Market Sell-Off: Assessing the Negative Catalysts

For the past several months, we have commented that a market correction or widespread sell-off of 10% or greater across the major stock indexes could occur at any time. This has now been fully realized, as on January 24 the S&P 500^® reached an intraday decline of more than 12% versus its January 3 record price level. During that same session, the Dow Jones Industrial Average reached a 10% drop, also measured from its January 3 high. NASDAQ and the Russell 2000, which had both reached all-time highs in November, declined to 18% and 21% below those levels.

We have said previously that market history and human nature warranted a high likelihood of a double-digit sell-off in stocks. The S&P 500 had increased more than 120% on a total return basis between March 23, 2020, and January 3, 2022. Over the past 70 years there have only been four instances in which the S&P 500 had more than doubled without a 10% decline along the way, those being 1984–1987, 1990–1997, 2003–2007, and 2011–2015. So, in many respects, this sell-off should not be very surprising. 

While there is a historic argument for this sell-off to have occurred, there have also been a host of negative catalysts exacerbating the recent stock declines and creating further risk of additional downside to stock prices. In our opinion, it is important to view what we believe these negative catalysts to be and assess them accordingly.

Inflation

Inflationary concerns continue as the headline consumer price index (CPI) report for the month of December, released on January 12, increased to 7%, representing its highest reading since 1982. Market worries also persist regarding global supply chain constraints.

We believe inflation reports will continue to run hot into the 2H of 2022 but could subside to the 3% range thereafter as global supply chain constraints ease and year-over-year CPI and personal consumption expenditure price index reports begin to be compared to the higher inflationary environment that started last spring. 

Interest Rate Environment

Fed policy expectations have moved more hawkish in recent weeks as markets now anticipate four quarter-point rate hikes in CY 2022 and a reduction in the Fed’s balance sheet holdings. Long-term interest rates have also increased materially in recent weeks, as the 10-year Treasury yield reached 1.90% on January 18.

We believe at this point the Fed is more likely to implement three quarter-point rate hikes on the federal funds rate in CY 2022, concluding with a federal funds target range of 0.75%–1.00%. This will likely be accompanied by a modest reduction in the Fed’s existing balance sheet holdings. We also believe longer-term interest rates will continue rising and a realistic range on the 10-year Treasury yield is 2.25%–2.50% by year-end 2022. We do not see these short- and long-term rate levels as, in and of themselves, necessarily detrimental to the longer-term outlook for equity or credit markets.

COVID-19 Case Trends

COVID case numbers continue to rise as a result of the Omicron variant and remain near their highest levels of the pandemic. This has created additional market angst pertaining to its potential economic impact in the year ahead.  

While COVID cases continue to rise and are at or near peak daily increases, we believe herd immunity or a change from pandemic to endemic status could occur in the months ahead. Key metrics pertaining to the virus should now focus on hospitalizations and fatalities that remain below peak levels. When the negative effects of COVID, as in risk of severe cases or fatalities, no longer impact consumer behavior, economic growth could experience a meaningful upturn.  

Economic Growth

U.S. gross domestic product (GDP) growth for 2022 is being questioned due in large part to tightening monetary policy, rising COVID cases, and the ultimate impacts of inflation. 

We continue to believe the U.S. economy can experience 3% GDP growth in CY 2022, driven by pent-up consumer demand and declining rates of inflation during the second half of the year. We would view such a level of economic growth as favorable for investors.

Earnings Growth

Corporate earnings growth is also under scrutiny by investors in terms of current estimates on S&P net operating earnings for CY 2022 presently forecast in the range of 8%–10% (Factset Earnings Insight).

In our view, S&P 500 net operating earnings should reach or exceed 10% in CY 2022. Even under the expected interest rate environment, this could still potentially provide for total returns on stocks in line with such profits growth.  

Geopolitical Risk

Geopolitical concerns have also risen due to the increasing risk of a Russian invasion of Ukraine.  

While a potential Russian invasion of Ukraine would be a real wild card for stocks and the credit markets, at this point we would expect markets to initially sell off on such news before assessing the longer-term global economic and market implications and likely recovering thereafter.

While the months ahead could see continuing volatility and bouts of price weakness, we will reiterate the following points:

• Calling market bottoms during times of intense market volatility can often be a fool’s errand and we emphasize the more constructive rout is to identify attractive long-term entry points for stocks. Based on expected earnings yields versus long-term interest rates, we view the broad equity market as currently at such entry points conducive to favorable long-term returns.

• So far, credit spreads have not materially widened for high-yield and investment-grade bonds versus comparable maturity Treasury bonds and remain close to multiyear lows. This could be interpreted as investor confidence in the credit markets despite the sell-off in stocks.

• We believe value stocks are better positioned than growth over the year ahead based in large part on the inflationary and rising rate environment, a steepening yield curve, and above-trend economic growth versus the previous decade.

• We view stocks as potentially setting up quite well for 2H 2022 given what could be a path toward herd immunity and/or a change in COVID-19 from pandemic to endemic status. This would help to unleash large pent-up consumer demand in the economy along with increasing corporate earnings expectations for 2023. 

In summary, while sell-offs of the current magnitude can certainly feel painful, we believe the ultimate resolution of negative catalysts recently driving stock prices lower, combined with a post-COVID economic set up as the year progresses, could favorably reward patient investors. We continue to maintain our year-end 2022 S&P 500 price target of 5,200.

Investments are subject to market risk, including the loss of principal. Asset classes or investment strategies described may not be suitable for all investors.

Past performance does not guarantee future results.

Equities are subject to market risk meaning that stock prices in general may decline over short or extended periods of time. Indexes are unmanaged and an investor cannot invest directly in an index.

Fixed income investing is subject to credit rate risk, interest rate risk, and inflation risk. Credit risk is the risk that the issuer of a bond won’t meet their payments. Inflation risk is the risk that inflation could outpace a bond’s interest income. Interest rate risk is the risk that fluctuations in interest rates will affect the price of a bond. Investing in floating rate loans may be subject to greater volatility and increased risks.

Growth stocks typically are particularly sensitive to market movements and may involve larger price swings because their market prices tend to reflect future expectations. Growth stocks as a group may be out of favor and underperform the overall equity market for a long period of time, for example, while the market favors “value” stocks. Value investing carries the risk that the market will not recognize a security’s intrinsic value for a long time or that an undervalued stock is actually appropriately priced.

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