The bumpy start we’ve seen in 2022 suggests that this year will be marked by increased stock volatility, so it seems like a good time to talk about it in broad terms.
But, first, a word about the recent past, for context. Despite uncertainties, market returns for investors have been extraordinarily robust over 2020 and 2021. The annualized US stock return during these 2 years was 23.4% (S&P 500) – more than double the historic average of 10% – and 17.4% on global stocks (ACWI). And those figures include the Spring 2020 pandemic downturn. If you examine the 21 months after that period, annualized gains were 55.5% for US Stocks and 48.6% for global stocks.
Alongside unusually strong stock market returns in 2021, corporate profits also exceeded expectations. The last quarter of 2021 was much better than expected, with more than 74% of S&P 500 companies reporting results that surpassed Wall Street estimates.
Wages are up; unemployment is low. The economy is strong, and it is growing. Whatever your investment positioning, this is good news. So why the volatility? The answer, of course, is inflation.
Inflation: The fly in the ointment
The main watchword of this year is “inflation,” which has been above 6% since October, and reached 7.5% in January. Perhaps more importantly, we’ve all been waiting to see what the Fed does about it. They’re in a strong position to raise interest rates to counter inflation, because interest rates are as low as they’ve been for decades, giving plenty of scope for rectification.
Sure enough, after months of experts predicting when interest rates will go up, Federal Reserve policymakers said January 31 that they’ll start to raise interest rates in March.
This uncertainty around inflation and interest rates caused the stock market to take a comparatively wild ride in late January. In a single day, the Dow fell as much as 1,000 points, the S&P 500 lost nearly 4%, falling briefly into correction territory, and the Nasdaq slumped 5%, before all three indexes staged a late- day rebound.
This is perfectly normal, even healthy
While this year may feel extreme or chaotic, it’s actually typical. According to Dow Jones Market Data, since the S&P 500 was created in 1957, the index has averaged about one 10% drawdown and more than three 5% declines every year. Last year was the exception, with the market having drawn down only 5% once.
So, what’s driving the volatility we’re seeing right now? We think it’s the market’s attempt to adjust to those much-anticipated higher interest rates.
Changes in interest rates can and should have an impact on stock prices. Higher rates translate into higher borrowing costs for companies (which is especially challenging for highly indebted companies) and can potentially eat into profits.
The growth in wages that’s partly driving the inflation numbers can cut into corporate profits as well.
Higher rates also give indebted consumers less discretionary income to buy goods and services, potentially reducing corporate revenues.
In addition, as interest rates move up, bonds start to become more compelling as investments, perhaps drawing capital and price support away from stocks.
Overall, as interest rates change, judgments about the fair prices of stocks change, and the market is the place for expressing investors’ collective wisdom on these prices. We see the current volatility as the market’s attempt to gain its footing on pricing, sometimes overshooting and then retreating.
What we’ve learned and what we’re doing
It’s natural to want to react to stock volatility, but our experience has taught us it’s best not to. We think famed investor Peter Lynch said it best: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” Stocks are the growth engine of portfolios. Reacting to their near-term noise too often deprives you of their tremendous, longer-term upside.
This doesn’t mean that we aren’t making changes in other parts of the portfolio. Bonds, for example, are also affected by rising rates, but less dramatically, and in more predictable ways. At Bridgewater we have shortened the maturity of our bonds because shorter-term bonds fluctuate less in price than longer-term issues when rates rise. They also don’t require you to tie up your money for ten or more years in exchange for minimal additional yield. It’s not a radical move but it will help to maintain and stabilize the value of your bond holdings.
So, yes, 2022 is likely going to be a year of increased volatility, but for the reasons mentioned here, it’s not a cause for a major rethink of your investment strategy. As ever, we take a vigilant, longer-term view, and we’re happy to answer any of your questions.
Your Bridgewater Team