Stocks have declined over 20% from the start of the year until late June. How can this be?
What is going on makes perfect sense for two reasons. First, things had to unwind from effects of the significant money that distributed to the U.S. economy during 2020 and 2021. Too much money chasing too few goods caused excessive price increases in products, services, stocks, and other assets. Now that the monetary and fiscal stimulus is fading, now that the punch bowl has been taken away, it only makes sense that things return toward more normal levels from the speculative excesses of 2021. The reason our U.S. Stock Market Landscape model was very cautious during 2021 played out with the turning of the cycle. We did not know when it would end, but the signs of excess were clearly in place.
In the long run, stocks follow earnings. If corporate earnings per share are strong the next ten to twenty years, investors will be rewarded with higher stock prices. In the intermediate 1-3 years periods what matters more to performance is the change in valuation, the change in the multiple of earnings that the stock market believes companies deserve.
The second major driver pushing stocks down is the change in the investment landscape relating to stock valuations. The current environment has changed from pushing stocks valuations higher to one that is associated with stock valuation going lower. As you may know, the price of a stock is the product of the earnings per share of a company multiplied by the Price to Earnings or PE valuation multiple. 2021 had the perfect storm to push valuations higher: low and/or declining interest rates and a belief that corporate earnings growth can continue to post strong results well into the future. Investors were focused on how high it can go. Things changed in 2022 for many reasons including the huge spike in inflation. Now firmly in place are the elements which cause stock valuations to decline. Those conditions include increasing interest rates and fears that the peak in corporate earnings is upon us. Once the peak in the earnings cycle is perceived investors shift to assessing how bad things can get and how low earnings will go. That is where we are right now.
Cycles persist both in the economy and the financial markets. At some point the economy will slow, possibly even with a recession. After that investors will at some point again believe the bottom is within sight and start to get excited about growth again. At some point inflation will ease and investors will start to believe that interest rates have hit their highs and could fall. When those things happen, the conditions will again be in place to push stock PE multiples and stocks higher once again.
There is no way to predict when inflation will ease, how much the economy will need to slow, or how well corporate earnings can navigate through increased inflation, a slowing economy and labor shortages. But what we do know is that cycles have persisted through time. We do not believe the cycle is dead. Current events will pass. It could take twelve to thirty-six months, but that is well within the time horizon of most investors.
We recommend clients adhere to their long-term asset allocation targets. Now is not the time to underweight stocks versus the long-term targets. Buy stocks to maintain target weights as they have reached much more attractive levels. Stocks could go lower, but the risks today are vastly reduced from one year ago. Fear is in the air. It is palatable. When this occurs, history shows it is not a suitable time to sell. Rather, it is a point from which higher returns often occur.
ViaWealth, LLC is a Registered Investment Adviser. Information in this article is for educational purposes only and is not intended to be an offer or solicitation for the sale or purchase of any specific securities or other types of investments. Investing in the securities markets involve risk of principal and unless otherwise stated, returns are not guaranteed. Be sure to consult with a qualified financial adviser and/or tax professional before making any financial decisions. Past performance is not indicative of future performance.