After a rough start for stocks in 2022, investors are wondering when to expect a rebound. After more than doubling off the pandemic lows in March 2020, without anything more than a 5% pullback in 2021, stocks probably needed a break. That does not, however, make this dip comfortable. Fears of rising rates and the Federal Reserve pulling back its stimulus more aggressively than previously anticipated to fight inflation have caused most of the market jitters, though earnings season—albeit in the very early stages—has not helped either.
The pain has been particularly acute for the many growth stocks that make up the Nasdaq Composite, which has corrected 14% from its November 2021 high. This is the third worst start to a year ever for the Nasdaq (down 10% year to date), though it was positive the rest of the month the last five times it was down 5% or more year to date through January 20 (thank you to Bespoke Investment Group for that nugget). Small caps have been hit even harder, with the Russell 2000 Index nearly in bear market territory with its 18% decline since November 8, 2021—though the higher quality S&P 600 small cap index has fared somewhat better in losing 12% during this period.
Part of the problem is that the economy is slowing. It is unreasonable to expect the economy to grow at the speed it did last year, with the extraordinary monetary and fiscal stimulus provided by the government to counteract the untoward effects of the pandemic. While the economy is still on solid footing, the rate of change represents a deceleration in economic growth. This phenomenon will become more apparent in the second quarter. In the meantime, the Federal Reserve is belatedly responding to higher-than-expected inflation. The stock market may be concerned that the Fed will make a mistake and may raise rates too much into an economic slowdown.
Inflation and the Fed’s response to it represent the immediate risks for markets. However, we could see evidence of easing supply chain bottlenecks and more people joining the workforce as COVID-19 disruptions hopefully fade (there are a near-record 10.5 million open jobs in the U.S. now compared to less than 7 million pre-pandemic in December of 2019). If inflation does start to ease and the markets remain jittery, the Fed’s posture will likely be less hawkish.
Earnings should be solid this year, but multiples may be under pressure from slowing growth. If history is any guide, then we should expect stock market gains to come from earnings growth and dividends and be more moderate than what we have experienced the last couple of years. Since we have lingering effects of supply chain disruptions, wage and other cost pressures, and unknowns from the Omicron and future variants, future earnings may be difficult to predict.
Despite these challenges, earnings could still provide support for stock prices for the following reasons:
- With about 70 S&P 500 constituents having reported, index earnings are still tracking to 5% upside, in line with the long-term historical average.
- Profit margin assumptions baked into analysts’ estimates appear to reflect many 0f these challenges, increasing the likelihood of mostly positive market reactions to results.
- Despite a likely smaller upside surprise than in recent quarters, an earnings growth rate potentially in the mid-to-high 20s for the quarter would still be impressive.
- Estimates for 2022 have been holding up well. Historically, earnings estimates fall during reporting season, which has not happened so far.
Investors have grown accustomed to steady, consistent gains over the past couple of years which makes the current bumpy ride feel more uncomfortable. After no more than a 5% pullback in 2021 and the S&P 500 having more than doubled off the March 2020 lows, more volatility in 2022 is to be expected. Higher interest rates and a less accommodating monetary policy from the Fed amid stubbornly high inflation are getting most of the blame, and rightly so.
It is also a midterm election year, which typically brings more volatility and smaller stock market gains. Historically, during mid-term election years, the S&P 500 has on average done nothing but bounce around the flat line until right before the elections, much different than the average path of the market across all years.
The volatility we have seen this year is uncomfortable, but it is well within the range of normal based on history. The S&P 500 has averaged three pullbacks of 5% or more per year and one correction of at least 10% per year over its long history. After just one 5% dip last year, and huge gains off the 2020 lows, we were due for a dip.
This pullback in the S&P 500 could easily go to 10%, or even more. The average max drawdown in a positive year for stocks is 11%. But based on the still solid overall economic and earnings backdrop, reduced inflation concerns and the stock market’s historically solid track record early in Fed rate hike cycles, we could see attractive yearend returns of more than 12% above Friday’s closing price.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. To determine which investment(s) may be appropriate for you consult your financial advisor.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Data provided by LPL Financial, Bespoke Investment Group and the Standard and Poor’s.
- Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses.
- The Standard & Poor’s 500 Index (S&P500) is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.