February 3, 2022
By Matt Kelley
Portfolio Strategy Manager, ESL Federal Credit Union
It has been a volatile start to the year, with the S&P 500 falling more than 7% from recent highs in December. Large-cap growth stocks and small-cap stocks have officially entered correction territory after decline of more than 10% from highs in November.
As always, it is important to consider volatility in a historical perspective. The average annual S&P 500 decline going back to 1980 is 14%, and the market remained positive in 32 out of those 42 years. Stock market corrections occur around every 1.5 years, and it’s worth noting we have yet to see an official correction for the S&P 500. What is less common, however, is a year like 2021 where the S&P 500 never experienced a decline of greater than 5%. Going back to 1980, the S&P has only experienced two years of decline smaller than 2021 figures (1995 and 2017). It is often in years with muted volatility, like 2021, when follow-on volatility starts to feel like the sky is falling. LPL Research recently put out an excellent chart/analysis showing that the average drawdown in a midterm election year is 17.1%! The good news? The average return one year later is 32.3%.
Part of the recent fear in the markets—and thus volatility—can be largely attributed to Fed action. Expected increases in the Fed Fund rates accelerated in the 4th quarter. At the beginning of the 4th quarter, the markets were expecting zero Fed Funds rate increases in 2022. As of early February, the market is expecting four increases in 2022, with the first occurring in March. Additionally, the Fed announced their plans to taper asset purchases earlier in the 4th quarter, and later announced an acceleration to the rate of the taper to combat inflation. The effect on interest rates, especially short-term, has been as expected, the 2-year and 5-year treasury rates are now trading where they were February 2020. Rising rates aren’t always a problem for stocks; however, it is rare that rates increasing this rapidly doesn’t cause some volatility. While some investors might be concerned about the current rate environment, falling rates coupled with January stock market volatility would be a greater cause for concern. This hypothetical scenario could signal lower future anticipated growth as investors sell stocks to buy treasuries. Given that unemployment is almost back to pre-pandemic levels (not considering the labor force departures), it is unsurprising for the Fed to raise rates to combat recent inflation. With employment levels this low and growth still coming in hot (4Q GDP at +6.9%), we could expect the Fed to raise rates even if inflation was more muted.
Other segments of the market are confirming, for now, that this is an equity driven selloff and not related to deteriorating economic fundamentals. Credit spreads have historically been a great market and economic indicator because they both move daily with bond prices and reflect the actual economic cost for companies to borrow. As the market feels there is more risk in lending to companies, bonds will sell off, widening the spread on both current and new issues in real time. High yield credit spreads have barely budged from recent levels and remain near all-time lows. Spreads have also remained resilient both globally, and in different markets (investment grade corporates, mortgages, CLOs).
We also see recent divergence in the performance of profitable companies versus unprofitable companies. Investors that have a quality-tilt in their portfolios (whether it is US, International, growth, value, large, small, etc.) have been spared some of the drawdown. Speculative holdings tend to perform poorly when interest rates rise and/or risk premiums increase. As an example, unprofitable companies in the NASDAQ (cumulative earnings over the last four quarters) are down 28% since September 30, 2021. Profitable companies in the NASDAQ are down only 0.7% over the same time frame. We can see similar results in the small cap universe comparing the Russell 2000 index (a broad small-cap proxy) to the S&P 600 (a small-cap proxy that removes companies with negative earnings over the last 12 months). As of late January 2022, the S&P 600 has outperformed the Russell 2000 (31% of the Russell 2000 index is comprised of unprofitable companies) by more than 300 basis points.
Portfolios with a quality-tilt can mitigate volatility throughout full market cycles. This strategy can focus on picking the best quality companies or simply avoiding the worst. There is risk to forfeit returns on the upside during more speculative environments, however in volatile times like we saw in much of January, the quality-tilt earns the cost of admission.
Matt Kelley is a Portfolio Strategy Manager with ESL Federal Credit Union. In his role, Matt oversees the portfolio strategy team at ESL and is responsible for the investment philosophy, approach, and overall performance of internal and external investment portfolios for ESL.
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