As most of us know, U.S. stocks over the past three weeks have experienced declines from their beginning of the year values. After three consecutive years of equities producing double-digit gains, a market “correction” (decline of 10% from the highs) or even a “bear market” (a decline of 20% or more) at some point isn’t unexpected or surprising. In fact, the surprise would be if we DIDN’T have a correction of some sort this year. Investor nervousness has increased due to a number of issues, including:

  • Inflation well above expectations and concern that inflation might run hotter and last longer than anticipated even just a few months ago.
  • Rising short term interest rates. The Fed has told us that 4 or more rate hikes are likely in 2022. These hikes, along with ending their bond buying activities, will produce tighter monetary conditions that could negatively impact growth.
  • Geo-political concerns. The possibility of Russia invading the Ukraine and China possibly moving against Taiwan would be politically and economically disruptive and indirectly impact market sentiment.
  • Stocks are trading at relatively high valuations relative to historical averages. At this writing the S&P 500 index is trading around 4,300, about 10% below its all-time high. With 2022 consensus earnings estimates for the S&P 500 of $222, the S&P is trading today at around 20 times expected earnings, which is higher than historical averages but arguably justified given today’s low interest rate environment. If GDP growth this year comes in at 4%, which is the Federal Reserve’s estimate, it’s reasonable to expect continued strong earnings growth even with the headwinds of higher inflation, higher interest rates and tighter monetary policy. After all, for most of the past decade corporate earnings experienced strong growth and stocks performed very well while GDP growth was consistently in the 2.0% to 2.5% range.

What Can We Expect in a Higher Inflation, Higher Interest Rate, Slower Growth World Going Forward?

In spite of some obvious potential headwinds, we believe there’s reason to remain cautiously optimistic about economic growth and earnings growth throughout 2022 and probably into next year. Below are a few of those reasons.

  • Strong corporate balance sheets. Corporate America has rarely been in better financial shape than it is today. Low interest rates have made capital for expansion very inexpensive and many companies are flush with cash. This cash will be used for a variety of reasons, including: higher dividend payouts, share buyback programs, capital expenditures to fund growth and business expansion via mergers & acquisitions. All of these options should be beneficial to shareholders. Speaking of dividends, S&P 500 companies today are paying out only 35% of their earnings in dividends versus 50% historically. There’s good reason to believe that higher dividend payouts are coming.
  • Financially healthy consumers. U.S. consumers are in better financial shape today than ever before. The unemployment rate is low, personal incomes have risen and saving rates are extremely high. Home prices have soared, stocks have enjoyed double digit annual gains for the past three years and monetary and fiscal stimulus has pumped trillions of dollars directly into the hands of both businesses and consumers. Presently there is over $2 trillion of cash sitting on the sidelines. Even after the Fed begins to increase short term rates and gradually begins to withdraw “excess liquidity” from the economy, there should still be significant amounts of cash in the system to fuel economic growth and earnings growth through 2022 and beyond.
  • Stocks should remain attractive relative to other investment options. This is sometime referred to as the TINA principal as in “there is no alternative”. With inflation running around 7% (hopefully declining to the 3% to 4% range by year end) cash is producing a negative real investment return, meaning return after the impact of taxes and inflation. Since the value of money is measured by purchasing power, this is not an issue to take lightly. Owning supposedly “safe” assets such as cash and short-term bonds producing negative real returns is sometimes referred to as “going broke safely” While bonds typically produce higher levels of interest income than cash they’re also at risk of price declines from rising interest rates. Does this mean investors shouldn’t own any bonds in this environment? No, but it does mean that great care should be taken with regard to the type of bonds one owns. Last, it’s imperative to keep stock market fluctuations in perspective when prices are bouncing around as they have this month, sometimes moving as much as 3 or 4 percentage points in a single day. The next time you hear the “financial media” obsessing over what they term a “plunge” in stock prices keep in mind that over the past 35 years the AVERAGE fluctuation in any given year from high point to low for the S&P 500 index is just over 14%, and every 5 years or so it’s twice that amount. The reality is that NOT having a decline of 8% to 10% or more during any year would be unusual and the exception. Acknowledging, accepting and tolerating this kind of short-term price volatility is the “cost” of owning equities and why stocks have produced higher returns over long periods of time than other assets such as bonds and cash.

So What Should We Do Now?

The short answer is this – the same things investors should do and always do if they want to be successful over the long term, as follows:

  1. Stay diversified, well balanced and patient. No one, including us, can predict short-term price movements of stocks. Trying to time the market is an exercise in futility that almost never ends well. Time in the market – not timing the market – is the key to long term investing success.
  2. Remember that stocks simply represent ownership in operating businesses. As such, by their very nature, they are long term investments. If you’re evaluating the success or failure of stocks over a few weeks or months rather than years, you’ve misunderstood how stocks function as investments and should either revaluate how you view them as investments or perhaps you should avoid stocks altogether. The former, by the way, is a much more preferable and profitable option than the latter.
  3. Remain disciplined, especially during periods of high volatility and market declines. It’s very easy to make poor investment decisions when we’re excited and optimistic or when we’re frightened and pessimistic. Be pro-active and logical with your decisions, not reactive and emotional.
  4. Understand the difference between owning one stock or a few stocks and owning an entire index or market of stocks. Individual companies can, and sometimes do, fail and become worthless while an index representing hundreds of companies might decline in value but will realistically never go to zero.
  5. Remain committed to your investment plan. Never let the headline news – whether economic, societal or political – dictate your long-term investment decisions.
  6. Never underestimate the power of the U.S. economy. Capitalism, technological innovation, economic freedom, entrepreneurial risk taking and hard work have built this country into the greatest wealth creating society in the history of the world, providing our citizens with the highest standard of living the world. That’s not to say America doesn’t have problems because we certainly do and we can always strive to be better. But there’s a reason why millions of people around the globe literally risk their lives to participate in the American dream. To paraphrase the greatest investor of the past century, Warren Buffet, “no one has ever become rich betting against America”.

We hope you found at least some of this information interesting, informative and perhaps thought provoking. Please feel free to call us at an anytime to discuss your portfolio or any other items of interest. As always, thank you for your trust, your confidence and your business.