Q2 2022 Commentary

The second quarter of 2022 ended with the S&P 500 down more than 20% for the year – concluding the worst first-half for domestic equity markets in over 50 years.  

There has been little room to hide from the losses. Thanks to rapidly rising interest rates, a 60/40 stock/bond portfolio would not have fared much better than stocks alone.  The conservative asset allocation benchmark saw losses over 16% for the half – the weakest start since 1932 (and the worst six-month period since the 2008 financial crisis). 

The pain is not only being felt in investment portfolios.  Inflation at 40-year highs means that everybody is feeling the negative effects of the economic shifts.

The combination of poor investment returns and high inflation has severely damaged the confidence of investors and consumers.

In June, the University of Michigan’s Consumer Sentiment Survey posted its lowest reading ever (a data set going back to 1952).  According to the American Association of Individual Investors survey, bears (those expecting losses over the next six months) outnumbered bulls for 25 of the 26 weeks in the half. Two of those weeks saw the bull-bear spread fall to -40%. According to Lipper, retail investors withdrew over $40 billion from equity funds in the second quarter.

These numbers sound quite dour, and they reflect just how bad things feel right now.  They are not, however, predictors of a weak market environment ahead.  The last time investors withdrew more over a 3-month period was in 2020 amidst COVID-fears.  The only two times we have seen bearishness sustain such negativity in the AAII survey were in 1991 and 2020 – both turned out to be extraordinary buying opportunities.  The AAII bull-bear spread fell below -40% a few times in late 1990, with 1-year returns between18% and 26% (depending on the week).  The only other time it crossed that threshold was in March of 2009 – stocks then rallied 67% over the following year.

Similarly, the last time the Michigan Survey hit a record low (amidst high inflation in 1980), the S&P 500 returned nearly 24% in the following year.  Readings below 60 (June was at 50) have seen subsequent 1-year market gains average more than 20%.  

Contrary to panicked/depressed retail investors, the second quarter saw plenty of optimism from corporate insiders.  Insider data from Thompson Reuters showed bullish activity for 12 of the 13 weeks in the quarter.  In May, the Vickers sell/buy ratio reflected more insider purchases than sales for the first time since March of 2020 (the COVID lows).

When retail investors and corporate insiders are on opposite sides of the trade, we generally know which side we would like to align with.

Dramatically falling multiples and the dynamic among market participants have been the driving data sets encouraging us to increase equity allocations.  Global accounts have pared some of their exposure, but domestic stock-oriented accounts ended the first half more than 90% invested in equities.

We are very confident in holding a basket of quality companies at these levels, but there are still risks associated with inflation, valuations and the Fed.

Though our preferred valuation ratio, Price/Peak Earnings, has fallen more than 30% from its 2021 high (which we can now confirm was a bubble), it still remains near a level that has been historically unsustainable.  In fact, only one week this quarter saw the multiple for the S&P 500 fall into the “historically reasonable” range.  We have managed to successfully enter the market at or above these prices several times in recent years, but it has always come with some consternation.

Adding to our current worries: high inflation environments are generally accompanied by lower-than-average valuations. With interest rates rising, it is quite possible that equity multiples continue to contract – and they have plenty of room to do so. 

Unlike many of the confidence-busting markets noted above, this time the Federal Reserve is not coming to the rescue of investors.  The S&P has fallen 20%, and other market segments have fared even worse, yet the Fed has maintained its resolve to fight inflation by tightening monetary conditions. 

The current Fed chair has been whipsawed by being too hawkish in late 2018 and too dovish in 2021. We can hope that the Fed manages a soft landing this time around, but we cannot place much confidence in monetary policy at this point.

Justifiably, there are growing concerns about recession.  Given rising costs for essentials, consumers are certainly being pinched, but strong balance sheets and a tight labor market can still provide plenty of economic cushion.  May and June saw particularly high inflation rates, but collapsing commodity prices are offering some hope that these pressures will abate before causing too much damage.

The first half of 2022 was the first major sustained reality check markets have encountered in over a decade.  It is possible that there is more pain ahead, but even if markets have seen their lows, a recovery from these levels is likely to be prolonged and choppy. 

If markets remain volatile, we are likely to remain quite active.  Among the changes we have made since the financial crisis is a willingness to become more nimble in down markets.  Close followers of our strategies may have noted some premature sales to briefly rotate into positions such as Costco and Boeing in order to benefit from volatility. We could make similar moves if markets again approach new lows.

Contrarily, given our long-term concerns, we will also be quick to capture profits, as we have been for the last several years.