Thank You Robinhood!

 

The email I copied below has to be about the best breakdown of what's happening in the markets I've been able to comprehend yet.

Kudos Robinhood, even though I haven't done active trading on that app in years, they keep their users updated nevertheless.



Hi Michael,

We have officially hit a bear market in the S&P 500 Index. As of today’s close, the S&P 500 total return is down -21.3% from its highs at the start of this year, breaching the down -20% mark.

How’d we get here? Two words, in our view: stimulus and expectations. 

Soon after Covid hit and the world stopped, the Fed jumped in to stabilize the foundation of our financial system (the bond market) with $4.5T of security purchases. It was followed by an additional $3.6T of US government money, first to businesses and then to the consumer directly through extra unemployment benefits, child-tax-credit payments, and checks in the mail.

Today, we find ourselves in a place where all that helpful stimulus money is unwinding. Since the start of the year, the market has been trying to find the correct expectations of the future.

So while the ignition for this drop was Friday’s inflation report (+8.6% year over year for May), the greater driving factor is still a question centered on valuations.

Let’s unpack that. 

The inflation report was a little higher than officially expected (by 0.3%), and with the benefit of near-term hindsight, it seems that unspoken expectations were for inflation to come in lower. So anything at the same level, or even mildly higher, was going to set off the stock market drop we got on Friday, following through to today.

The greater reference to valuation — the value the market agrees to pay today for a company’s future earnings — is that it’s trying to find what businesses should be worth in the future, knowing that the stimulus is gone and inflation is here.

In terms of numbers, the 12-month forward price-to-earnings ratio (P/E) for the S&P 500 Index is now about 16.5x, down from a peak of 23x last year. In a historical context, this is in line to above some of the historical averages: 10-year (16.9), 20-year (15.5), and 25-year (16.5).

So far, all of the fall in valuations this year have come from the drop in the “P” (prices), versus a fall in earnings expectations — the “E.” That’s because earnings estimates for this year and next are still at record highs.

Will the market continue to fall?

Anything is possible. Looking back to 1945, when bear markets occurred, 70% of the time they related to a recession, and the average return during a recession was -30%. 

From here, further drops in the market depend more greatly on the “E,” as expectations for the next 12 months and for 2023 are high and likely need to come down. For context, aggregate earnings for the S&P 500 Index are expected to be +10% higher for each of the next two years. That seems inconsistent with rising costs and the related expectation of slowing growth. As a result, it’s reasonable that earnings may actually be lower than current expectations by 5%. Assuming this is about right, in our analysis, it could mean market levels would look closer to fair value if down further, by mid-single digits. Thus, the S&P 500 would come close to 30% down for the year, and in line with the average for a recession.

Will we have a recession? 

It’s very possible — led by reassessment of corporate earnings while they cut their costs from higher expenses and softer demand. If that’s right, we are about two-thirds of the way through the market downturn (closer to the bottom than the top). 

Could we be wrong about this? (Yes — and we sort of hope we are, to the upside.)

Evidence of better earnings growing, a quicker cooling of inflation than expected, and even ancillary events such as a true shift in Covid policy from China or a ceasefire in Russia’s war on Ukraine, can quickly shift expectations positively.

What does this mean for investors?

Diversification is often the answer to a lot of investing questions. It’s never a bad time to review your positions and your plan (or make one). When looking through your portfolio, consider the balance of holdings — higher-quality or lower-valued areas such as dividend stocks, and those in energy and healthcare can be attractive to some investors and can serve as a balance for riskier growth companies that may take longer than average to recover. In addition, depending on your personal situation and investing style, keeping funds available for a “dip buy” may also be prudent.

Volatility is higher these days, but try not to let it trigger an investment reaction. Staying the course may be the right decision as equity markets have historically provided positive returns over the long term*.

For more on what’s happening in the markets, check out our daily Snacks newsletter.

Sincerely,

The Robinhood Team