as a long-term replacement for equities, you might be making a mistake that could turn out to be quite costly over time. This is why.
Let’s assume an investor can earn a yield of 3.6% on a 3-year Treasury note, one of the safest credit investments in the world. While the principal value of that note will continually rise and fall in value until it matures in 2026, the owner of the note will have their investment principal value returned to them at maturity, assuming no default. Now let’s consider an alternative. Let’s assume these same dollars are invested in a fund that owns stocks comprising the S&P 500 large cap stock index, an unmanaged index of large, publicly traded U.S. companies. Currently that index is producing a dividend yield of approximately 1.6%, a differential of 2 percentage points between the index and the Treasury note. With the S&P 500 trading at approximately 4,100 at this writing, the index price level would need to increase just 246 points to 4,346 over the next 3 years for the total return (price change plus dividends) of the index fund to match the return produced by the Treasury note. To put this in perspective, the index as of December 31, 2021, 15 months ago, closed at 4,766. While no one can predict how stocks will perform over time, this is an interesting metric to consider. In other words, assuming one can accept the significant short-term price volatility associated with stocks, the possibility that stocks may outperform Treasuries over the next few years doesn’t seem to be too big of a stretch. Naturally, there’s a substantial difference between Treasuries and stocks as investments and those differences should be carefully considered before any investment is made. The point here is that the “easy” investment decision, or the one that might feel the most comfortable or safest at the time, with benefit of hindsight, may not be the best long-term decision.
In summary:
• Market volatility will likely remain elevated through the rest of this year.
• Pessimism and economic cynicism will likely continue even after stocks are well off their lows and on their way to recovery and the next bull market.
• Investors will likely remain underweight stocks well into the next bull market.
• Investors who have become enamored with short term yields and holding substantial amounts of cash may be disappointed in the future if or when the Fed begins cutting rates and money market fund yields fall as a result.
• Investors who maintain a long-term, multi-year view and can handle high levels of price volatility over weeks, months and even quarters should benefit from owning equities over the long term from both price appreciation and potentially rising dividends.
We hope this information is helpful. Please feel free to call us or stop by the office at any time if you have questions or concerns or if you’d like to discuss the markets or your portfolio. As always, thank you for your trust, your confidence and your business. Have a wonderful week.
W. Edward Sutton
President and Chief Investment Officer
The Sutton Wealth Advisors Investment Committee
W. Edward Sutton
Zachary Sutton, CFP®, EA
Derek R. Gage, CFA
The information contained herein (1) is intended solely for informational purposes; (2) is not warranted to be accurate, complete, or timely; and (3) does not constitute investment advice of any kind. Neither Sutton Wealth Advisors, Inc. nor Purshe Kaplan Sterling Investments is responsible for any damages or losses arising from any use of this information. Past performance is not a guarantee of future results.
Securities offered through Purshe Kaplan Sterling Investments (PKS). Member FINRA/SIPC. Some employees of Sutton Wealth Advisors, Inc. (SWA) are registered representatives of PKS. SWA is otherwise not affiliated with PKS. PKS’s SIPC coverage only applies to those assets held at PKS and that other custodians may be SIPC members and that clients should contact those custodians directly or refer to their coverage specifically.
