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Inflated Expectations?

With the S&P 500 now down by low double digits so far this year and with bond returns not far behind, it is natural to ask how this could happen and why. For perspective, even though the first few months of the year have been volatile, the total return for the S&P 500 over the last 12 months has been a much more muted -3%, meaning that some of the recent weakness simply represents a return to a more normal environment than we witnessed as stocks increased at an unusually strong pace. Higher prices are pressuring margins and causing the Federal Reserve to increase overnight interest rates in order to slow the pace of inflation.

Technology represents some 27% of the S&P 500. The tech-heavy NASDAQ index is down about 30% on a year-to-date basis with the average stock in this index down over 40% from recent highs and some names such as Netflix and Peloton down by over 60% during 2022. Technology stocks are missing earnings estimates at a pace not seen over the last decade which has accounted for much of the softness in prices. The silver lining, however, is that much of the damage to stock prices may have already happened in this area of the market as evidenced by price/earnings multiples that are returning to more typical levels.

This comes as little consolation for balanced investors who hold a portion of their portfolios in both stocks and bonds given that bonds are experiencing their worst year in over four decades. The Bloomberg US Aggregate Bond Index has only registered negative returns during three calendar years since 1980, the worst of which was -2.9%. This shows how the roughly 10% drop in bond prices this year is extreme in comparison.

Numerous issues are causing the simultaneous weakness in both bonds and stocks, most of which stem from inflation. The war in Ukraine, shutdowns in China, continued supply chain issues due to the pandemic, and unemployment near record lows are all leading to higher prices. Headline inflation as measured by the Consumer Price Index registered 8.3% in April while core inflation, which excludes the more volatile components of food and energy, was 6.2%, which is several times higher than the Fed’s 2% target. On a positive note, there is evidence that inflation may have peaked. In order to mute demand and lower inflation, the Fed is engaging in what is expected to be one of the most aggressive interest rate hiking cycles in recent history. However, during the past 13 rate hike cycles, 10 have ended in recession. Although recessions are a normal part of the economic cycle, typically occurring every five years or so and lasting roughly 10 months, the U.S. economy has experienced only one non-pandemic related recession since 2008 making recessions seem less common due to their relative infrequency of late.

Despite its recent weakness, we remain confident about the longer-term outlook for the stock market. Betting the market will stay down goes against the odds. Moreover, even a soft market offers attractive opportunities. To that point, we are seeking out attractively priced opportunities to purchase high quality stocks and bonds of companies with strong balance sheets, ample cash flow, and the wherewithal to outperform under the current conditions.

It pays to be patient. As uncomfortable as the last few months have been, it is helpful to keep in mind that half of the 50 best days for stocks over the last 20 years have occurred during market downturns like we are witnessing now. Missing just the 10 best days over that time would have reduced equity returns by almost three quarters. Those investors who fare best in the long run are those who account for the inevitability of recessions and bear markets in their planning and maintain a disciplined approach. As always, feel free to contact your portfolio manager with any questions or concerns.

This market update was written by Broadway Bank’s Portfolio Managers.

Sources: Bespoke, Bloomberg, Broadridge, Factset, and Rosenberg Research

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