Market Update: A Rough First Half, What the Other Side May Look Like

A theme for the first half of 2022 would be one of “shift”. Consumers shifted from goods to services. The Fed was behind the curve, shifting to aggressive rate hikes (possibly too aggressive). The market sentiment shifted from high inflation to possible recession. The Great Resignation shifted to unretirement and rescinded job offers. Retail stores with empty shelves shifted to suddenly having too much inventory. Crypto millionaires shifted to crypto hundredaires. 

The first half of the year is a gentle reminder that not everything is permanent. As someone who has kept a pulse on the market for a long time, this is taking “not everything is permanent” to new levels. It feels like the market is reacting quicker than ever to new information. And understanding where we’ve been doesn’t necessarily help clarify where we’re going. 

Since the beginning of the year, the Fed has used its one tool to combat inflation, that is to raise rates - aggressively. There have been six hikes so far (each hike is worth .25% so a triple hike is .75%) with 4-5 more hikes on the way. When your only tool is a hammer, everything looks like a nail. Hammer away the Fed has. 

Hiking rates can have a lagging effect of about 12-18 months, so the current slowdowns in the economy are most likely due to high prices and worsening business outlooks. The Fed is teetering on a possible policy mistake (over hiking and sending the economy into recession) and they won’t know it until it is too late. If consumers and businesses continue to reduce spending, it can help to bring down inflation.

Supply is the other side of the equation. Supply chains are improving but are still a long way away from full health. If supply is constrained there will still be too much demand chasing too few goods. 

Out of painful bear markets, there is some hope to be found. We talked about when consumer sentiment bottoms out, the market returns over the next year are historically strong. In other words, “it can’t get worse from here!” I know it doesn’t feel good today, but the price of admission in the investment world is volatility. 2020 created excess and high levels of speculation. Some of it did need to shake out and reset, and it’s also creating buying opportunities for patient investors.

The rate hikes will also bring a sense of normalcy. Gone are the days of easy money policy (for now) and the Fed is rebuilding its arsenal for the next recession battle. It would be very difficult to stimulate a struggling economy by lowering already low-interest rates. Yes, there is irony in raising rates that will slow the economy only to lower rates again to restimulate the economy.

What do we think the second half will look like?

No matter what anyone thinks, no one knows. True diversification is needed because we won’t know what parts of the market will rebound first, or which parts will continue to struggle. 

Optimistically, inflation goes away without a recession, Ukraine/Russia conflict ends, and there are no outside threats that shake the markets. The S&P500 will recover by year-end (26% upside from here) and create new highs. When consumer sentiment bottoms, the average return for the next 12 months is 24.9%. If we don’t get it all back this year, it’s still looking positive for the rest of 2022 and early 2023.

Neutrally, inflation comes down but is still elevated, Ukraine/Russia drags on, and supply chain continues to improve. Our most probable outlook isn’t great but isn’t all bad. Housing should be flat but start to come down. High-interest rates have already slowed home purchases and the trend should continue. 

Pessimistically, inflation accelerates, Russia/Ukraine conflict intensifies, and there are external credible threats that shake the markets. The biggest issue for this year and next will be inflation. If it does accelerate, the Fed will need to hike rates and put us in a recession, much like what happened in 1980. The bright side to that scenario is the market bottomed at 17% down in 1980, a figure we’ve already blown by. 

A rebound is coming, it’s just a matter of when. It can be much sooner than we all expect because the market tends to look forward. Now is the real test for “buy low” and the trick is the ability to look to the future. Will you look back at this moment and say, “I should’ve bought”? Yes, most likely.

Disclosures: 

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