Is It Really That Bad Out There?

Both stock and bond markets have been bad this year.  This is without question.  Global stocks ended the month in a bear market1 and bonds are experiencing one of their worst years in history.2  Through the end of September, a portfolio consisting of 60% stocks and 40% bonds is facing the worst performance since the Great Depression.3

With this level of performance, it would be easy to conclude that we are experiencing decimation in the economy and within the companies that build and produce goods and services.

But, let’s take a more in-depth look. 

  • US Gross Domestic Product (GDP) is a widely used measure of economic growth. After two-quarters of decline, GDP grew at an annualized rate of 2.6% in the third quarter.4 
  • The most recent data showed an increase in employment of 263,000 jobs and an unemployment rate of a near 50-year low at 3.5%.5
  • Companies are currently reporting their quarterly results. As of Oct 28, 52% of the S&P 500 companies have reported.  71% of these companies have beat their earnings estimates, and year-over-year growth of earnings is 2.2%.6

This data would indicate a disconnect between the stock market decline and the level of decline that is actually being experienced in the economy.  While this is interesting, it isn’t unprecedented that stock performance and economic health diverge from time to time.

Investors in the stock market attempt to forecast an unknown future, not invest on what has happened already.  Also, buyers and sellers of the stock market are not emotionless robots and, especially in shorter-term periods, can get caught up in positive or negative sentiment cycles that may not perfectly correlate with fundamental trends. 

Of course, there are issues that are concerning.  Inflation is by far the number one concern of investors.  Inflation has been elevated and persistent.  This affects the consumer’s ability to spend on the things they want because the things they need are more expensive.  Further, the US Federal Reserve has two mandates: full employment and controlled inflation.  Employment is extremely healthy right now, but as employers have to pay more to attract talent, that wage growth is one of the reasons for elevated inflation.

As a result of persistent inflation, the Federal Reserve has been very aggressive in raising interest rates to control inflation.  Interest rate increases cause bond prices to fall.  Further, raising interest rates have a side effect of eventually slowing the economy.  The worry among stock investors is that the rapid increase in interest rates will cause an economic and corporate earnings recession. 

Going forward, stock markets will likely continue to react to inflation data.  In our opinion inflation has peaked, and we expect a gradual decline into year-end with further declines into 2023.  The Federal Reserve target for inflation is 2% to 2.5%.  While we don’t expect to be at these levels anytime soon, a gradual decline from current levels should provide a better indication that future interest rate actions may be less aggressive. 

Further, it is our expectation that the unemployment rate will rise, but we do not expect the level of job decline that we saw in either 2008 or 2020.  Our expectation is based on the recent (and current) shortage of employees in many industries.  The transition of COVID shutdowns and subsequent rebound left many industries woefully understaffed.  This recent history, in our opinion, will make businesses less likely to significantly reduce headcount unless economic trends begin to severely worsen.

Lastly, our expectation is that estimates for earnings growth will decline from current levels.  Consensus estimates for S&P 500 earnings growth in 2022 and 2023 are 6.3% in both years.6  Our expectation is that this could slow further but a prolonged earnings recession remains relatively unlikely. 

With the above in mind, it is entirely possible that we have already experienced the worst of the decline in the stock market.  However, markets can always surprise both positively and negatively based on changes in fundamental data or investor sentiment.  This is precisely why we advocate for a diversified investment plan that incorporates safe assets to protect from declines and growth assets to participate in market rallies. 

As always do the homework upfront to understand your personal situation and invest in a prudent manner to achieve the goals for your money within the bounds of your personal risk tolerance.