Special Market Update 3-15-2022

For more than two weeks, the people of Ukraine have bravely fought back against the Russian invasion of their sovereign country.  By all accounts, their resistance has far exceeded the original prediction that the country would fall in days, if not hours.  While it is widely believed that Russia maintains a military advantage, things have not gone well for Putin.  The growing fear now is that Putin, having cornered himself, may soon begin to act even more irrationally and indiscriminately.

At home, the rate of inflation has been running higher than any time in the past 40 years and the Fed is set to hike rates this week.  This would mark the first rate hike since 2018.  The U.S. economy has been showing early signs of slowing and recession forecasts have been increasing. 

All of this has produced an exceedingly difficult environment for equity markets.  Investor sentiment has turned decidedly negative, and every rally attempted by the S&P 500 over the past two to three months has failed.

Early last week, the Nasdaq made it official, entering bear market territory for the first time since the COVID crash.  A bear market as a decline of 20%+ on a closing basis without a rally of at least 20% in between.

The selling pressure is a global issue where last week the war in Ukraine triggered the largest ever single week outflow from European equities, a record $13.5 billion (Bank of America). 

Not even the largest and most sophisticated players have escaped the current drawdown.  At the end of January, BlackRock had about $18 billion worth of Russian assets, the majority of which it has marked down to almost zero (Financial Times).

If all of this feels alarming to you, it is not your imagination.  Except for commodity and energy related sectors, every single U.S. index (including fixed income) is negative for the year, as shown in the table to the right.  This is also true of the past six months with only utility stocks managing to generate a positive return (+2.65%). 

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For much of 2021, everything that could go right for the market seemed to be going right. For 2022, the opposite has been true. For the moment, the current set of challenges has formed a “nowhere to run, nowhere to hide” scenario.

It’s been over two months since the S&P 500 last hit a record high and we must concede this downtrend could extend further from here.  That is a prime dilemma of nearly every bear market and correction, the way out is never obvious.

If there is a silver lining to any of this, it is good times follow bad times.  Even if the S&P 500 were to drop into a bear market from here, it always has recovered from bear markets – eventually.  In fact, forward returns following bear markets have generally been better than the average for all periods.  In terms of consistency, six months later the S&P 500 was higher three-quarters of the time which was better than the 67% frequency of positive returns for all periods (BESPOKE).

Investor sentiment has clearly dropped to bearish levels.  The net bullish sentiment indicator has been below the 10th percentile for five straight weeks and seven out of the last eight.  To put that in perspective, during the COVID crash it was only below the 10th percentile for four consecutive weeks (BESPOKE).  Historically, some of the best market returns tend to follow periods of depressed market sentiment. 

The current drawdown in equity prices is unusual in that the estimated earnings of the S&P 500 over the next 12 months have continued to climb higher, despite two-plus months of declines for stocks.  In other words, there's a big disconnect between analysts and recent market movement.  Normally one would expect rising stock prices as analysts are forecasting rising earnings.

This uncharacteristic development represents a “compression” in equity valuations.  Elevated levels of fear have triggered a rapid reset in what investors are willing to pay for future earnings (i.e. the Price/Earnings multiple).  Should the war in Ukraine begin to recede, or should we see a dovish pivot from the Fed (as happened in 1994), a sudden and strong rally in equities could materialize.

While we do not know how the current period of stress will be resolved, we believe eventual resolution is certain.  The historians among us are pointing out the irony that this is the 105th anniversary of the ‘February Revolution’ which essentially ended the reign of czarist rule in Russia when Nicholas II abdicated his throne in 1917.  It was during that time when Russian citizens mounted large scale protests and, despite an attempted crackdown by Russian police and the military, refused to back down.  

The current issue of the BESPOKE Report recounts the story well:

Not long after Nicholas abdicated, Vladimir Lenin returned from exile in Switzerland to lead the Russian Revolution, and as he is often credited with saying, “There are decades where nothing happens, and there are weeks where decades happen.” During the February Revolution, it took less than a week for protests to lead to the abdication of the throne by Nicholas II and usher in the communist era.  

The current Russia-Ukraine war hasn’t even been three weeks yet, but several years from now, with the benefit of hindsight will the world look back and point to this as another one of those moments where ‘decades’ occurred within a matter of weeks?

One can only hope that the current geopolitical conflict in Ukraine will see positive resolution in the very near future.  Perhaps the world will see decades of positive movement in the coming weeks.  

The past couple of months have been punishing to all diversified investment strategies, ours included.  Despite several successful moves to lower portfolio risk, we are clearly in negative territory year-to-date.  While our efforts have served to blunt some of the downside, the investment world has quickly moved into a binary mode.  In other words, the only decision at this juncture comes down to “risk on” versus “risk off”.  Given the preponderance of current evidence and our view that better days are just ahead, we conclude that taking a “risk off” posture (i.e. exiting the markets at these levels) is not the best choice at this time.

Economic fundamentals in the U.S. remain relatively strong and we still have confidence that properly diversified investment strategies will best serve client objectives over the next three to five years, regardless of what might transpire over the next three to five weeks.

Please call us directly should you have any questions or concerns.  We will continue to provide these updates to you as long as may be necessary to emerge from this period of crisis.

John E. Chapman, CEO CIS

March 15, 2022