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Market Update Summer 2022
The S&P 500 had its worst first half of a year in more than 5 decades and so did the Bond market. What happens next? My assessment is that S&P 500 Index bottoms setting stage for stocks to rally over next twelve months. A normal Bear market last on average 11 month and declines 28% on average. This Bear market is in its 7th month and has given up intra-day gains of 24.5% from it’s high. The decline in stock values reflect stagflation economic conditions. The S&P 500 Index could decline another 4% from here if economy is just in a shallow recession (3% or less contraction in real economic growth).
Historically, many investors who moved out of stocks during down markets did not fare as well as those who stayed the course at this point. A hypothetical investor who missed just the best 10 days in the market over the past 4 decades could have reduced their long-term gains by 55% according to Fidelity research. Many of those best days occur after a Bear market bottom.
S&P 500 Index declines a median 23% into a short mild recession. We are already there considering this year’s stock declines and negative economic growth for the first two quarters. Expect a sharp rebound after this Bear bottom is in. The largest average returns occur from a market bottom to a few months out. In total the S&P has risen 59% on average during the 14 months period following a bottom according to research by CFRA. Investors must stay the course to recoup unrealized losses.
Furthermore, after 20% decline threshold is reached, in most past Bear markets without deep prolong recession, a low was in within two months (third quarter), and forward returns over the next 12 months tend to be better than average with a median return of 23.9% 78% time since 1945 according to Bespoke.
Presently, an economic slowdown is priced into earnings growth but not a pro-long recession. Recent Retail sales report confirmed that the consumer spending is cutting back (almost 70% of U.S. economy is consumer spending). The University of Michigan consumer sentiment survey hit an all-time low that does not bode well for consumer spending. Decreasing wealth effect will lower consumer spending along with higher energy prices. Real median household income is declining. On the other hand, household debt service payments as percent of disposable income are exceptionally low. The cushion in extra discretionary income due to low debt service payments will fade as Fed policy make credit more expensive in household finances. All this means earnings estimates should be lower than projected. I do not expect them to crater as in a recession.
Earnings is now the focus for markets. Analysts lowered their earnings estimates for the second quarter but not by much according to FactSet. As a result, the S&P 500 index is expected to report its lowest earnings growth since Q4 2020. More S&P 500 companies are issuing negative earnings guidance for 2022 but not at an alarming level. Companies are concerned about a recession. Earnings growth estimates of 8.5% and 9% for 2022, and 2023 respectively are too rosy given slowing economy. Analyst typically overestimate earnings late in the cycle, so investors are weary of Analyst estimates. The second quarter earnings season will be the telltale on whether Analyst are right.
The S&P 500 trades at 15.8 times forward earnings estimates. That is about an average multiple for the S&P 500 Index in an economy growing and not in a recession. However, those earnings estimates are too optimistic given softening spending, consumer sentiment, and tighter financial conditions. If the Fed continues to be aggressive with its rate hikes in the second half of the year, and economy does slip into recession, then earnings estimates would surely be cut by at least 20%. Of course, consumer spending headwinds and the aggressiveness of monetary policy could reverse course and save us from deep cut to earnings.
Profit margins, and valuations are adjusting to slower economic growth but not a full-blown recession. Profit margins for the median S&P 500 company are above average level for last five years but are declining from record high according to S&P Global. Profit margins should decline further as economy slows and cost of operating/labor stays high, just another headwind for stock valuations in the short run.
Investors who make decisions by looking backwards, it is like driving your car by looking through the rearview mirror, will not be successful long-term investors. Be forward looking to become a better investor, buy on extreme price weakness, after a lot of bad news is priced into stocks, to generate higher long-term returns.
CFRA research shows that since WWII, the S&P 500 Index rises 40% on average over the next 12 months after Bear market ends. Moreover, in the nineteen previous times the S&P 500 fell at least 15% in a single quarter (2Q22), the next quarter it rebounded 68% of the time by a median of 6.8%. Two quarters later, the S&P 500 has been up 100% of the time by a median of 13.0%. One year later, a 25.1% median gain 100% of the time.
What else? Historically, in a Mid-term election year, the fourth quarter along with the first two quarters of the following year, are among the best quarters according to CFRA. By the Fall the market will have discounted any recession, inflation should be moving lower, and the Fed should be shifting away from hawkish dovish commentary. History shows that next Bull market begins three months after the end of the bear market. I figure that the current Bear will bottom sometime before November.
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