We are hoping this update finds you and yours enjoying the summer as we celebrate our nation’s independence and the many freedoms we hold so dear. The second quarter continued to provide ongoing fluctuations and market declines that placed equity markets into Bear territory last month. This sell off was driven primarily by concerns over inflation and the long-term impact higher prices may have on the economy and the markets over the coming months. During the quarter Large Caps, Mid Caps, Small Caps and International Stocks experienced lows of at least 20% off previous all time highs, and the Bloomberg Aggregate Bond Index declined over 10% as well.1
Inflation has now increased to levels we have not seen in over 40 years, which remains the primary concern for economists, analysts and investors alike. The Federal Reserve’s effort to slow down the economy by raising interest rates seems to be a prudent, albeit belated, approach to dealing with what was initially coined as “transitory” inflation. Ideally increasing the interest rate environment, referred to as “Fed tightening”, should help to head off inflation without derailing ongoing economic growth. We see the uncertainty surrounding the Fed’s ability to navigate this effectively through either a mild recession or a “soft landing” as a primary concern. This very concern has caused much of the market sell off, which may have created an “oversold” status, placing PE ratios well below their 25-year average.
Trillions of dollars of stimulus alongside supply chain issues and Russia’s invasion of Ukraine have all contributed to the high levels of inflation we are experiencing. The hope is that the Fed’s efforts alongside strong labor markets, strong consumer spending, low unemployment, and solid corporate earnings will help us get through this cycle while still maintaining ongoing economic expansion. As you will note with the enclosed economic data, we currently have an interesting dichotomy with consumer sentiment, or outlook, at very low levels, while consumer spending and retail sales still remain very strong. With inflation at historically high levels, and consumers feeling the pain at the pump and in the checkout line, having negative sentiment is understandable. Amid these inflationary pressures, it has been encouraging that earnings and spending levels still remain strong, which obviously helps support ongoing economic growth.
1Data obtained from YCharts as of June 30th, 2022
While there has been much talk of recession lately, economists are still divided as to whether or not one will transpire. Recession is defined as two consecutive quarters of reduced GDP, and in the first quarter we were off 1.4%, so another reduced quarter would place us officially in a recessionary period. It is important to remember that if we do enter into a recession, all is not lost. While they are never really welcomed, they are a normal part of the economy as it goes through cycles of expansion and contraction. Based on the supporting economic data, we believe that if we do enter into a recessionary period, it will be shallow and short lived. Low unemployment coupled with strong corporate and personal finances are two huge differentiators when comparing recessionary periods that had high inflation 40-50 years ago, which is causing many analysts and economists to be cautiously optimistic that we can get through this cycle to a soft landing on the other side.
While we have seen great growth in home values over the last couple of years and an immense amount of activity, we believe this is an area that will provide slower growth moving forward. The Case-Shiller Index (Housing Values) has increased approximately 40% over the last 2 years, and 30-year mortgage rates are approaching the 6% level from the previous rates of less than 3% last fall.1 These two factors combined have nearly doubled the monthly payment required to purchase the same home a home buyer could have considered two years ago. We believe this will impact housing starts, existing home sales, and home values as we look out over the next couple of years. We also believe this forecasted pressure on the housing market is one of the many factors driving the recent downturn we have seen in market, and may already be priced into the market to some extent.
As mentioned above, virtually every major equity index reached Bear territory last month, off more than 20% from previous all time highs. Although these cycles are highly unpredictable and never fun to go through, they are a normal part of equity market growth over time. We recently cited a study by JPMorgan that covered the last 40 years depicting the average intra year decline to be expected in equites at approximately 14% per year.2 This is over a period where equity markets averaged over 10% annual returns. Although we have seen a stronger pull back in valuations recently, and we don’t yet know the full extent of the drawdown, the chart below provides some encouraging data regarding the growth phases after Bear markets. As noted, average declines are recorded at 42% during the Bear, and subsequently followed with Bull returns averaging 164% going back almost 100 years over 12 Bear markets. After the most recent Bear market (not reflected on this graph), believe it or not, the S&P 500 is still actually over 50% higher today than it was on March 24th, 2020, which can also help keep these fluctuations in perspective.
1 Data Obtained from Case-Shiller Index on YCharts and J.P. Morgan Weekly Market Recap as of June 30th, 2022
2 J.P.Morgan’s Guide to the Markets, page 16 as of May 31st, 2022
On the bright side, unlike last year, this year we have been able to initiate multiple rounds of tax loss harvesting which will help to offset current and future capital gains tax as much as possible. We have also seen current market valuations (as measured by Price to Earnings ratios) fall below their 25-year average. This means that while corporate earnings are still strong, stocks are now relatively inexpensive. Accordingly, we are continually rebalancing within the portfolio to take advantage of those opportunities as we are able. It’s also important to note that with major indices off 20-30% we may have already seen or are close to seeing the bottom of this Bear. Our hope is that the market may have already priced in many of its concerns over inflation, interest rates, housing, and the uncertainty surrounding the impact those things may have on economic expansion. The following chart depicts 3yr, 5yr, and 10yr average returns of the market after the most recent Bear markets lows, which are also fairly encouraging.
Data obtained from All Financial Matters as of March 31, 2020
Although we are hoping for a smooth landing, a recent example of a market sell off prior to an economic storm was just over two years ago. You may remember the stock market dropped 35.3% in just five weeks, and bottomed out on March 23th, 2020, at which point less than 1000 people had died from Covid. The subsequent 18 months were awful with hundreds of thousands of people dying, shutdowns across the globe, racial tensions, rioting in the streets, political tensions, and a 31% reduction in GDP. In the midst of all of this chaos the markets inexplicably rose almost 90% over the next 21 months.1 We believe this was largely due to a panic sell off that occurred prior to these challenging events playing out, and at this stage based on all the info we are evaluating, we believe the recent sell off may at least be echoing a similar pattern as leading economic indicators are still relatively strong.
As discussed in the past, we have stress tested your portfolio allocations to make sure it is in alignment with your highest likelihood for long term success in achieving your objectives. Accordingly, unless those objectives have changed, the only tweaks we are making to your diversification is rebalancing to maintain your portfolio in a manner consistent with your objectives. If objectives or time frames have changed recently, please feel free to call to discuss your current strategy in more detail. Your asset allocation details are enclosed with your performance update.2
There have not been many safe havens for investing most recently with both equities and fixed income valuations going lower this year. On the fixed income front it is important to note that your bond holdings are reporting a lower value than the beginning of the year due to the rising interest rate environment, if we elected to sell them. As you will see on the bond report, we are still receiving the bond interest to the date of maturity, and then receive the full face value of the bond at maturity. So, unless the bonds were to be liquidated in the near term, the recent decline in value is relatively inconsequential, and we will continue to receive the interest on the bonds as indicated. Our bond managers reduced the duration on your bond holdings to an average maturity of less than 5 years, which has also protected our bond holdings on the downside when compared to the index. This has also positioned us for higher interest bearing bonds as our existing holdings mature over the coming years. Data obtained from All Financial Matters as of March 31, 2020
1Data Obtained from S&P 500 total returns on YCharts and Real GDP returns on YCharts as of June 30th, 2022
2Asset allocation is an investment strategy and will not guarantee a profit or protect you from loss
Although our alternative sleeve has had a rough first half of the year with real estate and digital currencies recently struggling, our bond manager and the majority of our equity managers continue to perform well compared to their benchmarks. This has also helped us mitigate the recent drawdown, while still keeping us poised for longer term growth when our bonds, equities and alternatives turn back in the right direction.
Please take some time to review the enclosed market and economic data, along with your portfolio update, and should you have any questions or concerns, of course feel free to call. If we have not heard from you, we hope you enjoy the rest of the summer, and we will look forward to connecting with you again very soon. As always, it is an honor and privilege to be serving you and we look forward to doing so for many years to come.
MSFS, CLU, ChFC, AEP®, AIF®
Chartered Financial Consultant
Masters of Science in Financial Services
AEP®, RICP®, CAP®, AIF®
Securities Offered Through M Holdings Securities, Inc. A Registered Broker/Dealer, Member FINRA/SIPC. Investment Advisory Services Offered Through Legacy Wealth Asset Management, LLC. Legacy Wealth is independently owned and operated. This material is intended for information purposes only and should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney, tax advisor, or plan provider. Investments in securities involve risks, including the possible loss of principal. When redeemed, shares may be worth more or less than their original value. The Standard & Poor’s 500 Index (S&P 500 TR) is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. The Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).The Purchasing Managers’ Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors. It consists of a diffusion index that summarizes whether market conditions, as viewed by purchasing managers, are expanding, staying the same, or contracting. The purpose of the PMI is to provide information about current and future business conditions to company decision makers, analysts, and investors. The Composite Index of Leading Indicators, otherwise known as the Leading Economic Index (LEI), is an index published monthly by The Conference Board. It is used to predict the direction of global economic movements in future months. The index is composed of 10 economic components whose changes tend to precede changes in the overall economy. These examples are for illustrative purposes only, an investor cannot invest in an index. Commentary regarding the returns for investment indices and categories do not reflect the performance of Legacy Wealth, or its clients. Historical performance results for investment indices and/or categories generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. Past Performance of an index is not an indication of future results. File #4825386.1