Last week, in response to what Fed Chairman Jerome Powell called “eye-catching”, persistently high May CPI inflation data, the central bank announced a 75bps interest rate hike1. But just one month ago at the Fed’s May meeting, Powell said a 75bps hike was likely off the table1, once again demonstrating how behind the curve the Fed has been in tackling the inflation problem. In our view, alarming inflation and the Fed’s belated recognition of it has been the main driver of recent market volatility. Stocks reacted violently this week, with the S&P 500 losing 5.75%, its worst week since March 20201. Because inflation has gotten to this point, the Fed has no choice but to fight it by tightening financial conditions to slow demand in the economy. This in turn has led to higher interest rates and the repricing of virtually all financial assets from stocks to bonds to real estate. We expect markets to remain volatile until it becomes clearer that the Fed has indeed gotten a grip on inflation.
Both the S&P 500 and the NASDAQ are now in bear market territory, down 22.33% and 30.72% respectively so far this year. The Bloomberg Aggregate Bond Index is down 11.48%4. We think an abundance of fears about bad inflation, the Fed and recession risk are already priced in to the markets. Absent a major breakdown in credit markets or distress at a major investment firm, we believe stock and bond markets are reasonably close to the bottom.
But in the midst of “eye-catching” inflation, both the P and the E in P/E (price/earnings) ratio might still need more adjustment before we get through this volatility. The current S&P 500 forward P/E ratio is 15.8x, which is below the 25-year average of 16.9x1. However, a forward P/E of 11.3x was the average bear market low for the last five bear markets dating back to 19872. The good news is that it appears stocks and bonds look more attractive from a fundamental valuation perspective compared to recent years.
We again reiterate that this environment requires patience, balance and discipline from investors. We do not know exactly when inflation and related volatility will subside, so we want to focus on what we can control. We are longer-term investors, not day traders. We think investors should be prepared for continued volatility and consider these actions now:
- Look for opportunities to tax loss harvest while simultaneously increasing the quality of holdings.
- Diversify any concentrated positions
- Stay near “neutral points” with risk tolerance (i.e., if your risk tolerance indicates a 60% stock/40% bond allocation, then stay near that target) and do not try to time market moves.
- Seek companies that have strong competitive advantages, excellent management, solid balance sheets and generate free cash flow, which should allow them (and you as an investor) to hedge inflation.
- Seek opportunities for investment-grade yield: since interest rates have moved substantially higher this year, one can now find high-quality bonds that offer attractive yields.
- Review your financial plan. Unless something has changed with your liquidity needs, time horizon or general financial situation, we do not think you should make any large changes to your asset allocation. Also, consider other planning techniques like Roth IRA conversions, which may help your tax situation in the future.
- Don’t panic and make rash decisions. Inflation will come down over time and our economy and markets will be much healthier if we can maintain higher levels of interest rates compared to the last decade or so.
Thank you for your confidence in our team during this period of volatility,
Asset Management Department
Sequoia Financial Group
Sources: 1. Bloomberg/Bloomberg News, 2. Strategas Research, LLC. , 3. Ned Davis Research, 4. Morningstar Direct