2022 Q2 Letter to Clients

July 11, 2022

The first half of 2022 has earned a place in the record books. The Wall Street Journal summed up the first six months of the year with a simple but telling headline: S&P 500 Posts Worst First Half of Year Since 1970. Morningstar said the Dow's performance was the worst since 1962. 

Table 1: Key Index Returns

Source: Wall Street Journal, MSCI.com, MarketWatch, Bloomberg

MTD returns: May 31, 2022—June 30, 2022

YTD returns: Dec 31, 2021—June 30, 2022

*In US dollars

In part, it's a timing issue since both indexes hit their respective peaks in the first week of 2022 (St. Louis Federal Reserve data for the S&P 500 and the Dow).

Timing issues aside, stocks have tumbled since hitting all-time highs, and the S&P 500 Index has shed 23.6% from its January 3 peak to its June 16 trough, which officially lands us in a bear market. The stock market is in a bear market when the broad-based index falls 20% from a prior peak. Since 1957, there have been 13 periods when the S&P 500 has lost 20% or more over six months. According to CNBC, that averages out to about one such decline every five years. In other words, it's not that unusual.

The 2008 financial crisis had six out of the seven worst selloffs, with losses ranging from 29.4% to 42.7%. The outlier occurred in 1974 when the S&P 500 shed 32% over six months. Today's market weakness shares little in common with conditions during 2007-2008, when a housing bubble fueled by weak lending standards and massive speculation nearly brought down the financial system.

While housing prices have soared and bubble talk abounds, bank capital standards are much stronger today, and lending standards have tightened considerably since the housing bust. Moreover, the problem isn't too many homes. It's just the opposite: too few homes in too many locales.

The laypersons' definition of inflation is where we have too many dollars chasing too few goods. Couple that with a labor shortage, and services are costly as well. In other words, demand outstrips supply. We can draw parallels to the early 1970s.

That 70s show

In 1972, the Consumer Price Index soared from an annual rate of 2.7% in the middle of 1972 to over 12% by the end of 1974, per St. Louis Federal Reserve CPI data. In response, the prime loan rate soared from 4.75% in early 1972 to a peak of 12.0% in July 1974 (St. Louis Federal Reserve). 

Today, some loans still track the prime rate which we don't talk much about. The Prime rate is heavily influenced by changes in the fed funds rate, which gets much more attention. Nonetheless, the roots of inflation in the 1970s do not mirror what we see today. We do find some similarities, including ultra-easy money in the early 1970s, a lack of fiscal discipline, and soaring oil prices tied to the 1973-74 OPEC oil embargo because of the surprise attack by Egypt and Syria on Israel and retribution on the U.S. for airlifting supplies to Israel. The U.S. is not as dependent on foreign oil sources today, and much greater fuel efficiency mitigates some of the impacts, but rising gasoline prices are playing a role in the rise in the CPI, which hit 8.6% in May (U.S. BLS).

Today's world demand for oil is roughly 100 million barrels a day (mbd) and grows around 6-8% per year. Supply growth has declined in recent years to the point that the world is not producing enough oil for the current and growing demand. The world was going to be short 1-2 mbd this year, and the Russia/Ukrainian war has reduced supplies even more. The few producers that could increase production to fill the gap have done so. This caused oil prices to skyrocket this year and, of course, added to inflation. Like it or not, the world depends on diesel to propel ships, trains, and trucks.

Unfortunately, this issue will not go away soon, and elevated oil prices will probably be with us long-term. The U.S. government is pumping about 4 million barrels daily from the U.S. Strategic Petroleum Reserve to keep costs within the current range. Still, they can only do that for about 6 months with only 714 million barrels of reserves. Eventually, the global marketplace will once again dictate prices and increase as demand grows over time.    

An oil embargo, soaring energy prices, and a sharp rise in interest rates contributed heavily to a recession that began in late 1973 and lasted until early 1975, according to the National Bureau of Economic Research (NBER).

Some commentators believe we are already in a recession. And while there are parallels between then and now, no two periods are exactly alike.

The S&P 500 Index has entered a bear market, which typically signals a recession. Except for the one-day market crash in 1987, we must travel back to 1966, when investors lopped 22% off the S&P 500 Index, but a recession was avoided.

Today, Fed Chief Jerome Powell continues to talk about the importance of getting inflation under control and back down to the Fed's 2% target. He seems to be in no mood to veer from the inflation-fighting course, even if it means a recession. Many think the Fed wants a recession because of the demand destruction and deflationary effects. The only way to reduce inflation right now is to reduce the demand for everything that went up in price, which will then bring prices back down again over time. The practice works but not rapidly. 

We expect another ¾-point interest rate hike in July and perhaps another in September. As painful as recessions are, high and enduring inflation exacts a much worse toll on everyone, and Powell understands this.

The rate hikes the Fed has done so far are beginning to have an effect as economic growth is slowing and consumer confidence is down. The Atlanta Fed's GDP forecasting model shows an estimated decline of-2.1% for Q2 GDP. You wouldn't know it with consumers splurging on travel and other services that were out of reach in the pandemic. Job growth has been robust, but we now see signs of higher layoffs. Despite the good jobs report, the participation rate remains low.   

Because the cyclical economy leads the ebb and flow during recessions, it follows that we focus on these areas to gauge the labor cycle. Specifically mining, construction, manufacturing, wholesale and retail trade, and transportation. Wouldn't you know, red lights flashed in May for the retail and durable goods sectors as layoffs began to show up in the data. In addition, the manufacturing and services employment PMI's - have dropped under 50, into contraction, reinforcing the recession conviction. Last week, Michigan's initial jobless rate claims were up +71%, more than 5 times Ohio's at +13%. The two lead the nation in pink slip tallies. The auto industry's plummeting car sales are not only from supply chain issues, but demand is also falling off. In addition, auto repossessions are on the rise.

Moody's Analytics argues that plenty of stimulus cash remains in bank accounts, which could support consumer spending, and typical signs of rising loan delinquencies have yet to materialize (St. Louis Federal Reserve).

Unfortunately, 70% of the savings gains are heavily concentrated in the top 10% of households, with the bottom 50% with only 7% of the savings pool. The "excess savings" for the bottom quartile has not only retraced any pandemic gains but is -$138 billion less than pre-pandemic levels as of Q1-22. 

Final thoughts

We won't try to pinpoint a stock market bottom, and today's economic fundamentals have created stiff headwinds for equities. We have not seen high inflation or interest hikes like this since 1980. Some estimates show inflation remaining over 7% through the end of 2022, gradually dropping to the desired 2% level over 18-24 months. CPI numbers came in at 9.1% for June 2022, and earnings reports will begin to be released.

We have been very cautious with your portfolios and have moved to a more moderate risk profile across the board. We have raised cash and implemented tax management strategies where appropriate. Much of the cash has been allocated to short-term T-bills, interest-bearing money market funds, and certificates of deposit. These are great places to park cash in the short term while we look for good investment opportunities.

Market pullbacks and bear markets are inevitable, and we recognize they can create unwanted angst. We also know that an unexpected, favorable shift in the economic fundamentals could fuel a sharp rally since sentiment today is quite negative.

As we have seen from over 200 years of stock market history, bear markets inevitably run their course, and a new bull market begins.

We saw that after the 2008 financial crisis, and we saw that after the Covid lockdowns led to a swift bear market and a steep but short recession.

We also saw stocks rally from the lows of the 1974 bear market. We know times like these can be difficult. We are only an email or call away if you have questions or would like to talk.

Sources: Investech Research; ECRI Institute; Real Vision; Hedgeye Research; Horses mouth; The Quill Intelligence report

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Personal Notes @ SVWA:

Tracy Lasecke & Roberta - escaped to Castle Hot Springs in Arizona this past May to celebrate Roberta's birthday. It is truly an oasis in the desert; Great Spa, mountain biking, rock climbing, aka Via Ferrata, and incredible food with many of the ingredients harvested right on the property.

Scott and Erin - We enjoyed a week in Tahoe with our two nieces from San Diego. The weather was great. We went to Donner Lake to swim and paddle board, visited the pool a few times, and seemed to spend the rest of the time cooking or eating out at some local restaurants. They had a great time.

Scott Yang and family are enjoying a relaxing summer with the kids on college break and are very happy that the Golden State Warriors won the championship.

Mo & Family- are enjoying summer. We love the variety of fruits available at the local farmer's market.

Lisa Ozaki - visited Yosemite National Park in May and saw Yosemite Falls and Mirror Lake. She also hiked the 8-mile Vernal and Nevada Falls trail, and her now-fiancé proposed next to the waterfall. Additionally, she finished eight of the Bridgerton book series.

Charles Tran - did a Spartan race for the first time. A Spartan race is a 5k run with obstacles scattered throughout the race. These obstacles include monkey bars, carrying heavy objects a certain distance, and climbing various nets and ropes. He hopes to complete a trifecta which is three races within a year. He is still progressing through his CFP education and is looking forward to a vacation in Mexico and the FPA NextGen conference in August. 

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We trust you've found this review to be educational and helpful. If you have any questions or want to discuss any matters, please feel free to call us.

As always, we are honored and humbled that you have given us the opportunity to serve as your financial advisor.

Gratefully yours, 

The Silicon Valley Wealth Advisors Team

Tracy Lasecke, CFP®            Scott Yang, CPA, CFP®          Scott Ponder, MBA, CFP® 

Monique Ruiz                                     Lisa Ozaki                               Charles Tran

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