The S&P 500 posted a 4.95% loss in Q1 2022, which makes this the first quarterly loss for the index in two years. We have been advising caution on stocks since October 2021 when a two-quarter divergence (i.e., an Alligator Jaw) arose between weakening corporate earnings expectations and rising stock prices. Although the Alligator Jaw closed via falling stock prices in 1Q 2022, our cautious view has not changed and we continue to maintain underweight towards equity investments.
What happened in financial markets during 1Q 2022?
Extreme optimism gave way to heightened fears and uncertainty in the markets. Questions surrounding the potential of the Fed raising interest rates more than anticipated to combat inflation, along with the Russian invasion of Ukraine, added to market concerns. International stocks were no place to hide, posting larger declines than the S&P 500, with the MSCI Developed International index falling -by 6.46% during the quarter and the MSCI Emerging Market Index declining -by 7.57%.
On January 1, 2022, the yield on a 10-year Treasury bond was +1.63% and by March 31, 2022, the 10-year yield was up to +2.32%. This means bonds sold off with stocks. What’s more the yield on a 2-year Treasury bond began the year at +0.73% and ended the quarter at +2.28%. The difference between the rate on a 10-year Treasury bond and a 2-year bond is referred to as the “yield curve.” When the yield on the 2-year bond is rising at a faster rate than the 10-year, this is referred to as a narrowing, or flattening, of the curve. This usually indicates a slowing economy ahead. This is what occurred during the 1Q 2022 period.
Outlook for 2022
Our research indicates the strong earnings estimate trends, which led to higher stock prices in 2021, may continue to fade this year. We are hopeful that inflation and supply chain disruptions will abate, Covid fears will subside, and there will be a peaceful end to the War in Ukraine that will allow the Fed to keep monetary policy accommodative. However, hope is not a sound investment strategy.
Because overall S&P 500 EPS estimate trends weakened and prices kept rising in 2021, stock prices appropriately re-set lower during the 1Q 2022 period to reflect less than previously thought growth. Although stocks have become less expensive, we continue to be cautious as the Fed deals with inflation and earnings along with a potential deceleration in economic growth. This view may change if corporate earnings estimate revisions stabilize and begin to improve again.
While there may be reasons to be cautious in the near term, our view is that owning equities provides an advantage over the long run, and staying disciplined with your target asset allocation makes sense. While it’s true that no one knows what the future holds, this does not mean that we believe investors should deviate sharply from this discipline.
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