Elean
Hi everyone. Welcome to the podcast and thank you for tuning in. I’m Elean Mendoza, and I’m here with Evan Shorten, the firm’s founder and principal.

Evan
Hello. I hope everyone is doing well. I know our listeners probably want to hear our thoughts on the current state of the markets so I’ll keep the introduction brief. Please subscribe to the Podcast on the Apple Podcast App, Stitcher Radio App, or to our YouTube channel. So, without further ado, let’s jump right in.

Elean
So, 2022 has not been a great year for investors. Despite the S&P500 peaking on January 4^th 2022 with an intraday price of $4818.62, by May 16^th 2022, the S&P500 is down 18.16% year-to-date.

The Nasdaq is off to a worse start having peaked on November 22, 2021 and currently being down by 27.24% year-to-date.

And lastly, outperforming the two indices, the Dow Jones peaked on January 5, 2022 at an all-time high of $36,952.65 and only being down 13.99% year-to-date.

So what’s happening with markets? The reality is – everything. The markets are dealing with an unprecedented amount of uncertainty regarding energy and food shortages; inflation; conflict in Ukrain; the Federal Reserve’s quantitative tightening; and interest rate hikes. To this day we’re still dealing with some of the lingering effects of the 2020 covid-19 pandemic.

So with that said, Evan can you break down some of the headwinds going against the markets?

Evan
Let’s start with the 800lb gorilla in the room – the Federal Reserve. If we think back to last year, the Federal Reserve board committed themselves to reducing their balance sheet. Their comments of balance sheet reduction alone increased volatility across the major indices, with the biggest negative impact on the NASDAQ, which as we mentioned peaked last November.

Then in March of this year the Fed instituted the first rate hike since 2018, a second rate hike on May 4^th, and the Fed is adamant about pursuing multiple rate hikes moving forward in its effort to fight inflationary pressures.

Elean
Balance sheet expansion, reduction, and interest rate adjustments are some of the tools the Federal Reserve implements in what’s called monetary policy. When the Fed expands the balance sheet and keeps interest rates low, monetary policy can be referred to as quantitative easing or QE, which is a term you might be familiar with. When the fed reduces the balance sheet and raises interest rates, monetary policy can be referred to as quantitative tightening or QT. QE and QT are the primary tools used by the Fed in its efforts to maintain price stability throughout the economic cycle.

Evan
Quantitative tightening can negatively impact stocks as stocks are considered risk assets and rising rates can make risk assets less attractive – especially those assets whose prices are heavily based on future potential instead of current profitability. A second effect of quantitative tightening that can also negatively impact stocks is the balance sheet reduction. Essentially the Federal Reserve is trying to take money out of the economy, an action that’s also referred to as a liquidity reduction. Liquidity reductions take out some off the excess money that was being allocated to the most speculative investments – meaning a reduction in liquidity forces investors to pursue higher quality assets.

A good way to illustrate this is to think about the major indices themselves. The Dow Jones is comprised of all large blue chip companies whose industries span banking, industrial sectors, energy, etc. It’s also the best performing of the three major indices. The S&P on the other hand has heavily moved toward technology stocks in last decade with 25% of the index being comprised of technology. The higher waiting to technology and the fact that technology is considered riskier means the S&P has underperformed the Dow Jones. Moving down the quality spectrum, the NASDAQ has performed worst and is heavily comprised of high growth and technology stocks. And if you want to move even further down the risk spectrum we can see the crypto markets which have no businesses, no dividends, or even provide much value beyond buying and holding, have completely collapsed. 

Elean
Another way to think about risk vs. reward in the current environment is through interest. With interest rates rising and the 10-year Treasury bond floating near the 3% mark, many of the growth stocks or crypto coins that promise future returns but with little to no current profit, will most likely continue to lose favor in comparison to a bond with a 3% guaranteed return.

Evan, what else do you see as impacting equity markets?

Evan
If the Federal Reserve is the 800lb gorilla in the room, I would say inflation is the 700lb gorilla standing right behind. While the Federal Reserve’s monetary policy is creating the biggest impact on stocks, the only reason the Fed is engaging in quantitative tightening is because of higher than normal inflation the economy started experiencing in the very beginning of 2021 which has continued to the present.

-On May 10^th AAA reported the national price of gasoline hit an all-time high and on May 17 they reported gasoline is officially above $4 in all 50 states for the first time ever and $6.00 a gallon here in California.

-The Case-Shiller Index which tracks housing reported a 19.2% annual increase in home prices for from January 2021 to January 2022

-Redfin the real estate brokerage reported rents across the US increased 14.1%

-The overall cost of food continues to rise as supply chain shortages continue around the world stemming from both covid-19 and the conflict in Ukraine.

-Additionally, it’s likely we’ll continue to see rising food prices as many countries are choosing to hold on to their food exports in order to manage their own concerns around food security.

Elean
This is interesting. I pulled up a list of countries who are banning food exports, meaning they’re choosing to hold on to their locally produced food and so far 14 countries have imposed bans on exporting food. Most notably are Ukraine and Russia for obvious reasons, but also Argentina, Egypt, Turkey, and most recently India which announced a halt to its wheat exports.

Evan
It’s looking more likely that higher inflation is going to persist. How long? We can’t predict that, but as of now, it seems the Fed is committed to combating inflation for as long as the economy keeps printing high inflation numbers. Meaning, if we continue to see higher inflation, the Fed is most likely going to continue to increase rates, which in turn makes risk assets like stocks less attractive to own relative to bonds and their perceived safety.

I also want to discuss another point directly related to inflation and the Fed. The Fed didn’t know when to turn off QE. Even with congress providing an estimated $10 trillion of stimulus to the economy throughout 2020, the Fed continued to pursue easy monetary policy; so how can we be sure the Fed will know when or how to back off the monetary tightening without adversely affecting the economy?

I don’t mean to sound overly critical. What the Federal Reserve does is incredibly difficult. They try to balance the line between minimizing the potential for recessions while also not letting an economy run too hot with inflation. It’s a tall order and Fed doesn’t always get it right. So with that, there is the general fear that the Fed might tighten too much and break the economy itself. The risk of over tightening is even more prevalent when you consider the economy is most likely slowing down on its own due to the effects of inflation we previously touched on.

Elean
Ok, that brings up another point as to why stocks have been performing negatively, and that’s slowing growth in the economy. In fact, the term slowing growth is probably wrong at this point as the US Department of Commerce reported GDP fell by 1.4% in the first quarter of the year.

Evan
Yes, in fact we have had some notable earnings reports for this earnings season so far. A few examples include:

1. Google or Alphabet reported weak earnings and a significant slowdown in revenue growth.
2. Amazon reported a decline in revenue while their expenses continued to rise.
3. Apple, who despite reporting record earnings, warned of inflationary headwinds and supply chain issues as possibly impacting their business moving forward.
4. Additionally, Target, Walmart and Ross Stores triggered this week’s large sell-off when they reported what Wall Street considered to be disappointing earnings due to rapidly increasing inflation in the retail sector as both wages and shipping costs increased significantly.

Despite corporate profits having surged to new records throughout 2021, in 2022 corporations are seeing declining profits albeit still positive overall. They’re lowering their guidance expectations or not issuing guidance at all; and many are warning of fuel, shipping, and a waning consumer as headwinds for their businesses moving forward.

Elean
Ok so Evan. With markets facing multiple headwinds, what are some things investors could do to shield themselves?

Evan
Well for starters, I would turn off the TV. Stop listening to all the news and take a step back from all the negativity – of course don’t turn off this podcast.

Yes markets are underperforming and it can be unnerving. The longer markets underperform the more stressful it becomes, but don’t forget, stocks as a whole may underperform, but not all sectors will underperform equally – some may even outperform. For example in the last year we’ve seen a pretty big rotation from growth stocks to value stocks.  As part of that rotation we have seen sectors like commodities, energy, and utilities become some of the best performing sectors. Additionally, there are other sectors that perhaps may not outperform but can keep up with current conditions. For example, if rents are rising at a fast pace, residential REITs could do well.

I also want to point out one last thing. If interest rates are rising then bonds are becoming more attractive. If the 10-year Treasury bond continues to rise and possibly even approach 4%, increasing your bond allocation may not be a bad course of action. Especially if you’re already enjoying your retirement and your investment priorities are capital preservation and income.

Elean
Ok, so hopefully you found this episode of the Paragon Podcast informative. We understand no one enjoys down markets and frankly, we’re navigating unchartered waters in both the equity markets and the economy. If you have any questions, uncertainty, or want to discuss your portfolio and financial condition, please don’t hesitate to give us a call or reach out to us by email.

We know this episode is a little longer than most so I’ll simply ask that you subscribe to the podcast. Thank you for tuning in.