Rough Start to the Year

During the first four weeks of 2022, the S&P 500 declined 9 percent – it has been a rough start to the year.  From a broader perspective, the index is back to where it was at the end of September.  The overall return from the start of 2021 through Friday, 1/28/2022, is +19.8 percent.

One of the reasons that we prefer broad market index funds for our stock investments is that the volatility is lower than some of the more concentrated investment strategies.

For comparison, large technology stocks are down -14.2 percent since the start of this year{1].

Why Are Stock Market Investors Nervous Now?

We believe there are three main concerns:

• The Federal Reserve will raise rates too much this year and cause a recession.
• Corporate profits will be lower than expected this year -- maybe due to Covid slow-downs, maybe due to supply chain disruptions, and maybe due to higher wages which will lower profit margins.
• Some parts of the stock market have very high valuations when compared to history and those stocks are declining to lower valuations.

Issue #1:  Rates are Low and Inflation is High

The chart above shows the yields currently available in different segments of the bond market.  While the yields are higher than they were in December, it is still hard to get excited when inflation hit 7 percent in 2021.

 It is unsustainable when the gap between bond yields and inflation is so large.  It is reasonable for the Federal Reserve to begin to raise rates, especially from the current low level of 0.07 percent.  Before Covid in December 2019, the rate was 1.54 percent.  We believe there is room to increase the rate before it hits recession-causing levels.

Issue #2:  Are Corporate Profits at Risk?

Companies are in the middle of reporting results from the last quarter of 2021.  The chart above illustrates the actual quarterly earnings (pre-fourth quarter 2021) and the forecasted quarterly earnings of all of the companies in the S&P 500 combined. 

This chart shows profit growth (i.e. earnings growth).  Both charts are looking at the same data but in different ways. 

In the S&P Earnings Growth chart above, it is easy to see that the growth rate is forecasted to be the lowest in the first and second quarter of 2022.  The growth rate then increases in the second half of the year.

Historically, Wall Street analysts underestimate the earnings power of companies when the economy is coming out of recession.  We believe that is true today as well.  Of the three causes of the market decline, this is the one we are watching most closely.

Issue #3:  Growth (Earnings Per Share growth) versus Valuation (Price/Earnings)

The perfect stock environment is one in which corporate profits are growing a lot and we don’t have to pay much for it.  Both rarely happen at the same time so we try to find a balance.

The table above shows the major stock market indexes sorted by the profit growth expected this year (2022 EPS, or Earnings Per Share), compared to its Price/Earnings ratio.

The large-capitalization growth stocks have had many years of strong performance but the high valuations make them vulnerable to declines.

Due to the profit growth/valuation tradeoff, we prefer the broad US market as represented by the Standard & Poor’s indices (large, medium and small companies), plus some international small company exposure.  We view the stock market pullback as a temporary pause after three strong years of stock returns.  We do expect the stock market to recover as the growth in corporate profits continues.

At Archer Bay Capital, we help clients better understand the markets and the economy so we can make better financial decisions together.  Contact us to discuss stocks, bonds, and our forecast for economic growth, or to schedule a consultation today.

*Measured by the iShares Technology stocks ETF, ticker IYW
**International Small Cap: MSCI EAFE Small Cap, Large Cap Growth: Russell 1000 Growth; Emerging Markets: MSCI Emerging Markets; Large Cap Value: Russell 1000 Value; International Developed: MSCI EAFE