With financial markets under significant pressure, we wanted to share a special macro edition of Talking Shop. Typically, our focus is on news and updates that pertain to our portfolio companies but given recent market volatility, we thought it would be helpful to take a broader look at the markets and why we remain confident in the long-term outlook.
The market trend in 2022 has been down. Inflation, the war in Ukraine, and rising interest rates are the major concerns that market participants have been grappling with. Good investors know that while the stock market is a great tool to create wealth over long time horizons, it is never a straight line up. This is easy to forget especially given the fact that volatility has been muted for much of the past two years; the S&P 500 generated positive returns in 16 of 21 months preceding the end of 2021.
We must also remember that bear markets (defined as a 20% decline) are common. Since 1960 there have been 11 bear markets or roughly one in every five and a half years. Even more common are market corrections (defined as a 10% decline). In 10 of the last 20 years, the S&P 500 has experienced a market correction.
In fact, we have seen declines of 13%, 20%, 34%, and now 17% since late 2015. Historically, the average correction has lasted a little over two months with an average S&P 500 decline of 18%.
While it is natural for down markets to cause anxiety, it is helpful for investors to zoom out and remember that investing is a long-term game. During the Great Recession, the S&P 500 declined 52% from peak to trough. Despite that ugly bear market, the index has returned over 250% since its pre-recession peak. During the COVID outbreak in February 2020, the market declined 34% in one month. However, from the pre-COVID peak, the market is up nearly 20%, even accounting for the current sell-off. While difficult, being able to separate facts from the emotions caused by daily market movements may provide some level of comfort.
The bond market – typically considered a safe-haven when volatility grips equity markets – has seen a dramatic sell-off as interest rates have rapidly moved higher. Bond prices decline as interest rates rise. The Bloomberg U.S. Aggregate Bond Index, which is often used as a representation of the entire U.S. bond market, was down nearly 10% through the first four months of the year. If the year had ended April 30th, this would have ranked as the worst full year performance of the index in its history, with its inception going back nearly 50 years!
Poor bond performance has driven over $100 billion of outflows from bond funds, with realized losses being forced on fund investors. While the individual bonds in your accounts have not been immune to rising interest rates, our primary focus on credit quality gives us confidence in holding our bonds to maturity when principal will be repaid in full.
The bonds you see in your portfolios will be “marked to market” as interest rates move, so you will see price movement. However, given we almost always hold bonds to maturity, you will receive the return that was “locked in” at the time of purchase because the cash flows you receive from the bonds will not change (barring credit issues). The marking to market of your bond portfolios can be unsettling – but bear in mind that the pace at which interest rates have risen and the corresponding losses in the bond market are largely unprecedented. We remain highly confident in each bond we own in your portfolios and expect short term losses to be recouped as bonds near their maturities.
Despite the bearish sentiment surrounding inflation, interest rates, and financial asset valuations, there are some bright spots that should be considered. Importantly, the labor market and corporate earnings are quite strong. While this is often true at the start of most rising rate cycles, current leading indicators give us confidence that the economy can withstand some Fed tightening. In addition, we are confident our portfolios are well positioned with high-quality, well-run companies.
We are currently at the tail end of what is the most unusual employment data trend in history. Unemployment rates hovered around 3.5%-3.6% in the months leading up to the pandemic before ballooning to 14.7% in April of 2020. Since then, we’ve seen a rapid decline in the unemployment rate all the way back to 3.6% in the two most recent readings. COVID lockdowns took employment levels from a pre-pandemic peak of 152 million down to 130 million by April of 2020. After an initial bounce back, the Great Resignation stalled employment just above 140 million as many who left the workforce delayed their return. This trend has corrected in recent months and the latest payroll data showed that we’ve now eclipsed 151 million working Americans, just shy of our pre-pandemic high. On top of that, job openings nationwide are at an incredible 11.5 million, well above the pre-pandemic average of 7 million. The tight labor market gives workers options, boosts sentiment, and uniquely positions the economy to be able to weather the rate-tightening cycle.
From the corporate view, first quarter earnings are out – our first of four quarterly report cards for publicly traded companies – and the results were positive. Despite some issues associated with input cost inflation and logistics, earnings on the whole were very solid. In fact, 96% of our CEA portfolio companies reported earnings that were in-line with or above expectations. So, while we may see short-term asset price fluctuations due to market volatility, as owners of these businesses, we are encouraged by their results and remain bullish on our investments moving forward.
The Sandhill Research Team
Disclosure: This has been prepared for informational purposes only and does not constitute, either explicitly or implicitly, any provision of services or products by Sandhill Investment Management. Sandhill Investment Management (“Sandhill”) is a registered investment advisor with the Securities and Exchange Commission that is not affiliated with any parent company. Third-party information in this report has been obtained from sources believed to be accurate; however, Sandhill makes no guarantee as to the accuracy or completeness of the information. All statements made regarding companies, securities or other financial information contained in the content are strictly the beliefs and opinions of Sandhill and are not endorsements of any company or security or recommendations to buy or sell any security. Holdings discussed are part of our Concentrated Equity Alpha (“CEA”) investment strategy. For a full list of CEA strategy recommendations for the preceding year, please email your request to email@example.com.
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