This year is the worst bond market we have seen in 30 years. And April was the worst month ever for bonds. 60/40 balanced investors could be down double digits YTD (based on common benchmarks) unless they have strategically positioned themselves to avoid some of the pain, including in their bond portfolio. This has been an unusual year as two out of three reasons for owning bonds have broken down as explained below:
– Safety: Bonds have not been safe investments this year as prices are down considerably. For example, AGG (core U.S. Aggregate bond ETF which includes different quality levels and maturity lengths) is down 9.6% YTD.
– Diversification: This has also broken down for bond investors. Often bond prices rise as a safe haven asset when stock prices contract, but this year has seen both stock and bond prices fall.
– Income: This is the only bright spot for bond investors as yields have risen. For example, the current yield on a high quality, short-term corporate bond fund is now over 3%, up from 1.5% earlier in the year.
Will the pain from the bond market continue? Possibly, but we think most of the interest rate increases may be behind us (market interest rate increases, not Fed rate hikes). Why? Market yields have already risen to discount severe monetary tightening expected from the Fed despite signs that U.S. economic strength may have peaked and appears to be slowing somewhat. In fact, if the U.S. economy continues to slow, bonds, especially mid and long maturities, could rally.
ARE STOCK VALUATIONS CHEAP ENOUGH?
We are as happy as anyone that for most Americans, life is normal again after Covid. The stock market has another story. Moving beyond Covid has meant moving beyond what has been the easiest period of monetary policy any of us will likely see, and markets have had trouble adjusting to the new reality. Performance of major equity averages since the April 26/27 FOMC meeting ranks among the most severe short-term declines the market has ever seen, and the S&P 500 and NASDAQ have now declined for six straight weeks. Who would have ever thought that coming out of Covid would prove to be more difficult for markets than Covid itself. The current backdrop for investors could be one of the more challenging investors have ever faced.
As stocks have been pummeled, valuations have come down considerably. But are stocks cheap enough to form a bottom here given the ongoing problems of inflation, Fed policy tightening, war, China’s slowing economy, and signs U.S. demand may be peaking?
The S&P 500 traded at last Thursday’s low at 16.8 times its projected earnings over the next 12 months, down from its recent peak of 24x in September 2020. Valuations have come down substantially with rising earnings contributing to the decline. This forward P/E multiple compares to 14.2x in 2002 after the tech bubble burst in 2000, and 8.8x in 2008 when the country was in severe recession. So 16.8x may be a more reasonable valuation but it is yet not in bargain basement territory. Since stocks overshoot during market extremes in both directions, it suggests we may have more downside to go based on historical market behavior. One caveat: corporate earnings may come to the rescue because prices are just one component of stock valuations. Earnings are the other component. When earnings rise and prices stay steady, valuations contract. Fortunately for equity investors, earnings are expected to grow 10% in 2022 with further growth expected in 2023. This should help valuations come down further.
The rally since last Thursday afternoon has been impressive suggesting we may have seen a short-term low. Does it also indicate the end of the correction? Only time will tell. Perhaps baseball great Yogi Berra put it best when he said “it’s tough to make predictions, especially about the future.”