Does Your Dog Bite?
In the film The Pink Panther Strikes Again, as Inspector Clouseau is checking into a hotel he sees a dog sitting on the floor and asks the innkeeper if his dog bites. The man says no, so Clouseau proceeds to pet the dog and is subsequently bitten. An obviously agitated Clouseau says to the innkeeper, “I thought you said your dog did not bite,” to which the innkeeper responds, “That is not my dog.” The stock market also seems to bite investors from time to time, just as it has over the past couple of weeks. The year has gotten off to a rough start. The S&P 500 is lower by more than 7.5% since the beginning of the year and the tech-heavy Nasdaq is now in correction territory as it has fallen by more than 14% from its all-time high reached in November. Last week was the worst week for the markets since the beginning of the pandemic. What caused this pullback and is it going to continue?
The largest sources of angst in the market are continued inflation and possible action from the Federal Reserve, both of which are very much intertwined. Recent inflation data indicated that year-over-year price increases are at the highest levels since the early 1980’s with prices of consumer goods 7% higher than a year ago and wholesale inflation nearing 10%. It seems inevitable the Fed will raise interest rates this year in an attempt to combat inflation, with the questions being how much and how often? Current estimates range anywhere from two to seven interest rate hikes this year. It is widely anticipated the Fed will begin to raise rates at their March meeting with some speculation of the first rate hike possibly being half of a percent and not the more traditional quarter percent rate hike. Our expectation is the Fed will start slow and raise rates by a quarter of a percent and then determine the effects on the economy and markets, which generally takes at least a few months to fully ascertain. The Fed will want to be deliberate and not risk unnecessary damage to the economy so we anticipate they will raise rates in quarter point increments throughout the year, most likely once each quarter.
The prospect of higher interest rates, which lead to higher borrowing costs, have had an outsized effect on technology stocks which were already trading at expanded price to earnings (P/E) multiples. Stock prices are based upon expected future earnings, which are then discounted back to present value based upon current interest rates. As interest rates rise, it makes the present value of future earnings less, causing downward pressure on stock prices. This has a lesser impact on companies with established earnings. Abnormally high Price-to-Earnings ratios last year were mostly brushed off as being a result of irregular earnings due to the pandemic but as we are now getting farther away from the lockdowns which temporarily crippled the economy, earnings are being more closely watched and those companies still trading at high multiples are being punished. Conversely, with the recent market pullback many companies with histories of stable earnings are now trading at fairly reasonable multiples.
Safely Losing Money…
In anticipation of action from the Fed, interest rates have moved higher causing bond prices to fall. As a reminder, there is an inverse relationship between bond yields and bond prices. Historically high-quality bonds have been viewed as a safe haven during times of volatility in the stock market and therefore have been a good way to diversify a stock portfolio and reduce overall portfolio risk. However, with interest rates being very low and upward pressure in yields from inflation, they have not provided this safe haven nor do we expect them to over the next few years as interest rates rise. Year to date the Bloomberg Barclays Aggregate Bond Index, which is the most widely followed bond benchmark, is lower by about 1.5%. This follows a loss of almost 2% in 2021.
Many of our clients have protected income and therefore should not be overly concerned with the recent market volatility since they are not required to take money out of stocks or bonds when they are trading lower, as they are now. They should be able to rest easy despite the market volatility. At Secured Retirement, our goal is to ensure our clients remain confident in their retirement spending and have reliable income regardless of what the markets are doing.
We would refer to the recent market pullback as a “reset” since earnings are again being considered and high-quality names are back in focus. The coming week brings a Federal Reserve meeting, where there is a chance of an interest rate hike, but most likely will set the stage for a March liftoff. Earnings season will be fully underway, which we think will provide some support for the market. Thus far earnings have been mixed but we have seen more earnings surprises than disappointments. We anticipate continued earnings growth this year, but not at the pace seen last year. And despite the recent setbacks in the market, we remain optimistic for what lies ahead.
Cash or low-yielding investment are losing purchasing power due to inflation remaining elevated. If you have been on the fence and hesitant to invest cash, this pullback provides a great opportunity to do so but we would recommend being selective given the rotation occurring in the market. Give us a call to discuss investment strategies, especially if you are worried about recent market volatility. There is quite a bit going on in the markets right now and you do not want to get bitten.
Have a wonderful week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
Please contact us if you would like to review your individual financial plan or learn how the TaxSmart™ Retirement Program can help you.
Office phone # (952) 460-3260