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The Brave Report: Market Commentary for July 2022

Click here for the .pdf version of this report: The Brave Report-July 2022

Markets only go down… or so it has seemed so far this year.  In a sharp reversal from what we have experienced since the pandemic lows in 2020, the markets have continued to sell off throughout the first half of the year.  All major indexes are down more in the first six months than they have been in decades, or in the case of the NASDAQ, ever.  Rising inflation and fears of an imminent recession have spooked investors to the sidelines and with bond prices dropping as well, there have been few places to hide. A lot of the economic slowdown has already been priced in but is it enough yet and how far will traders overshoot to the downside?

Market Overview

June was not a pretty month across all of the major indices. The Dow Industrials lost 6.71% while the S&P 500 and the NASDAQ lost more than 8% and 9% respectively.  While defensive areas of the market have performed the best to start the year, all of the major sectors were negative for the month.  With the sharp drop in equity prices across the board, there are some areas of the market that are starting to look attractive from a valuation standpoint.  But as has been the case over the last month, sentiment has been more important than valuations in driving stock movements.

On the fixed-income side, we saw rates rise sharply to start the month, especially on the short end of the yield curve.  This rise abated later in the month to see rates settle back close to where they started the month. The 10-year treasury started and ended the month with a yield in the mid 2.8%. However, the yield spikes all the way up to 3.5% halfway through the month.  These kinds of wild rate swings are expected to continue as the markets try to handicap the proper path for the Fed and how many rate hikes they will need to get inflation under control.

The markets just completed the worst first half of the year in decades. The S&P was down more in the first six months than any year since 1970 and the NASDAQ completed its worst start in history. Rapidly rising inflation, uncertainty about the proper path for the Fed, and fears of a looming recession have weighed heavily on the markets. Even with the drop we have already seen, there are many still calling for more carnage ahead, especially if a recession does materialize.  While recession is not the base case for everyone, the probability has been rising and it has spooked investors to the sidelines.

Looking at the losses so far this year, a lot of the economic slowdown is already priced in but that doesn’t mean there can’t still be more trouble ahead.  As is often the case, markets tend to overshoot in both directions.  We saw that to the upside over the last few years with markets storming higher, stretching valuations beyond normal levels.  If we look at the losses so far this year, a portion of them just represents an unwind of the froth from last year. The question is how much of the pullback can be attributed to that unwind and how much represents a pricing in of economic slowdown? Furthermore, how much will markets overshoot to the downside?  The answers to these questions lie in the resolution of the uncertainties in the markets, driven primarily by inflation and the Fed’s reaction to it.

The Fed has put itself in a situation of threading a needle to achieve a soft landing for the economy.  They must raise rates to try to stabilize prices and mute further inflation.  However, they must do this without damaging the economy too much and sending it into recession.  This is no easy task.  Much of the recent selling can be attributed to the market’s lack of confidence that the Fed will be able to achieve this goal.

Inflation is the key driver of all of this at the moment.  In my opinion, the driving factor to whether enough of the economic slowdown is already priced in is how inflation is brought under control. If we see inflation begin to peak and start to drop on its own, then the Fed will be put in a position of not having to raise rates as much as is currently priced in.  This is the best-case scenario and one in which I see the markets bouncing back in the 2nd half of the year, albeit with continued volatility.  However, if inflation data continues to come in hot and the Fed is forced to more aggressively raise rates then some of the more gloomy market predictions could materialize and we would see the markets drop another 10-15%.

While the inflation data will be the key to all of this, we are starting to see some signs we tend to see at or near market bottoms. Consumer confidence and market sentiment are currently at multi-year lows. There are also several areas of the market that are completely oversold and undervalued from a long-term valuation perspective.  These factors do not always predict a market bottom, but these factors are often present when one is close.

So how do you invest during these trying times? If you are a long-term investor with no short-term liquidity needs, you are hopefully already in a well-diversified portfolio. If this is the case, then continue to dollar cost average any savings into your portfolio. Also, make sure your portfolio hasn’t drifted out of balance during this pullback.  If you do have excess cash on the sidelines, you can start patiently putting small bits to work.  We might not be at the bottom yet and while I expect volatility to continue even if the market bounces, slowly buying in over time will give you the best average entry point.

If you are looking for some more opportunistic plays and are comfortable with the risk, now is the time to be making your buy list.  There are a lot of names that have been thrown out with everything else and are down far more than they deserve.  In this vein, I would look for profitable companies with strong balance sheets. I would not chase the unprofitable “story” stocks at this time even though those are the ones that are the most beat up. They are beaten up for a reason.  Furthermore, valuations in the small and midcap space are at some of the lowest levels in more than 25 years so identifying some of the higher-quality smaller companies could present some great long-term value.

Strategy Commentary

Patience continues to remain the key as we see the markets sell-off.  It has been a painful stretch for most investors as there have been few places in the market to hide.  We are also not yet at a point where we can sound the all-clear.  If inflation continues to come in hot and the Fed is forced to stay aggressive then downside pressure will remain.  With that said, I do not see this as the time to start panicking and selling.  I continue to urge clients to stay the course and make sure their allocations are still in line with their long-term risk tolerance.  If you do feel the desire to make moves in your portfolio it should be just to update the quality of the names you own and not feel pressured into making widespread allocation changes.

On the domestic side, the defensive names continue to outperform. Utilities, consumer staples, healthcare and energy are the 4 sectors that are positive over the past year.  These sectors all tend to perform the best during uncertain economic times.  With uncertainty and volatility expected to continue, these sectors should continue to perform well.  However, if the market does start to bounce back it will probably be led by other sectors, such as technology and consumer discretionary as these have been the most beaten up.  As I have been putting together a buy list to start nibbling at over the next few months, I have been looking toward the high-quality names in these sectors.

On the international side, things have not fared much better. Developed international markets also dropped sharply last month. Emerging markets formed the best but still lost 6%.  Moving forward I will continue to look to add to EM as it seems China is committed to getting its economy back on track.  I am avoiding the Eurozone for now.  They are experiencing the same inflation and rate uncertainties as us but they also have additional pressures caused by the conflict in Ukraine.  This pressure could increase as we enter colder months since their reliance on Russian oil is so high.

I continue to hold increased cash positions as a replacement for some of my fixed-income allocations.  With both stock prices and bond prices dropping over the past month, the diversification benefits of fixed income have been muted.  If we start to see rates regulate and we get a more clear roadmap from the fed then I will begin to add back to some of my fixed income positions that I have been underweight for the past year.