The smooth road stocks have been traveling on has recently gotten a lot bumpier. Several issues have surfaced almost simultaneously that have led investors to sell stocks and reduce risk, lowering the prices of stocks in the short run. While we have Russia saber rattling and trying to bully change in Ukraine, the issues most pertinent to financial markets are interest rates, economic growth, and central bank policy. Since New Year’s Day, the U.S. stock market has dropped 8% to reflect these new uncertainties, and the current level is 10% below its November peak. Following the correction, stocks are still about 10% higher from a year ago, which is the historical average return for stocks. After three fabulous years of rising stock prices, with a gut-wrenching interruption in March 2020, a stock market correction should not be a surprise. We know corrections inevitably occur and they are also scary and uncomfortable when they happen. This is the third stock market correction in the last five years and the fifth correction over the last ten years. One could say corrections and volatility are the price stock investors pay to earn returns above inflation and bonds. The question everyone is asking right now is whether this is just a correction or the beginning of something bigger. We do not know the answer, but it would be very unusual for a decline of greater than 20% to occur without a recession. It has happened twice -1987 and 1966 – and stock prices fully recovered following each episode. Considering that Q4 GDP has initially come in at 6.9%, the best quarter in four decades, and business inventory levels remain historically low, conditions for a sustained economic downturn are seemingly not present.
The market correction has relieved a lot of the speculative excesses that formed in the markets over the last 18 months. Speculation in IPO’s, SPAC’s, cryptocurrencies, and low-quality stocks got ridiculously out of hand and investors that were heavily involved in those areas have been punished. However, stock prices of high-quality companies have held up much better, a trend we expect will continue.
We do expect 2022 to be a year of greater volatility and modest investment returns. There is also a concern that the Fed would be making a policy mistake if it went through with tightening monetary policy by raising rates and reducing the size of its balance sheet. Government spending is expected to drop by 17% in 2022 and that should help dampen inflationary pressures. The first half of mid-term election years are historically choppy and occasionally result in negative stock market returns. The second half of mid-term years have been positive 90% of the time. Patience and perseverance will be important this year. 2022 could even turn out to be a year where stocks muddle along and finish lower by only a few percent. Of course, stocks are already down to begin the year. Anytime the Federal Reserve begins to adjust monetary policy and signal higher interest rates, markets get rattled. It happened in 1994, 2004 and again in 2016. The correction could have a little further to go, but an investor with a diversified portfolio that is aligned with their personal goals can get through any market or economic cycle.
