February 2022 Outlook — The Thrill of Volatility
Photo by Liam Simpson
As if COVID, macro conditions, and the Federal Reserve weren’t providing enough to discuss, the threat of Russia invading Ukraine and the recent volatility in stock performance as well as corporate earnings make it easy to feel overwhelmed by all the news pouring in. When there is a surplus of topics to discuss, it can be difficult to find a place to start. In times like these, I fall back on one of my core beliefs: markets often react too quickly to minor events and too slowly to major events. I’m not saying I know for a fact what information is truly important and what is just noise, but I make an active effort to distill what really matters. I’ll recap market performance for the month of January, talk briefly about earnings that have come in so far, and delve into the Russia-Ukraine situation before discussing my updated forecasts.
January was the worst month for the S&P 500 Index since March 2020 1 . Language from the Federal Reserve showed greater confidence in more and faster rate increases than the market seems to be comfortable with. The number of hikes expected by institutions varies, but the highest forecast I’ve seen so far is seven2.
Growth stocks in particular have been hammered – the S&P 500 Growth Index was down almost 8.5% for the month. All returns are computed using data from Yahoo Finance. A number of high-revenue growth and high-earnings growth companies tend to have a decent amount of debt on their balance sheets; as interest rates rise, taking on debt becomes more expensive, and this eats into the future growth expectations and valuations of these companies. The S&P 500 Value Index was substantially less impacted and fell by about 1.8%.
LPL chart of S&P 500 performance following select geopolitical events
The chart above details performance of the S&P 500 Index after major geopolitical events starting in 1941. The worst drawdown was after the Pearl Harbor Attack after which the S&P 500 lost about 20% over 143 days. I won’t bother computing averages or medians for these statistics – each scenario is unique. What this chart suggests, however, is that if the conflict is kept relatively contained, US markets could be less affected than people might expect. Of course, the possibility of true existential crisis (nuclear war, mobilization of China and North Korea, etc.) exists, but I’m not here to fear-monger, and I truly believe the probability of any really devastating sequence of events playing out is very low.
Looking to the future, the movement caused by earnings volatility and fear turned my expectation for US equities more bullish. With the compression of pricing multiples in January, my forecasts suggest equities offer an improved risk premium relative to fixed income at this point. Rising rates could impact both asset classes negatively, but interest rate expectations are not a factor I currently consider. Prior to January, my forecasts were showing US core fixed income slightly underperforming broader US equities, but the updated forecast shows a larger spread favoring equities. An important point to make is this – I make medium-term forecasts with about a six-month horizon. With all the uncertainty in the world, the path that the market takes in the next six months could be quite volatile. Fixed income could very well outperform in the short term, but I do believe equities will outperform in the medium term. Between growth and value within the US, I continue to favor growth, but my expected returns for both equity-styles have increased.
I’m more bearish on international equities – my forecasts for international developed equities and emerging market equities both declined after January. Inflation ticked up in Europe5 which is part of the reason the forecast came down. The dollar strengthened in January5, likely benefitting from global uncertainty. While a stronger current dollar and possibility of mean reversion generally provide a tailwind to international asset classes, there could still be room for the uptrend to run before changing course.
I’m expecting US real estate to perform in-line with US core equities. Demand for housing may be more susceptible to rising interest rates in the long-term, but the appetite for housing remains high currently. Until that diminishes, my medium-term outlook for US real estate remains positive. Much like the other international asset classes I follow, I have a weaker outlook for international real estate relative to US asset classes, but the outlook is improving. While I try to make my machine learning models as interpretable as possible, I’m currently vexed as to why the outlook improved given that my factor readings haven’t changed much. My best guess at the moment is that the asset class is expected to exhibit some mean reversion, but regardless, my outlook will need to improve more before I become bullish.
The breadth of factors contributing to uncertainty has increased over the past month. COVID is still with us, and the new normal is still being defined. Heightened geopolitical tensions inflamed by certain aggressive actors are also contributing volatility to a market already uncertain about inflation and how the Federal Reserve will try to counter it. If there’s one thing the chart from LPL has affirmed for me, however, it is that human optimism can power through uncertainty. As a species, humans are coded to be optimistic – hope helps people push through difficult times. If humanity were overly pessimistic on average, the species might not have made it this far. That being said, one of the main reasons I maintain this blog is that it pays at times to be pessimistic about markets. This generally isn’t the case – the markets have gone up exponentially over the long-term, but there were major drops along the way. Even though these major drops have occurred, it is still hard to be bearish in bull markets. Take a look at some bearish perspectives on internet forums – I’m sure there will be examples of pessimists being ridiculed by optimists. Personally, I endeavor to take an explicitly probabilistic approach. There is a chance the market is being too sanguine about Russia and Ukraine. There’s also a chance some new risk will emerge that no one knows about yet. Although I respect that substantial risk exists, my quantitative forecasts point towards a relatively bullish medium-term period, and I trust my forecasts. I won’t pretend that the path will be smooth, however, and I also acknowledge that I could be very wrong. To me though, this is when I’m the most excited as an investor. Volatility can be scary, but it creates the opportunity to stand out, and that’s what I hope to do. Stay vigilant and stay healthy. I’ll write again soon.