US markets had their worst start to a calendar year since 1970, with the S&P 500 losing ~20% in the first 6 months while the NASDAQ is down almost 30%. To answer the question of what lies ahead, let’s take a step back and review how we got here – below is the chart of the S&P 500 from the start of 2020 through June 30, 2022:
This chart is intentionally devoid of numbers, events, and datapoints – as these will be added as we go. Over this period, the S&P 500 returned 8.2% annualized/21.97% cumulative, including the current bear market. Not as good as it was (if measured from the top in January 2022), but still a respectable return in the face of a pandemic, high inflation, and geopolitical volatility.
To spotlight a few specific datapoints, the S&P 500 peaked around 3,400 pre-COVID, then following the COVID downturn, went on an absolute tear, culminating in a bull market high around 4,800 in January 2022:
As mentioned in the opening, to know where we are going, we should discuss where we’ve been, and specifically, some of the unprecedented events over this particular period:
As we continue to add to the original chart, here are the notable fiscal packages passed from 2020-2022 (each 💰 equals $1 trillion of stimulus):
Last, and certainly not least, let's add the various monetary policy actions taken by the Fed (each “Jay Powell” Emoji equals a policy action):
What this new, (hopefully) improved chart shows is just how much support policymakers provided during this 26-month period (and recent removal of support indicated by the upside-down Jays). The results of this support was nothing short of miraculous. Businesses were forced to shut-down, tourism went dormant for ~18 months, and somehow the economy emerged relatively unscathed – even stronger depending on the datapoint measured. A textbook case of policymakers stepping in when no one else would to support economic activity. But the $5 trillion dollar question facing the economy and investors alike is quite simple: Was the support too much and what happens when it’s removed?
Was the support too much and what happens when it’s removed?
The jury is still out whether too much support was provided, but current indications suggest that it was a little much. The American Rescue Plan passed in March 2021 seems to get most of the blame for “piling on” as the recovery seemed imminent. However, I will give policymakers the benefit of the doubt here, as one could easily argue that providing too much stimulus vs. too little was preferable based on the 2008 housing crisis and slow recovery that followed.
So, what happens when the support is removed? Well, the downturn in equity markets is likely related to the double whammy of fiscal stimulus ending and monetary tightening. The end of fiscal stimulus is proving that revenue growth expectations were a bit unrealistic, while monetary tightening is increasing borrowing costs - tough conditions to grow profits, even for the most resilient companies. The excess support also provided the kindling needed to fire up inflation. As such, the act of stopping that support should moderate inflation. We are starting to see signs of this, but nothing concrete enough to declare victory. With that said, don’t be surprised if inflation starts to moderate over the next 12 months.
What does all of this mean moving forward?
In hindsight, it seems obvious that there were excesses in the system in late 2021 – from valuations in global equity markets, to Bitcoin crossing $65k, and digital rocks selling for millions of dollars. Since the end of 2021, market prices have fallen and the market doesn’t appear as richly valued as it once was, but that’s only part of the story.
What matters now is quite simple and can be broken down into a few categories:
All three of these are related – think of it like a three-legged stool, all legs need to be stable to support healthy equity market returns. So, what does the data tell us about the stability of these legs? The answer – the data isn’t sure yet:
So the real question is as follows – who is correct? Are consumers about to roll over and struggle economically, joining the negative side of the ledger, or is the market overreacting to the removal of stimulus and inflation fears given the relative health of consumer's balance sheet?
Unless consumers experience significant deterioration through job losses or increasing debt, or we see an escalation of geopolitical instability, it is quite difficult to see a “worst case” scenario on the horizon. Market volatility is likely to continue in the near-term given the current uncertainty surrounding the items above and those that have yet to make it to the forefront (housing market softening and global food shortages). As long-term investors, we tend to lean on the side of optimism, and investing during downturns of this magnitude has historically been rewarded. As such, sticking to your long-term investment strategy should pay off in spite of this barrage of negativity.
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