Interest rates continued to climb during the third quarter, leading both equity and fixed income assets to experience a third consecutive quarter of price declines. It is looking more and more like 2022 will be a year of significant losses for both stock and bond markets around the globe - greater than 20% down for stocks and greater than 10% down for bonds.
There is a lot of uncertainty about how much higher interest rates are going to go during the next year and beyond. The Federal Reserve has been keeping interest rates artificially low since the Great Recession started in late 2007 and a whole new generation of investors, home buyers, and consumers are going to have to recalibrate their expectations for rates on home loans, car loans, credit card interest rates, and savings accounts. The new neutral interest rate level will also be important to help predict the fair price level for the stock market. Historically, the price level for the S&P 500 index has averaged around Annual Earnings per Share / (10 Year T-Bond Yield + 1.89%), where 1.89% is a form of equity risk premium demanded by the market above Treasury yields.
Often history can help us set forward expectations for future market valuation levels. But when we look at a 40 year chart of historical yields for 10 Year U.S. Treasury Bonds (below), we see the very long slide in rates from 15% in the early 80’s to below 1% two years ago, without much “normal” along the way. We might use the few years before the start of the Great Recession started in Q4 2007 as our benchmark for Normal. The 3 ½ years starting 2Q 2004 and ending Q3 2007 followed the tech bubble’s pop and preceded the Fed’s reaction to the Great Recession and might be considered the most recent period during which supply and demand in the market were free to naturally set rates. The average yield for 10 Year Treasury Bonds during this period was 4.55%. This is meaningfully higher than 3.80%, where yields ended at September 30, so I expect rates to continue to climb and I expect analysts who do not use a long term lens to continue to be surprised at the pace of rate increases.
If we insert an expected yield of 4.55% into the stock price formula above with an earnings value of $220 per share, we find a potential S&P 500 index price level target of $3,416 = ($220 / (.0455 + .0189)) for the end of the year. The S&P 500 index ended September at $3,585 per share, so we are pretty close, but still a little high - unless rates do not actually rise that high or earnings end up surprising to the upside in the next couple quarters.
Inflation has very recently shown signs of tapering off. Each month the Bureau of Labor Statistics publishes their Consumer Price Index values and their July and August readings are not much higher than the June readings. Two readings are not any sort of guarantee that inflation is now under control, but these flat readings are a terrific start. If the Fed does not have to worry about runaway inflation, the chance of seeing rates above 5% is very slim.
Before this year, there were six calendar years with losses over 20% for the S&P 500 index since 1926. The one year following each of these drawdowns has averaged an above average +12.0% total return (and much higher if we were to exclude the Great Recession in the 1930’s) and is a good reason for investors to not panic and exit the market at a low point.
Value has been outperforming Growth during 2022, after 15.3 years of outperformance by Growth. While Value has made a comeback relative to Growth, valuations for many Value oriented investments continue to look more attractive than Growth investments and we are holding onto our slight Value overweight in our portfolios.
Non-US Equities have performed worse than US stocks after currency impacts are taken into account. It is interesting to decompose returns for non-US mutual funds and ETF’s into the local price change and the currency impact. For the year, prices are down only 14.1% year-to-date for the MSCI EAFE local currency index, while the S&P 500 is down 23.9%. This would be great news for investors who diversify into international stocks, however, the currency impact of -13.0% erased all of the diversification benefit and the total return for MSCI EAFE US Dollar index has been -27.1% so far in 2022. Technical analysis has identified interest rate differentials across countries as a major driver of currency changes. The US has increased interest rates much more quickly than many other countries, making our bonds and our currency much more attractive than countries that still have very low interest rates. It was remarkable but understandable that the Euro’s value dropped below $1 in August as a result. Many economists expect non-US currencies to continue to lose value relative to the US Dollar until other countries increase rates. For this reason, we are a bit apprehensive about investing in non-Dollar denominated securities for now.
While stocks have historically shown a tendency to exhibit price rebounds following price drops, bonds are much less likely to experience the same sort of price rebound. Bonds with fixed coupon payments have prices that react to changes in prevailing yield. Because the yield increases we have seen during 2022 are very unlikely to reverse themselves, we are unlikely to see prices “pop” back up to give us double digit positive bond returns next year. However, the good news is that long run bond returns are primarily made up of their yield and future yields are very likely to stay higher than the yields from the last 15 years. This makes longer term bonds much more attractive today than they were over the last few years. We have a duration underweight in our portfolios, but will likely remove it soon.
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