Despite a late-month rally attempt, 4 out of the 5 major equity indices ended the month in negative territory with the S&P 500 falling 0.56%, the NASDAQ losing 3.63%, the Dow Jones Industrial Average shedding 0.22%, the Russell 1000 Value being the sole gainer with a 1.71% rally & the Russell 1000 Growth underperforming with a 3.68% loss.
May 2022 Stonemark Market Commentary
Looking at the markets from a sector view, Energy (+13.40% for the month of May), once again, led the way while Consumer Discretionary (-6.19% for the month of May), Consumer Staples (-3.48% for the month of May), Real Estate (-2.65% for the month of May) & Information Technology (-2.54% for the month of May) continued to weigh on the broader equity indices.
1st Quarter Earnings Wrap-Up
With the end of May, 1st quarter earnings are essentially done & Wall Street is now looking forward to 2nd quarter earnings. Despite some disappointing earnings results & the corresponding negative price action, looking at Figure 1 below, earnings results for the 1st quarter did in fact grow by 4.62% & are forecasted to grow by 7.80% for full-year earnings. While 79% (according to FactSet) of S&P 500 companies did beat 1st quarter earnings estimates, it was the forward-looking guidance for the 2nd quarter & beyond that led to the aforementioned negative price action. For this, we turn to Figure 2 below, which shows the earnings revisions (earnings estimates as of November 2021 compared to earnings estimates as of May 2022) for the 2nd quarter & full-year.
As Figure 2 indicates, just in the last 6 months, analysts over at CFRA have revised 2nd quarter earnings results to the downside for 7 out of the 11 S&P 500 sectors & have revised full-year earnings results to the downside for 5 out of the 11 S&P 500 sectors. Despite these downward revisions to full-year earnings on the S&P 500, CFRA is still forecasting 4.32% year-over-year earnings growth to $227.91. Given where interest rates are, specifically the yield on 10-Year U.S. Treasuries, we believe that at 3% 10-Year yield would equate to a 16.5x forward 12-month P/E multiple on the S&P 500 while a 3.5% 10-Year Treasury yield would reduce the multiple even further to 15.5x. With that said, a 16.5x & 15.5x multiple on full-year S&P 500 earnings of $227.91 would give us 3,760 & 3,532 on the S&P 500, respectively. Assuming full-year earnings come in right in line with CFRA’s estimates, a 16.5x (3% 10-Year) P/E multiple would represent a 9% decline from May’s S&P 500 closing price while a 15.5x (3.5% 10-Year) P/E multiple would represent a 14.5% decline from May’s closing price of 4,132. That being said, we still have another 6 months left in the year & if certain catalysts (i.e. inflation, the war in Ukraine, etc.) can slow down or end, we would view those as potential catalysts that would allow equity markets to move higher. However, take this with a grain of salt as everything is pointing towards continued elevated inflation & Putin has not shown much desire to end Russia’s invasion of Ukraine.
Inflation, Interest Rates & the Federal Reserve
Towards the middle of May, we received April’s print of the consumer price index (“CPI”), which showed that inflation, on a year-over-year basis, rose to 8.3%, which, while it was lower than March’s print of 8.5% is still at extremely elevated levels relative to historical numbers. With no indication that inflation is easing & the average American spending significantly more today than they were one year ago on everyday essentials, the Federal Reserve (“the Fed”) is being put in an extremely difficult position & Wall Street is taking notice. Many investment professionals have been critical of the Fed, with the idea that the Fed was too accommodating with its monetary policy in order to prop up the economy during the height of the COVID-19 pandemic. Those same investment professionals now fear that the Fed will overshoot once again in being too aggressive with raising interest rates & reducing its balance sheet, which has the potential to send the economy into a recession.
As we discussed in our May 6th Market Update (Fed Raises Rates), the Fed raised interest rates by 50 basis points (“bps”, 100 basis points = 1%) to a targeted range of 0.75-1.00%, marking the largest interest rate increase since 2000. Citing the ongoing Russian invasion of Ukraine & COVID-related lockdowns in parts of China, the Fed acknowledged that, as a result of record high inflation & ongoing supplychain disruptions, future interest rate hikes will be appropriate. Comparing Figures 3 & 4 below, as of February 28th, which is right before the Fed made its first interest rate hike in March, the CME Group’s FedWatch Tool was forecasting the targeted Fed Funds rate to be at 2.00-2.25% by the end of the year. However, as of the end of May, we have started to receive a bit more clarity with regards to the trajectory of interest rates, but Wall Street is now forecasting the targeted range to be 75bps higher by the end of the year with a new targeted range of 2.75-3.00%.
With the average American paying significantly more for everyday goods such as groceries & gasoline to more luxury goods such as travel & automobiles, the Fed is walking an extremely thin line between being too aggressive with interest rate increases (which could send us into a recession) & not being aggressive enough, which would put them “behind the 8-ball” when it comes to reigning in inflation. That being said, all of Wall Street (including ourselves) will be keeping an extremely watchful eye on inflation & what the Fed will do as a result.
Equities & Cryptocurrencies Have Been Pummeled… Is Real Estate Next?!
So far this year, all five of the major equity indices are in negative territory with three of those down double-digits on the year. Also, as we mentioned in April’s Monthly Commentary, cryptocurrencies are also down significantly on the year & well below their all-time highs that we saw less than a year ago. With very few asset classes serving as a shelter from rising interest rates, record high inflation & the prospects of an economic recession on the horizon, many investment professionals are worried that the real estate market is the next to watch for cracks. Every month, the U.S. Census Bureau releases its Monthly Housing Starts data, which measures how many single-family homes or buildings were constructed during the reporting month. Looking at the graphic below, Monthly Housing Starts have been trending in a positive direction ever since April 2020, right after the entire economy essentially shut down. However, we have recently started seeing the Monthly Housing Starts data start to plateau somewhat, leading us & many on Wall Street to believe that the housing market could be starting to fracture.
In addition to new home construction data, we have started to see weekly mortgage applications data start to slow down, with the data making lower highs & lower lows over the past year & a half (see figure below). Every week, the Mortgage Bankers Association of America releases the number of mortgage applications that were received for the reporting week. Historically, mortgage applications have been seen as a leading indicator of the housing market as mortgage applications are submitted prior to the purchase of a new home. As a result, if the number of mortgage applications filed on a weekly basis is falling, it can reasonably be expected that the number of houses being sold is falling (or will be falling in the near future).
Declining mortgage applications shouldn’t come as much of a surprise given the fact that interest rates are on the rise. As we have discussed previously, when the Fed raises interest rates, just about every type of interest rate that is tied to the Fed Funds rate will fluctuate. As a result, we have started to see mortgage rates rise significantly ever since the Fed began the current rate hiking cycle, which unfortunately have started to price out individuals who cannot afford to pay for a mortgage at these higher rates.
Finally, as has been the case for much of the last two years, housing markets across the country have been what is referred to as a “seller’s market”, that is, houses are selling for well above asking price, those houses that are for sale are only on the market for a few days (if that), homebuyers are waiving home inspections & other contingencies & the demand from prospective buyers is well outpacing the supply of homes on the markets. However, we are starting to see a changing of the tides in these housing markets & a shift towards a “buyer’s market” is beginning. We are starting to see houses sit on the market for weeks instead of days, sellers are reducing their asking price & the number of bidding wars is dwindling – giving leverage to new home buyers as the supply of houses on the market is catching up with demand. As a result, it is clear that the housing market is appearing to cool-off & while not every housing market in the country will slow down at the same time or by the same magnitude, it is certainly worth keeping an eye on. While we do not anticipate the type of housing bubble that we saw during the ’08-’09 Global Financial Crisis, the housing market is undoubtedly slowing down & we will continue to monitor the situation as it can have broader implications for the overall health of the economy as a whole.
As we enter the final month of the first half of 2022, there are plenty of catalysts that could have market-moving implications. We expect that the Federal Reserve will continue to raise interest rates & speed up the pace by which they reduce their balance sheet in order to combat the record setting inflation that we continue to see. As inflation continues to run rampant, we would expect corporate profit margins to come under pressure as individual consumers scale back the amount that they spend on non-essential goods & services. Furthermore, as the Fed continues to raise interest rates to as much as 3% by the end of the year, we would expect that the P/E multiple on the S&P 500 will continue to come down as higher rates put downward pressure on earnings multiples. Lastly, November’s mid-term elections are right around the corner & the outcome of those elections could have significant political & economic implications. As we get closer to November’s mid-terms, we will provide everyone with a more detailed synopsis of what we are seeing in the various races, how the outcomes of these races will impact the political environment & the potential economic repercussions. As we continue to navigate what will almost certainly be a volatile next few months & rest of the year, we will remain diligent in the actions we take within our portfolios. Should we see further degrading in the equity markets, we have the ability to raise cash across our portfolios (something that we have already begun doing) or implement a hedged position that would benefit from a falling market.
As always, feel free to reach out with any questions or concerns!
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