myICLUB Blog

The S&P 500 barely avoided a 20% drawdown, the recognized threshold for entering into a bear market. After a recent bounce, it is currently down 15% on the year. The more volatile NASDAQ 100 is down 23%. Despite this year’s weakness, both indices remain well above their pre-pandemic highs, even in real terms adjusted for significant inflation. Bulls can take heart that the stock market has made good progress despite the unimaginable stress and uncertainty of the past three years, while bears may believe that stocks still have plenty of room to fall back to reality.

Who is right? Have we seen the bottom or not? The only reliable answer is maybe. FactSet’s John Butters notes that based on estimated forward earnings, the S&P’s P/E ratio is below 18 for the first time since the pandemic started. From a pure valuation perspective, we have come full circle. That said, stocks tend to carry lower P/E’s when interest rates are higher and also when economic conditions are softening, both of which are currently true relative to pre-pandemic levels. On the other hand, inflation tends to push stocks higher, and expectations for a new normal of somewhat higher inflation rates would support higher stock valuations.

As the difference between the S&P 500 versus NASDAQ 100 performance statistics implies, the recent drawdown has disproportionately penalized high-growth stocks, many of which are down by more than 50% since the start of the year. The ARK Innovation ETF, a basket of ultra-high growth stocks, is down 55% on the year and down 73% from its all-time high achieved in February 2021. That would be an incredible amount of volatility for a single stock, much less for an entire fund!

This kind of volatility naturally raises the question whether the market has been fulfilling its responsibility of allocating capital reasonably, or whether it has been playing video games instead of doing its homework? It is not always possible to tell. Sometimes market volatility occurs for a clear reason. EPAM Systems, a software development company with more than half its employees concentrated in Ukraine, Russia, and Belarus, is down more than 50% since Russia invaded Ukraine on February 24. That certainly tracks as a rational market response to an unexpected negative world event that has a significant impact on this company.

If it were possible to cross examine the stock market, we might point at EPAM and ask, “If that’s what a war is worth, what’s your excuse on these other companies insulated from Russia that are down even more?” Either these stocks went up way too much previously or the current prices are ridiculously cheap. In most (but not all!) cases, it looks more like the former. Misallocations of capital necessitate painful future corrections. To put it plainly, brace for more volatility—up and down. To put it less plainly, financial bubbles don’t usually pop. Instead, they whiz around the room like an untied party balloon before finally plopping on the floor.

One underappreciated contributor to the recent stock market decline, and one that is certainly not the fault of overexuberant bull market investors, is the strength of the U.S. dollar. The dollar has gained 9% against the euro and 12% against the yen in 2022 alone. Over the past twelve months the dollar is up 16% against the euro and 18% against the yen. Those are big moves in the currency market! Strong currencies tend to be a drag on returns, as foreign revenue and profits are worth less than before. Companies with domestic customers and foreign supply chains can get a boost, as revenue is collected in strong currency and costs paid in the weak currency, but this positive effect is only temporary as old contracts expire and new ones are drawn up.

The dollar’s strength speaks to investor’s trust in the Federal Reserve’s commitment to fighting inflation. The primary catalyst for the recent declines in stock and bond prices is that the Federal Reserve raised its discount rate another 0.5% in May, on top of an earlier 0.25% hike. It also published a schedule for drawing down its swollen balance sheet. This takes the Fed’s thumb off one side of the supply/demand balance, causing gravity to favor the other side.

Stock investors can be forgiven if recent market volatility causes them to lose a little sleep, but they need to remember that stock market gains are not supposed to be smooth and predictable. The world does not follow a predictable course. Two things you can rely on are that governments generally want to print as much money as possible, and businesses generally want to earn as much money as possible. The more money printed, the more businesses can earn. This is to say that stocks are real assets.

An investor in well-managed, growing companies -- like the financial data company, internet service, or media company profiled in the June 2022 issue of the Investor Advisory Service --  has a claim on their future success, and that success is largely independent of what pictures of dead presidents come to be worth.

Reprinted from the June 2022 issue of the Investor Advisory Service stock newsletter, rated #1 for performance in 2021 by Hulbert Ratings.

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