September saw losses across just about every segment of the equity, bond, and commodities markets. Nonetheless, we believe there are three good reasons for investors to be cautiously optimistic about U.S. equities:
September 2022 Stonemark Market Commentary
1. Valuations are generally reasonable.
2. The Federal Reserve may be achieving their objectives.
3. The U.S. economy is relatively well positioned.
Let’s take them one by one:
Valuations: The S&P 500 is currently trading at a trailing price-to-earnings (P/E) multiple of just under 18. That appears to be about fair for today’s level of interest rates.
Current S&P Price-to-Earnings Valuations Are in Line with Interest Rates
Source: Bloomberg data from 12/31/62‒9/30/22. The price-to-earnings ratio shows how much investors are paying for a dollar of a company's earnings. Past performance does not guarantee future results. Indexes are unmanaged, and one cannot invest directly in an index.
Consensus estimates call for an additional 10-15% growth in earnings for 2022. Since we are close to the end of the year and 18X lies near this trend line, you could conclude that the S&P 500 is priced for no further earnings growth this year—or to potentially miss expectations by 10-15%. With that information, it appears valuations are reasonable. (Source: Bloomberg)
The Federal Reserve: There has been a pervasive refrain that the Fed was late, and it won’t be able to get inflation under control. Here is a data point that counters that narrative: the two-year breakeven inflation rate—a measure of the markets expectation for inflation two years in the future—was 1.98% at the end of September. That’s right on the Fed’s 2% target and down from a peak of nearly 5% in March. So, the Fed may be achieving its objective. (Source: Bloomberg)
The U.S. Economy: While near-term prospects for the U.S. economy may not be robust, they are better than much of the rest of the world. Consensus estimates for U.S. GDP growth for 2023 stands at 0.8%. That compares to 0.2% for a Eurozone challenged by war and negative 0.2% for a United Kingdom challenged by Brexit and political instability (Source: Bloomberg). The U.S. economy could experience a competitive boost resulting from European weakness, increasing the odds of a soft landing, at least domestically.
Market segment returns were negative across the board in September.
Asset Class Returns — September 2022
Asset Class Returns — Year to Date
Source: Bloomberg. September returns from 9/1/22‒9/30/22; YTD returns from 1/1/22‒9/30/22. Past performance does not guarantee future results. Indexes are unmanaged, and one cannot invest directly in an index.
Is There More Pain Ahead?
Last month’s equity market performance did nothing to alter September’s historical record of producing the market’s weakest returns. Much of the cause this time sits with a steadfastly hawkish Fed, which delivered its third consecutive hike of 75 basis points to the Fed Funds rate. Where it all ends remains to be seen, but more rate hikes seem likely for what is turning out to be one of the most aggressive tightening cycles on record. As a result, certain segments of the economy, like housing, are already slowing significantly. And, we believe more economic pain will follow.
The markets take their own distinct path in the face of rising rates, so some historical perspective may be useful for investors.
Equity Market Performance During Prior Rate-Hike Cycles
Despite market weakness since the Fed started hiking rates in March 2022, stocks can and have performed quite well during previous cycles. There have been four rate-hike cycles—periods in which the Fed has raised the Federal Funds Rate on multiple occasions over an extended time—during the past 30 years. While each had different circumstances, examining the performance of different market segments during those cycles may offer clues to investors who want to reallocate their portfolios or put new capital to work.
Historical data provides some basis for optimism. Markets have tended to move lower in the months immediately following the first increase in the Fed Funds rate of a cycle, but they have also recovered quickly and have done fine over the full cycle.
The table below shows the performance of large-cap (S&P 500), mid-cap (S&P MidCap 400) and small-cap (Russell 2000 Index) equities during the last four Fed hiking cycles. In most cases, stocks across the capitalization spectrum delivered positive performance over the full cycle, and the performance of mid-cap and small-cap stocks is particularly noteworthy. Despite a perception that smaller-cap stocks underperform when rates move higher, mid-cap and small-cap stocks outperformed large caps during the years after the first hikes.
Mid-Caps Have Led When Treasury Rates Moved Higher
Another way to assess equity market performance during periods of rising rates is to examine periods when the 10-year Treasury yield has spiked. While there is overlap in the time periods, this approach paints a similar picture—smaller caps have been a solid investment.
Stock Market Performance During Rising Rate Periods
Source: Bloomberg data from 12/31/01–8/31/22. Periods of rising rates indicated by shaded bars and are based on monthly changes in yields. Past performance does not guarantee future results. Indexes are unmanaged, and one cannot invest directly in an index.
Investors may want to be selective with their mid-cap allocations in what remains a difficult equity environment. A potential solution worth consideration is a dividend growth strategy, which has a history of weathering market turbulence. Akin to their large-cap peers, the S&P MidCap 400 Dividend Aristocrats are high-quality stocks that have grown their distributions for at least 15 consecutive years. And the S&P MidCap 400 Dividend Aristocrats Index has outperformed the S&P MidCap 400, delivering an attractive combination of upside and downside capture that may be just right for the times (Source: Morningstar, 2/1/15-9/30/22).
Fixed Income Perspectives
Rising Treasury yields put all but one fixed income segment in the red for the month of September.
Fixed Income Returns — September 2022
Source: Bloomberg data from 9/1/22–9/30/22. Past performance does not guarantee future results. Indexes are unmanaged, and one cannot invest directly in an index.
In previous sections, we noted that there was some good news and reasons for optimism. Inflation expectations have come down. Here’s the challenging news: Interest rates may continue to rise.
Interest Rates May Rise Even If Inflation Is Transitory
Source: Bloomberg data from 1/1/22–9/30/22. Breakeven inflation rate is calculated by subtracting the real yield of the inflation-linked maturity curve from the yield of the closest nominal Treasury maturity. The result is the implied inflation rate for the term of the stated maturity.
Quantitative tightening removes the artificial suppression of longer-term treasury yields. Even as inflation recedes, and even if shorter-term Treasury yields like the two-year yield may have peaked, longer-term Treasury yields—five-year, 10-year and 30-year—may have further to go. It may be too early to become complacent regarding interest rate risk in the bond market and to rely on long-term Treasuries to provide meaningful upside in the event of a less-than-soft landing.
Sources for data and statistics: Bloomberg, FactSet, Morningstar, and ProShares.
Impact of Upcoming Elections
The first point worth mentioning is that the lead-up to midterm elections has historically proven very volatile for the stock market, a pattern that matches what we’ve seen in 2022. Going back the last 60 years, the average drawdown for the S&P 500 in the lead-up to a midterm has been a stout -19% – a sizable correction close to in line with 2022’s declines.
It is also true, however, that stocks have staged strong rebounds in the months and years following a midterm election, with positive performance far more than just a seasonal or statistical quirk. Case in point: since 1950, there have been 18 midterm elections, and stocks have gone up the following year 100% of the time. And, not only do stocks go up, but they also tend to go up significantly. From 1950 to 2018, here are the forward returns for the S&P 500 following a midterm election:
6 Month Forward Return = +35.5%
12 Month Forward Return = +18.6%
24 Month Forward Return = +15.2%
We think it’s more than just chance that stocks tend to behave this way leading up to and following the midterms. In the run-up to the election, there is usually an increased chance that the party in power will attempt to squeeze legislation through before the balance of power shifts, which adds uncertainty to the business and economic environment. As a rule of thumb in equity markets, uncertainty drives volatility.
But once the midterm elections take place and markets can digest how the balance of power has shifted, the uncertainty fades and corporations (stocks) have a clearer sense of what to expect from Congress in the coming two years. The ideal outcome for markets, in our view, is gridlock – split power within Congress and between Congress and the executive branch. This significantly lowers the likelihood of sweeping legislation, which reduces uncertainty for businesses when it comes to tax and investment planning.
Gridlock looks like a distinct possibility in this cycle. Since 1946, when a president has had lower than 50% job approval, the party has lost an average of 37 seats. With President Biden’s approval rating closer to 40% and Republicans needing only 5 net seats to regain control of the House, Republicans appear poised to take at least one chamber of Congress. Gridlock may provide a tailwind for stocks.
To be fair, there is one key caveat to the 2022 midterm election cycle that we have not seen in years past. This may come as a surprise, but the U.S. economy has never had a recession in year three of a presidential cycle, going back to 1929. This long-standing trend could break in 2023, as leading economic indicators are pointing to a mild recession either now or in the not-too-distant future. The upshot, however, is that bull markets tend to start during recessions, and stocks also historically rally when CPI peaks and comes down. We think these conditions will appear in the year following the midterm election, which only adds to the historical bull case presented above.
Bottom Line for Investors
Stocks are rarely influenced by a single factor like midterm elections, and past returns do not influence future returns. But there is a multitude of other factors working in tandem with the midterm elections that we think should give investors hope looking forward.
The risk of recession has risen with falling profit margins, a weakening housing market, and leading economic indicators that have turned slightly negative. While that does not seem like good news on its face, it is important to remember that bull markets typically start during a recession, around 6-9 months before a trough in earnings. Equity markets have also done very well once CPI peaks and comes down, and also when growth is weak but improving (rather than when it is strong but slowing). In our view, we may be closer to reaching these conditions than most appreciate, just as a midterm election is about to take place.