How We Got Here
Indications that the Federal Reserve was nearing an end to its zero interest rate policy first surfaced late last year, with a notable tone change at the Fed’s November 2021 meeting right as inflation was lingering past any reasonable definition of “transitory.” As of November 8, 2021, the market was anticipating zero rate hikes over the next 12 months. By January 2022, that changed to three expected hikes, and then as of today, the market expects the federal reserve target rate to hit approximately 4.50%, requiring five or six additional rate hikes (125-150 bps) to occur by November 2023. As the market has raced to keep pace with the expectation of Fed action, volatility has increased accordingly.
What We Know
- In the first half of 2022 the S&P 500 was down -20% in total return, a threshold that defines “bear market” by most traditional standards. However, National Bureau of Econmic Research (NBER), the final arbiter of official recessionary proclamations, has yet to declare that the market drawdown is coinciding with an economic recession.
- As we near the end of the third calendar quarter, the S&P has ranged between +13.9% to now -2.1% quarter-to-date, with the Fed dumping cold water on the market in order to achieve price stability. Chair Powell’s commentary at both Jackson Hole and the last FOMC meeting reinforced that the Fed is laser-focused on reducing demand; any near-term pain inflicted is intended to be an acute trade-off for what otherwise would be chronic draconian outcomes created by high inflation.
- Traditional measures of embedded volatility have done a poor job of reflecting conditions ripe for large single-day drawdowns, as we’ve experienced over the past few weeks. Yet the current market volatility suggests we’re wavering between bottom-testing lows and recovery. Despite headline concerns of the bottom falling out of the market due to worsening economic conditions, we’re currently at parity with July 2022 levels. This suggests that the market had begun pricing in the current economic environment, one we diagnosed back in July and March.
- Relative to the 2008 crash, today we’re in an entirely different realm of credit risk when it comes to the health of the consumer, as evidenced by debt service ratios (9.6% now vs the 13.2% peak in 2007), excess savings levels (to the tune of $2.4 trillion), and employment (we currently have two job openings per one unemployed person).
What We Wish We Knew
Public equity investing is a perpetual exercise of trafficking in imperfect information. It also requires a constant reassessment of probability weightings, as hypothetical scenarios become actual outcomes. As helpful as it would be to know whether global central bank actions will result in a hard or soft landing, waiting for perfect certainty is likely to occur long after bottom formation in the US equity markets.
What We Are Doing to Find Out
Our fundamental investment management process constantly assesses changing impacts to both supply and demand across issuers in every major economic sector. Accenture Plc [ticker: ACN] is a good example of an issuer in both our Dividend Equity and Growth Equity strategies that provides a good proxy for our process. With 721,000 employees globally, Accenture exists as a solid proxy for how companies are deploying capital to create value for their shareholders. After seeing a 31% increase in quarterly bookings for its quarter ending August 2022, its chair/CEO noted, “While industries and markets are being affected differently, there are two common themes: all strategies lead to technology, particularly cloud, data, AI, and security, which are fundamental to a strong digital core.” By favoring issuers responsible for enabling digital transformations across our portfolios, we believe we stand stronger odds of better relative footing over time.
What We Are Frustrated With
The baby is being thrown out with the bathwater. Companies with failing or failed business models are being commingled with companies whose business models are using this environment to strengthen their competitive advantages. Our quarterly analysis highlighted evidence of this unfolding, and the update today looks similar: half of the issuers in the Russell 2000 Growth index—accounting for over 561 stocks—are down 51% YTD on average, with the bottom quartile down 64%. This volatility isn’t isolated to small-cap though; the bottom half of all large-cap growth issuers (259 stocks in total) are off 44% year-to-date on average.
What We Are Optimistic About
The future. We see the current market environment as offering a compelling opportunity for highly attractive returns over the medium- to long-term. With the latest Fed dot plot suggesting a path to the Fed’s target of a 2.5% Fed funds rate by 2025, the public markets are entering territory where forward expectations, and valuations, will have to incorporate a conversion from rate hikes to rate easing. Further, we are now 18 months into the market flushing out over-levered and over-extended issuer companies and market participants.
As public market investors, we don’t take lightly or blindly ignore the macroeconomic or geopolitical reality. We focus on investing for the long term through individual positions determined by a data-dependent analysis versus allowing price to drive the narrative. While it’s far too early to declare that the dust has settled, we see evidence to support that the markets have already priced in a sizable amount of bad news. As in every major drawdown in modern equity market history, the white flag gets waived long after the market recovers.
As always, if you have any questions or concerns please reach out to us.
Investment advisory services are offered through SWS Partners, LLC (“SWS”). SWS is an investment adviser registered with the Securities & Exchange Commission. Registration as an investment adviser does not imply any particular level of skill or training. All opinions and views mentioned in this report constitute our judgments of the date of writing and our opinions are subject to change at any time. We will not advise you as to any changes in figures or views found in this report in the future. Investing involves risk of loss and the investment return and principal value of portfolios under our management will fluctuate as the stock and bond markets fluctuate. Past performance is not indicative of future results.