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The 2022 Sell-Off: Making Sense of the Markets

The 2022 Sell-Off: Making Sense of the Markets

The market weakness in 2022 has continued to accelerate, driving equity prices lower. While it may feel like a pretty extreme selloff, the S&P 500 selling off 15% is fairly normal, occurring every 2.5 years. Even if we reach a “bear market”, defined as a 20% or more decline, this will occur on average every 4 years, so we are experiencing a phenomenon that is relatively frequent.

This, of course, doesn’t make anyone feel particularly better. As our revenue is tied to our clients’ assets under management and every advisor in our firm invests in the stock market in some form, we all feel the pain. There are many reasons for this. Inflation has run significantly above target levels. The Fed is moving away from ultra-low interest rate policies. And the war in Ukraine continues. These have all contributed to the uncertainty surrounding companies and their future outlook.

We have continued to watch earnings as they have been reported. Presently, they still are strong but earnings surprises have trended lower and future earnings are looking a bit more tenuous pending all the above uncertainty. This is not to say that we haven’t already hit the bottom of this pullback, nor is it saying that things can’t get worse. It is worth mentioning that today’s stock prices reflect the expectations of future earnings by companies. It is predictive in nature, and that’s why we have seen the results in 2022 when we look in a rearview mirror. An end to the Ukraine war, easing of inflation numbers, reduced COVID cases & lockdowns, and better news on supply chains could all be factors that will likely drive equity markets higher. A dive into a bear market could be caused by a worsening of any of the above as well, and that is precisely why we tend to advise caution in making any short-term decisions that can have long-term impacts.

Did you also know that the bond market is having its worst year since 1842(!!!)? Normally we see an inverse relationship between stocks and bonds, with bonds increasing in value while we see a negative stock market.

So, What to Do?

Assessing timeframes is obviously extremely important. Keep in mind that despite the pretty awful market we’ve seen so far this year, the longer-term returns look strong. Here’s a chart of the S&P 500 over the last five years:

Just from eyeballing the chart, you can also see that we’ve had some pretty feracious pullbacks before we hit higher highs. The difference between now and then? Inflation is running hot, and recent reports are showing that it is not coming down quickly.

What Can We Expect in the Future?

According to research by First Trust, out of the last 185 quarters, only 16 had stocks and bonds falling together. When we look back at historical data, returns tend to be positive in the stock and bond markets, especially in the 1- and 3-year periods. See this chart that lays out prior stock and bond market returns. While we know that the future is uncertain, we also know that it’s almost never about timing the market, it’s about time in the market.

Clint Walkner

Market Correction: What It Is and Why Market Corrections Matter

Market Correction: What It Is and Why Market Corrections Matter

The domestic and international stock markets have started 2022 with a level of volatility unseen for the past few years. The rather benign market conditions, over the last 10 years, have lulled investors into a false sense of security and normalcy that is anything but normal. 

This is completely understandable when we look at the recent history of the S&P 500, a benchmark for US stocks. The S&P 500 has only posted one year of negative returns greater than 1% since 2009. The index’s loss of 6.24% in 2018 was paltry compared to its 38% loss in 2008 and three consecutive double-digit down years of 2000-2002. This is all to say that the beginning of 2022 is a reminder that volatility and market corrections are part of the normal market cycle, not a deviation from it. 

What is a Market Correction?

The term “market correction” is generally defined as a drop in a given market index of at least 10%, but not more than 20%. A drop of more than 20% is referred to as a bear market.

To give some perspective on the recent history of market corrections, the S&P 500 experienced a market correction in 11 of the past 20 years. Further, the S&P has experienced a correction, on average, every 19 months since 1928. This helps to illustrate the fact that market corrections are common over most periods of time and should be viewed as the market resetting stock valuations back to a more fundamental level.

Most economists believe that periodic corrections are healthy for investment markets, particularly stock markets, as equities tend to have large price swings. As stock prices appreciate over periods of time, there can start to become a disconnect between the valuation for a company and the price of its common stock. While the relationship of company valuations and respective stock prices can be a moving target, market corrections help to bring this relationship back in line, and, in some cases, corrections can provide a buying opportunity as the stock price may fall too far relative to the valuation. The circumstances and variables that cause the to market slide are different each time, which makes predicting when a correction will happen and for how long nearly impossible. Furthermore, many corrections have been caused by non-financial related events such as geopolitical issues or military skirmishes.

Investing During a Market Correction

Now that we have a better understanding of corrections and their history, we need to turn our attention to how we should react during a correction. Corrections can be a scary, unnerving period of time in a market cycle, however, history shows us that corrections last, on average, four months before the market makes up the loss. This is the reason why most economists recommend riding out market downturns. Often people ask the question, “why not just sell stock positions when the market begins to fall and buy back in when the market bottoms”. This is almost always a recipe for disaster as it requires correct market timing, not one, but two major moves in a portfolio. It also requires that we are actually at the start of a correction. We know that we are in a correction once the market has already fallen 10% and, by that point, it is too late to avoid the loss by selling shares. The best advice for weathering volatility in the markets is to fully understand your personal risk tolerance and accurately match your investment allocation to that risk profile. This way, we can have confidence that our portfolio is built to withstand the appropriate amount of market loss for your specific situation.

Nate Condon

What is Index Investing? History, Construction, Weightings and Factors

What is Index Investing? History, Construction, Weightings and Factors

The subject of index investing is one of the most popular topics of the investment industry. It is written about constantly in business magazines, newspapers, and websites and generally comes with the author’s opinion on the topic whether you are interested in their opinion or not. As often as it is covered, I rarely find a piece that explains indexes and index investing in an easy-to-understand way. The goal of this article is to provide a general overview of indexes, the differences in how indexes are constructed, including equal-weighted indexes versus market capitalization-weighted indexes, and passive and factor indexing strategies. 

A BRIEF EXPLANATION AND HISTORY OF INDEX FUNDS

One of the most notable indexes is the Standard and Poor’s 500, more often referred to as the S&P 500. Simply put, the S&P 500 tracks the stock performance of the 500 largest companies, primarily based in the U.S. Investment companies took this idea and developed a way to purchase this basket of 500 companies in one investment as opposed to buying each stock as its own investment. The index itself was created in 1957 and is used to provide a broad representation of the overall stock market’s daily performance. The Dow Jones Industrial Average, which is arguably the most well-known index, is made up of only 30 stocks and, therefore, gives a more narrow representation of the market. The first S&P 500 index fund was created by Vanguard in 1976. This was the beginning of an entirely new way of investing. The vast majority of index investments, including Exchange Traded Funds, that exist today have been created within the last 20 years

An Exchange Traded Fund (ETF) is a different form of index investing. The first ETF was created in Canada in 1990, with the first U.S. ETF created shortly thereafter in 1992. One of the fundamental differences between index funds and ETFs is that ETFs trade throughout the day on a given exchange and, therefore, have price fluctuations intraday. Mutual funds only change their price per share once per day after the market has closed. With ETFs behaving more like individual stocks, they tend to be more tax-efficient than mutual funds as well. 

THE EXPANSIVE WORLD OF INDEXES

Since the beginning of the 2000s, the index investing world has exploded with offerings. The bellwether indexes of large companies, mid-sized companies, and small companies have given way to more niche and exotic indexes such as cybersecurity, photonics, and global blockchain, to name a few. A recent estimate put the total number of ETF investment products at more than 7,000; however, the number fluctuates by the day. The splintering of the ETF market also creates challenges in comparing what appear to be similar index investments, only to find out they can be vastly different. If we look at three Small Cap US ETFs from Vanguard (VB), iShares (IJR), and Charles Schwab (SCHA), we find three very different investments.

This chart represents a one-year performance comparison between the three mentioned ETFs. While this is a relatively short time frame for performance, the chart highlights the drastic difference between these investments, even though they all appear to be similar by title. The biggest reason for this performance variation is the makeup of each of these investments, which represents a different investment philosophy. The Schwab ETF owns the most small-cap companies in its basket with 1,761, then the Vanguard investment with 1,560, both of which dwarf the iShares offering with 684 total holdings. These are three of the most popular, passively managed U.S. small-cap index investments. It is fair to say that not all small-cap index investments are created equal. 

INDEX CONSTRUCTION

The development of index investments has evolved drastically over the past two decades. Let’s start with the most basic – the S&P 500. The purchase of an S&P 500 fund will yield you a basket of the 500 largest, mostly U.S.-based companies. The methodology used to determine the 500 companies that make up the S&P 500 is agreed upon by the investment community as a whole, in that, the list of companies that make up the index is published and accepted. That said, the construction of S&P 500 index funds can be quite different because the relative weighting of each of the 500 stocks can be different. Many of the S&P 500 funds are market capitalization-weighted, meaning that the largest stock in the index holds the largest position within the fund. This, proportionally, happens all the way down to the 500th company in the fund. By purchasing a market-cap-weighted index fund, the investor should understand they are not getting an equal slice of all of the stocks in the 500. Currently, the top five companies in the 500 make up over 20% of the index. By comparison, an equal-weighted index fund will do just that – invest an equal amount across all of the stock in the index. Here is a chart to illustrate how the performance of these two strategies may differ by using the SPDR S&P 500 market-cap-weighted fund (SPY) and the Invesco S&P 500 equal-weighted fund (RSP). 

The one-year performance chart of these two investments ends in relatively the same place. However, a closer look at the chart will show how the two investments behaved differently throughout the year. This next chart, representing the five-year performance of both investments, shows the more dramatic separation. 

This isn’t to say that one method is superior to the other, but rather, to illustrate the differences in index investing as well as the importance of knowing what you own in your investment portfolio. 

PASSIVE VERSUS FACTOR STRATEGIES

In the infancy of index investing, the idea was to model a well-known stock or bond index and simply follow the performance of the stocks in the basket. This eliminated the need for dedicated portfolio managers to use their expertise to pick stock or bond winners for their portfolios. The logic was simple: Why try to beat the performance of said index year-in and year-out when you can participate in the performance of the index. This is the way it went for many years until the development of factor strategies. Factor investing was a groundbreaking idea that would theoretically take a good idea – index investing – and make it significantly better. Typically, factor strategies will start with an index and use factors such as profitability or price-to-earnings ratios to weed out underperforming companies and then rank the remaining companies in the index. The idea is centered around the thought that not all of the companies in any given index are solid investments. Why own the bad with the good? Of course, this idea also relies on the correct combination of factors to determine what defines a “good” company and what defines a “bad” company by way of their investment merit. While the past five years have been difficult for many of the factor investment strategies, there are also periods when they dramatically outperform.  

When index investing was created and began to gain traction in the 1990s, it was difficult to see where it might lead. Many investment ideas have come in quickly, had their day in the sun, and went away almost as quickly. Index investing is not one of those ideas. It is as popular today as it has ever been, and the daily creation of new funds is evidence of that growth. Investment companies will continue to tinker with different ways to package their index offerings and try to build a better mousetrap. But, in the end, millions of inventors still prefer to own the funds from the early days, and that isn’t likely to change any time soon. 

Nate Condon

2022 Investment & Market Outlook Guide

Syl Michelin’s piece is part of Walkner Condon’s 2022 Investment & Market Outlook Guide, a comprehensive reflection of 2021 and glimpse at the factors impacting the year ahead in 2022.

It Only Gets Harder from Here: Valuations, Bond Environment and Wage Growth

It Only Gets Harder from Here: Valuations, Bond Environment and Wage Growth

If we look back at the stock and bond markets with a Monday Morning quarterback lens post-2008 financial crisis, one has to consider if the “easy money” has already been made. It’s almost hard to believe that the historically good run in equity markets has also been coupled with a favorable bond environment as well, with returns looking very solid net of inflation through many portfolios. The simplicity of this gain also bears noting  – if you simply bought the S&P 500 and coupled it with an aggregate bond strategy solely based in the United States, you did very well for yourself.

Note: SPY used for S&P 500 index proxy, AGG for aggregate bonds, DBC for commodities, EFA for international developed companies, and VWO for emerging markets. 

Naturally, we can ascertain from this chart that it hasn’t been a totally smooth ride from the equities perspective, but it is also safe to say that stocks have pretty much acted as stocks should. It also should be noted that a globally diversified portfolio detracted from your gains over this period compared to a solely U.S.-focused one. 

Looking forward, as we digest both the longer-term past as well as the last 12 months, some headwinds are developing that may affect the future of our portfolio management. Some of these will be more fleshed out in the remainder of our commentary, as they bear a deeper dive. 

Here are three of the main challenges we see as we go forward.

Stretched Valuations, Particularly in U.S. Equities?

Generally, the thoughts we get from many of our clients is that the U.S. stock market is overvalued. Over the last year, however, many may not realize that the “overvaluation” of the market 12 months ago was even more pronounced than it is today. See this price to earnings ratios (P/E) chart since 2017:

Note: This is the S&P 500 index price to earnings (P/E) ratio.

Why did this occur? Simply speaking, the earnings of companies ended up catching up while revenues remained strong due to waning COVID lockdown measures coupled with unprecedented government stimulus. Treating 2020 as somewhat of an outlier due to COVID factors, today’s P/E ratio remains elevated relative to the last 10 years. 

The question remains whether this elevated P/E ratio actually signals that the U.S. market is overvalued. There are several factors that come into play – low interest rates with expected interest rate increases, pension and institutional wealth funds trying to hit rate of return targets, inflation expectations, and many others. These factors when coupled together paint a much more complex picture of the “why” concerning elevated P/E. But in the end, we will continue to need strong earnings to support higher prices. In 2022, we see more headwinds due to an anticipation of higher rates, potentially pouring some cold water on the inflation heat and possibly slowing growth as a result. We also believe that there should be tailwinds – at some point, we will emerge from COVID, leisure activities and travel will increase significantly, and taxation on businesses and individuals will likely remain low until at least 2025 absent any unexpected legislation. 

Low-Interest Rate Environment Matched with Expected Low Returns in Bonds

The Fed has been quite transparent about its plans to raise interest rates throughout 2022 in a response to inflationary pressures and potential overheating of the U.S. economy. While we have been through a long-term decline in interest rates over the last thirty years, there have been periods of time where interest rates have been on an upward trajectory, albeit relatively short ones. One more recent period of time where this occurred was in 2018 when the 10-year treasury rate increased over 12%. In looking at how this increase in rates affects bond prices and yields, we can reference the following chart:

Note: BND used to represent the total bond market, BSV used to represent short-term bonds.

Some takeaways from this:

    • The 10-year treasury did not move in a straight line during the year. Despite this, dividend yields from the two ETFs (used as examples), steadily climbed throughout much of the year.
    • As yields climbed, prices fell, which is the conventional wisdom we learn in economic textbooks. Keep in mind that the 10-year treasury started in the 2.5% range in 2018 and crested over 3%. We ended 2021 with a rate of around 1.5%. Here is a data source for treasury rates.
    • Short-term bonds weathered the higher interest rates better than longer-term bonds, which again would fit conventional wisdom. Additionally, shorter-term bonds were less volatile than longer ones during this period.

As we look at 2022 and beyond, we expect interest rates to keep climbing throughout the year, though it is unlikely the climb will be in a straight line. One strategy to employ for the year would be to keep the duration of your bonds short if interest rates do indeed rise, and perhaps consider using some inflation-protected bonds if you expect inflation to continue to remain high. The issue with that is we are starting from a very low-interest rate – the 10-year treasury (which would be considered intermediate bond duration) is still well below 2% at the time of this writing in early January. As rates rise, bond prices will fall, so it is highly unlikely we will see much in the way of gains.

Another strategy is to move into higher-yielding bonds – perhaps considering lower credit quality or floating rate bonds to juice up yields. The issue with going too far down that path is simply that a decrease in credit quality will lead to taking higher risk in your overall portfolio, and aren’t bonds supposed to be your hedge against falling stock prices and your way to diversify? 

If you are gathering from the above comments that this is a tough environment for bond investors, you would be correct. Starting from such low yields, historically speaking, with the prospects of increases in interest rates, would portend a less than rosy outlook for bonds in the near future.

Uncertainty of Wage Growth

Nearly 70% of our GDP measurement ends up coming from consumer spending. When we emerged from the depths of the pandemic, as states started to reopen, there was a significant shortage of workers to fill job openings. Resultantly, we saw a significant increase in wages that persists today (and at the bottom of the wage ranges, this started before COVID). This is the good news. 

The bad news is this is only one side of the equation, as we care more about “real” wage growth, defined as wage growth minus inflation. Unfortunately, we have seen inflation quickly overwhelm wage gains. As we all have felt the higher prices at the pump and in our grocery stores, we all hope these will be temporary

If Americans are feeling the effects of inflation, several things could happen:

    • Purchases could be delayed or canceled due to the increased costs of items.
    • Substitutions could be made to minimize the impact of price increases, for example, instead of buying the organic strawberries you choose to buy non-organic or you substitute pork for beef.
    • Purchases are accelerated with the thought that prices will be higher in the future. For example, ordering countertops from Home Depot now instead of waiting a few years.

Aside from the accelerated purchases, cancellations or substitutions will be negative for GDP growth. Additionally, the greater wage uncertainty one has, the less “risk” they are willing to take when making purchases. If “real” wage growth isn’t so real, despite the likely outcome of prices being higher a few years from now, a family may not choose to buy a home, automobile, or other higher-priced items just based on the perception that they won’t be able to maintain their purchasing power. 

So What Does This Mean for 2022?

We don’t believe in producing a market forecast, as it is a fool’s errand. What we will posit is that we expect greater volatility, as the first few days of 2022 would indicate, while returns may come a bit harder than 2021. As it stands, to score runs right now we may have to settle for some small ball and lots of singles – for those baseball fans out there. For advisors, it means that we have to remain open to considering investments beyond the S&P 500, as we always have. In any market, there will always be opportunities. Perhaps this can be found in considering a rotation towards value-oriented U.S. stocks, a more substantive allocation to non-U.S. stocks, or potentially, more tangible assets such as commodities or real estate. In the end, we all must remember that time frame and time in the market are inherently crucial to long-term success, so review these items with your advisor in your strategy meetings to see how it applies to you specifically.

Clint Walkner

2022 Investment & Market Outlook Guide

Clint Walkner’s piece is part of Walkner Condon’s 2022 Investment & Market Outlook Guide, a comprehensive reflection of 2021 and glimpse at the factors impacting the year ahead in 2022.

2022 Investment and Market Outlook Guide

2022 Investment and Market Outlook Guide

Walkner Condon’s team of experienced financial advisors explores key topics that are top-of-mind as we transition out of 2021 and into a new calendar year, featuring the market outlook and review from Syl Michelin, a Chartered Financial Analyst™. Other topics include index funds, sector & factor performance, a pair of U.S. expat-focused pieces, and more.

Below you can find a breakdown of the individual pieces in this year’s outlook. 

1. The Year of Impossible Choices: 2021 Market Recap & 2022 Outlook
Syl Michelin, Chartered Financial Analyst™

Through a lens of current and historical data, Walkner Condon’s resident CFA® explores the last year in the markets, with an eye on factors that may impact 2022. 

2. It Only Gets Harder from Here: Valuations, Bond Environment & Wage Growth
Clint Walkner

With a multitude of market highs throughout 2021 and a long stretch of gains post-2008 financial crisis, it would appear the “easy” money, if we can call it that, has been made. In this piece, Clint dives into the three main challenges as we move forward into 2022.

3. Reviewing 2021 Sector and Factor Performance and Positioning in 2022
Mitch DeWitt, CFP®, MBA

The markets were up routinely throughout 2021, but that doesn’t mean the gains were shared equally. Mitch discusses the sector winners (and losers) of the last year, along with what factors – things like high beta, value, and quality – had their day in the sun. He also goes into what might be on the horizon this year.  

4. Exploring Index Funds: History, Construction, Weightings & Factors
Nate Condon

The goal of this piece from Nate is to provide a general overview of indexes, the differences in how indexes are constructed, including equal-weighted indexes versus market capitalization-weighted indexes, and passive and factor indexing strategies.

5. Three Reasons to Look at Investing Internationally in 2022
Keith Poniewaz, Ph.D.

Though the U.S. dollar had its best year since 2015 in 2021, Keith explains several reasons to think about international investments in 2022, including the very strength of that U.S. dollar, valuations, and the rest of the world’s growth in GDP.  

6. Top Five International Destinations for U.S. Expats in 2022
Stan Farmer, CFP®, J.D.

One of our U.S. expat experts, Stan jumps headfirst into possible locations for Americans to consider in 2022 if they’re thinking about a move abroad – or even if they’re just wanting to dream a little bit. Stan covers ground in South America, Europe, and Asia in this thorough piece, perhaps his first crack at being a travel journalist in his spare time.