Market Update as of June 30, 2022
The last six months have seen the broad U.S. Stock market decline in value by about (20%). As reported by CNBC, this is the worst first six-month performance for over 30 years (since 1970). What makes these six months particularly unusual is that the bond market also declined significantly. Normally in a large stock market decline there is a flight to quality with bonds performing well (or not as badly). The unusual activity this year reflects the combined effects of supply chain disruptions, a war in Europe and a rebound in inflation, all while the Federal Reserve is tightening monetary policy. The combination of declines both stock and bond values make this one of the worst first six months in the last 100 years. In this update we take a closer look at the performance of investments in general and the current short-term market decline relative to historical and recent multi-year returns.
Economic Expectations and Market Risk
Returns can be volatile as prices of stocks, bonds and other investment assets are based on expectation of the future – the economy, interest rates, global harmony (or disharmony) and ultimately the amount that investors will likely receive in the future from interest, dividends, and the sale of those assets. Let’s look at stock returns as an example. Over the period 1926 to 2021 the realized average annual return on a portfolio of S&P500 stocks (large company stocks) was 10.5%. Returns in individual years varied from an annual loss of 43% in 2008 to an annual gain of 54%. There were 25 years with negative annual returns and 71 years of positive returns. Some years in which there was a positive return had significant losses at interim points during the year.
For example, in 2020 when the global pandemic hit the stock market declined by about 30% in line with a revision of economic expectations. Market participants were expecting a global recession. By year end 2020 the market had recovered and as was up over 18% for the year. Note by historical standards this was a very fast recovery. Recoveries from low economic expectations typically take much longer. Note also that you only benefitted from the recovery if you stayed invested the entire year. If you sold when the market was at its most pessimistic and did not return to investing until the market was more optimistic you would have ended up with a loss for 2020. The main takeaway is the market will be volatile as we cannot predict the future. Expectations for future economic conditions and growth will constantly change as new information is received by the market. Research has shown that timing the highs and lows of the markets is not possible. The best long term investment strategy is to have an asset allocation diversified across investments that matches the amount of risk you can tolerate and stick to that plan. For example, a typical endowment or retirement portfolio is 60 to 70% stocks and 30-40% bonds and other investments.
Year-to-date Performance
The performance of the markets this year reflects another period of pessimism. Some pessimism is warranted as we have a war in Europe which has exacerbated supply chain disruptions, inflation and lower economic activity. What is unknown at this point is when the war will end, when inflation will moderate and when economic growth will again by positive. Economists are split on whether the U.S. will enter a recession this year or next – about a 50-50 possibility. We have already seen some reduced economic activity but so far it is a mild reduction. What will be most important is how much of an economic downturn will occur and how long it will last. All of this new information hitting the markets in the last six months and caused all investments, except commodities, to have large negative returns year-to-date through June 30, 2022.
The table below presents returns for selected Exchange Traded Funds (ETFs) over the last 6 months, 3 years, 5 years and 7 years. We prefer to look at ETFs rather than just stock price indices. ETF returns represent actual returns earned by investors versus price indices such as the S&P 500 price index. Price indices do not consider dividends or interest income. They also do not consider trading costs such as investment management fees and commissions. ETFs following price indices, on the other hand, do reflect the actual return to investors including income and expenses. For example, the SPY ETF invests in the 500 stocks comprising the S&P 500 price index and its return included dividend income, fee expense and commissions on trading the underlying stocks.
The QQQ ETF follows the NASDAQ stock index, which is comprised mainly of growth stocks, including technology stocks. Investments following this index were the hardest hit year to date with a 28.4% loss. Growth oriented stocks typically trade at a premium to other stocks – they are priced higher due to market participants expecting high future growth. When future growth prospects do not occur or there is fear that this growth will subside these stocks are hit the hardest.
The SPY ETF follows the S&P 500 Index comprised of large company stocks. This index includes high expected growth stocks (Growth Stocks), stocks selling at reasonable prices relative to growth (GARP Stocks) and stocks selling at low prices relative to growth (Value Stocks). As a result, this index is typically described as a blended index (growth and value oriented). However, this index is market capitalization weighted so it is biased toward higher priced growth stock performance. This ETF had a loss of about 19% year-to-date. A substantial loss but not as high as the high growth QQQ index. Note the S&P 500 only includes 500 stocks. If we broaden our perspective to the largest 3,000 U.S. stocks (IWV ETF) we similarly see about a 20% loss year to date.
The VTV ETF follows large company valued oriented stocks (lower price relative to future prospects). This index has a loss of only 9% less than half of that of the S&P 500 and a third of that of the QQQ. Value stocks over very long periods of time have outperformed growth stocks and with lower volatility. One issue with this index is that it invests solely based on low prices and excludes stocks selling at reasonable prices relative to growth.
The FNDX ETF is another more value-oriented fund. It invests in large companies but weights them in the portfolio by factors such as sales, asset value and earnings. I generally prefer this type of value-oriented fund/index to a pure value index such as the one underlying VTV. This fund was down about 11.5% year-to-date as was the international stock version of this ETF (FNDF).
Turning to small and medium sized public companies returns were about minus 15% and minus 12.5% respectively (VBR and VOE ETFs).
In summary, stock investments are all down year to date with the worst performance in the U.S. growth sector. Value, international, small company and medium company stocks have outperformed, albeit at losses as well. Given current valuations of each of these sectors, I would expect value, international and smaller company stocks to continue to outperform in the coming years.
Bonds, also known as fixed income, have also performed poorly. As inflation has risen and the U.S. Federal Reserve has raised interbank interest rates, interest rates demanded by investors on bonds has increased year to date. The yield curve presented immediately below shows the market interest rates for U.S. government bonds by maturity as of December 31, 2021.
Three year U.S. bonds were priced to yield about 1%. 20 year U.S. Bonds were priced to yield 2%. These rates were very low relative to historical norms due to loose monetary policies in the last decade. From 1926 to 2021 the average annual total return on long term government bonds was about 6%. This was a period in which inflation averaged 3% per year. So historically, long term government bonds offered a 3% rate of return over inflation. In recent years both inflation and bond yields have been low with bond returns often lower than inflation.
With recent increases in inflation and the Federal Reserve tightening monetary policy (increasing short term interest rates), the yield curve has shifted to that shown below as of June 30, 2022.
Three year U.S. bonds now offer a 3% return, three times the level of the beginning of the year. 10 year U.S. bonds offer about 3.5%. This yield curve is flatter than normal with longer term bonds offering about the same rate as shorter term bonds. If the inflation does not subside and the Federal Reserve continues to aggressively tighten monetary policy the curve is likely to steepen such that longer term rates increase.
This shift in rates is both good and bad news. For new investments in bonds you are getting a higher interest rate, however prior investments in lower yield bonds have declined in value since they do not offer today’s higher rates. This has resulted in a 10% loss in overall bond investments in the last six months. Intermediate bonds (5-7 years) declined by 8%. Inflation protected bonds had a very modest decline of 1.5% given their rate is variable to compensate for inflation.
Commodities were the only safe place to be. With inflation high particular related to oil and gas, commodities have offered a 30% return in the last 6 months.
Given declines across most investment types, diversified portfolios were also down substantially for the last six months. The AOR ETF which represents a portfolio of 60% stocks and 40% bonds was down about 15.5% for the period.
Long Term Perspective
While the recent losses are painful, returns have still been strong over the past few years. The table above shows that even with the recent declines, stock portfolios are still higher than they were three years ago. The average annual return on large stocks over the last three years was about +11% including recent losses. Only bond offered a cumulative negative return over the last three years. Looking back five and seven years, all investment types have offered strong returns even after considering recent losses. Looking forward we need to see inflation subside and economic activity to return to normal for the recovery to begin. This recovery will likely not be as quick as in 2020 and may take a year or more. The good news is that returns on bonds will likely remain at their new higher level or increase further such that bond investments will be more attractive going forward than in prior years. The best long-term strategy is to have a diversified portfolio that includes stocks, bonds and alternative investments (such as commodities and real estate) that matches your risk tolerance. You should also make sure to have sufficient cash/money market holdings such that you can withstand declines in investment markets for one to two years.