The economic and financial market backdrops are changing, and the news headlines have been quite disconcerting. After averaging gains of 20% for the previous three years, the stock market is experiencing a correction, with the S&P 500 Index down about 10% year-to-date. Some corrective market action was to be expected and a healthy tonic for long-term stock market returns. Certain parts of the stock market, however, have experienced severe declines in price, especially those stocks that had been bid up on unrealistic expectations. Companies, many of which have been described as “disrupters,” are being reassessed and reevaluated based on more realistic growth trajectories using more conservative valuation metrics. In other words, investors are pulling back on their risk tolerances, which is, again, a part of a normal and healthy process. If the current market environment turns out to be similar to the period following the dot-com bubble deflating, these stocks still have downside risks. This is potentially very good news for our clients, as opportunities to invest in faster growing, earlier stage companies might improve materially in the coming months and years. Many disrupters will not make it. Others will mature and begin to generate long-term profit streams, at which point we might get more interested. For now, we are building our shopping list.
Against a backdrop of evolving investor risk tolerance, current geopolitical tensions have dramatically increased levels of uncertainty. Prior to the recent offensive maneuvers in Ukraine by Russian forces and the significant retaliatory financial tactics of the West, investors had been pricing in solid growth in corporate profits for this year and next. 2021 turned out to be one of the best periods on record for corporate profit growth. The winds of change began to blow late last year when the U.S. Federal Reserve announced an end to their bond buying program (to keep long-term interest rates low) and the goal of raising short-term interest rates to help fight inflationary pressures. More recently, higher commodity prices, especially for energy, will likely turn the tailwinds of 2021 to headwinds in 2022, increasing the risk of economic recession and lower corporate earnings. Investors are just beginning to price these risks into the securities markets.
Bear markets tend to coincide with recessionary economic conditions, as investors reduce their risk appetites at the same time that corporate earnings begin to decline. Bond market conditions seem to be signaling some challenges ahead (maybe fewer rate increases). The U.S. Dollar has been exceptionally strong, and this puts pressure on developing economies. The Euro has declined materially, especially since Russian troops entered Ukraine. We have concerns about the strength of Europe’s financial and banking systems and are keeping a close eye on the risk of contagion. The good news is that the U.S. banking system is well-capitalized and should be better positioned to withstand financial market turmoil.
For now, we expect the economic recovery from the pandemic to continue, with governments and central banks navigating the difficult balancing act of maintaining economic growth while controlling inflation. With interest rates still so low relative to history, we are inclined to focus new investment in high-quality, growing businesses whose stocks have already priced in the potentially more difficult economic conditions ahead. At present, we advise a cautious approach with a patient temperament as well. If conditions deteriorate, we will be here to provide further counsel.
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.