Financial markets began the third quarter positive only to see gains evaporate by September 30th. It was the tale of two halves as the S&P 500 gained 13.7% during the first six weeks of the quarter and then declined 16.36% the final six weeks. The first half of the three-month period saw equity prices rebound from a soft second quarter as investors anticipated a slowdown in rising inflation rates. During the second half of the quarter stock markets experienced a complete reversal as inflation rates continued to be elevated, the Federal Reserve re-committed to lifting short-term interest rates, and possible large institutional investors re-allocating their portfolios at quarter-end.
The result was that most major stock indexes were lower for the third consecutive quarter and remained firmly down year-to-date. Uncharacteristically, small-capitalized stocks defended better than larger capitalized stocks in the third quarter with a decline of just 2.18% (Russell 2000 Small Cap Index). International stocks fared worse as the MSCI EAFE Index finished the three-month period down 9.26%. The Dow Jones Industrial Average and the S&P 500 were also down in the third quarter 6.66% and 4.89% respectively. These most recent quarterly returns pushed 2022 year-to-date results into bear market territory (defined as decline of greater than 20%). By September 30th, the NASDAQ had lost 31.99%, the MSCI EAFE was down 26.71%, and the S&P 500 had declined 23.88%.
The prevailing theory that has plagued stocks all year is that the current strong economy has pushed inflation higher. And to quell inflation the Federal Open Market Committee will raise interest rates to such an extent that it will force the U.S. economy into a recession. Unfortunately, this scenario is also bad for bond holders. Increasing interest rates forces bond prices lower. So, instead of offering a “safe-haven” for investors, bond indices have also been in retreat mode. The Bloomberg U.S. Aggregate Bond Index ended the third quarter down 4.75% and the first nine months of 2022 down 14.61%.
A decline in stock markets greater than 20% is nothing new. The S&P 500 has dropped 20%, or more, three times in the last four years. This current decline in equity is only different in its duration. The 20% decline in the 4th quarter of 2018 lasted three months. The 33% decline in the first quarter of 2019 (beginning of the pandemic) lasted just five weeks. By contrast, the 2022 correction has lasted nearly nine months. Long-term investors should see the current pullback as another great opportunity to add to investments, rebalance, or potentially defer current and future tax liabilities. Since 2000 the S&P 500 has seen seven time periods where the S&P 500 has fallen more than 10%. In these cases, the succeeding twelve-month return was positive. The average twelve-month return after a 10% drop of the previous six occurrences is 14.96%.
The stock market behavior is currently perverse. Generally, good economic news is good for stock prices. In 2022 good news is perceived as a bad thing because it gives the Federal Reserve more encouragement to raise interest rates. Investors should remember that good news is good news. A strong economy with low unemployment and high consumption is good for stock prices. D’Arcy Capital believes that an economic dynamic with 4% short-term interest rates and growing corporate earnings is healthier than 0% interest rate environment.
Investors should consider taking advantage of the current level of lower stock values. This appears to be a great time to add to portfolios on both the bond and stock side of the allocation. It is empowering to add to portfolios when it is most uncomfortable to do so. As history suggests, bear markets are often followed by a sustained bull market. Investors should picture themselves five years into the future. Do they want to be known as an investor who sold during the 2022 bear market or the investor who bought during the 2022 bear market? These opportunities don’t typically exist forever. D’Arcy Capital believes it is critical to remain diversified, overall. The last twelve years it was easy to identify the leaders in equity investing (large cap growth and indexing). There is no clear leadership currently, so it is important to be exposed to lots of asset classes. Philosophically, D’Arcy Capital prefers active investing versus passive/index investing. On a stock sector level D’Arcy Capital favors emerging markets, U.S. financials, and biotechnology. In fixed income D’Arcy capital remains invested in tax-free municipal securities, short-term investment grade bonds, and treasury inflation protected securities.