Mid-Quarter Market Update

A challenging market environment continues in the second quarter. Though most risk assets have recovered somewhat over the past few weeks, volatility remains ahead. The economic slowdown induced by central bank tightening has begun. While we are closer to the bottom in equity markets, we are not out of the woods just yet. 

A bottom for equities is likely to coincide with a decline in inflation once it has peaked. That will signal how much more central banks must tighten. The Consumer Price Index reached 8.3% in April, which we believe may be the peak of inflation. However, labor markets are at their tightest levels in the post-war era, supply chain pressures have yet to abate, and rising food and energy prices are feeding into production inputs. Inflation will remain sticky and must fall convincingly before central banks can stop tightening. This will take some time and will likely result in a shallow recession.

As we look at the year so far, much of the market movements have been reminiscent of 2001. Then as now, extended valuations, particularly for stocks with no earnings in sight, have come back to earth. The S&P 500’s forward price to earnings ratio in mid-2021 peaked at nearly 27. Today, we are between 17-18, as shown in the chart below. 

The multiple of earnings investors are willing to pay for stocks is no longer expensive. However, though valuations are now cheaper, equity markets will remain volatile for the next few months until investors find the right valuation for the ultimate level of interest rates.

Despite short-term headwinds, remaining in the market is the best strategy. Historically, stocks tend to bottom an average of four months before a recession is over, and we don’t know the official end of a recession until well after it’s ended. We will look to add risk to portfolios as we see better news on the inflation front and stronger market breadth. In the meantime, we will focus on strong cash flow-oriented stocks with healthy balance sheets which should provide better relative performance. Diversification across and within asset classes remains the best defense.