Since the major stock market indices peaked at record high levels on January 4, 2022, investors have been unhappily reacquainted with gut wrenching market behavior.  In recent trading, the S&P 500^® was down approximately 17% year to date, while the growth sector of the S&P was down about 25%.

Many large, high profile growth stocks, especially those that soared during the pandemic, have experienced even more precipitous declines of 30-70% or more.

Periods of market stress usually have varying catalysts, but all revolve around the inevitable natural cycles of economics and markets. They also tend to happen when the Federal Reserve (Fed) raises interest rates. Markets are considered to be in a correction when they decline 10% to 20%, and in a “bear market” when they decline more than 20%.

To put the recent market downdraft in perspective using annual historical averages, market corrections occur, on average, about once every 12 to 18 months, and more severe bear markets occur on average about every four years. Since 1946 there have been 25 market corrections, with an average duration of 133 days and an average decline of 14%. This current correction is now about average in length at 138 days but more severe, with a decline roughly 17%.

In the past 13 years, there has only been one negative performance year, 2018, and then the loss was a modest 4.5%. However, this abnormally long stretch of positive returns occurred just after the deep bear market that followed the 2008 financial crisis. In hindsight (which is always 20/20), the markets were overdue for this reality check.

Less frequent are periods when investors pivot from excessively valuing high growth and/or speculative companies, and back to rewarding the bedrock investment virtues of companies that exhibit sound fundamental businesses, solid financial performance, and rational valuation.

These periods occur roughly every 10 to 20 years, the last being the bear market that followed the Dot-Com Bust of 2000-2001. These market pivots to quality have historically been persistent, leading to lengthy and meaningful dispersion of returns between various sectors of the market. The market seems to be going through just such a period of an aversion to risk and a return to quality.

NASDAQ history – “Dot.com” to “FAANG”

Technology and companies that commercialize technology have certainly changed the global economy; and the stocks in this sector have heavily influenced market returns for over two decades. This sector has created incredible wealth but has also led to speculative excess.

In the late 1990s “Dot.com” was the moniker given to this group of technology companies. After spectacular price gains, this sector suffered devastating losses when the Fed began to raise interest rates in 2000. Although the Fed’s policy change may have been the catalyst for dramatic market declines, the core problem was that markets had been too euphoric over money-losing businesses centered vaguely on the emerging technology of the Internet. The following five years saw the NASDAQ index decline in value by more than 50%.

However, even though price declines in this sector were extreme, other more reasonably valued sectors performed dramatically better, as investors pivoted back to companies with solid fundamentals. From the end of 1999 through 2004, in contrast to the sharp NASDAQ losses, the total return for the S&P 500 was -12% and the value-oriented sector of the S&P was -8%.

An even larger divergence in performance during this time frame came from the returns of smaller capitalization stocks. The Russell 2000 Index of small stocks was up 35% over that time frame. Even more stunning was the S&P 600 Small Cap Index, which, unlike the Russell 2000, excludes money-losing companies. It was up 70% over that five-year time frame!

Over the past 10 years, the NASDAQ index and the overall stock market, became dominated by new technology sectors of the market, dubbed the “FAANG” stocks – an acronym for Facebook (now Meta), Apple, Amazon, Netflix and Google (now Alphabet). Unlike many of the Dot.com era companies, these FAANG stocks and many other technology innovators have been immensely profitable, with astounding rates of growth. Their business models and financial performance have justified their burgeoning market valuations.

However, aided by historically low interest rates, enormous cash flows into mutual funds and ETFs, and investor FOMO (fear of missing out), once again valuation for these “disruptive” technology companies went to excess. And similar to 2000, a pivot in Fed policy to higher interest rates has been the catalyst for stock market declines, with the NASDAQ and the S&P 500 indices down 26% and 17% respectively.

Similar to the end of the Dot.com time frame, stocks of companies that exhibit quality, value and even higher dividends are now substantially outperforming. The Value component of the S&P 500 has suffered only half the decline of the full index, down 7%. In the smaller capitalization sector of the stock market, stocks of higher quality/lower valuation companies are also dramatically outperforming more speculative, unprofitable companies.

Post-policy-pivot positioning

Investors are now laser focused on three interconnected challenges: 1) inflation, 2) the potential for an imminent recession, as consumers and businesses react to inflation, and 3) the impact a potential recessionary environment may have on corporate earnings.

• Recent inflation reports continue to be discouraging. However, there are some modest signs that inflation may be moderating.  Some goods prices have come off their peak, unexpectedly high retail inventories are leading to pricing discounts, freight rates are falling, and some commodity prices have stabilized.  But the market is still looking for a more decisive decline in inflation statistics.

• Warning signs are mounting for a potential recession, as consumers pull back on activity in response to high prices, businesses become more cautious, massive pandemic-induced government spending programs recede, and the Fed continues its tightening program.  However, with employment levels remaining very healthy, consumer spending holding up, and the banking system quite solid, if a recession were to occur, it is difficult to believe that it would evolve into a deep and protracted issue.

• Corporate earnings remain a real wild card for the markets. There have been some very disappointing earnings reports for many key companies as they grapple with rising expenses.  Profit margins have probably peaked, albeit at still historically high levels.

Both the bond and stock markets have priced in much of the aforementioned issues. The question then is whether these issues will persist and/or worsen. The bond market has shown some sign of stabilizing over the past month. The short/intermediate maturity sector of the market seems reasonably valued relative to the Fed’s guidance. Longer maturity issues remain a question mark until inflation shows real signs of retreating.

Caution and quality should be the key dimensions as investors navigate this still challenging stock market environment. Second quarter earnings could be disappointing as corporations struggle with labor and materials cost pressures. However, the market price/earnings multiple of approximately 16 to 17 times earnings is reasonable relative to history.

Stressed markets are always jarring, should be expected, are impossible to time, and ultimately need to be endured by long-term investors. Even though the Dot.com bear market was severe, the overall market eventually recovered, led by fundamentally strong companies with rational valuations. Today’s market is going through a similar cyclical pattern, although the large technology companies of today are vastly stronger than many of the flimsy companies of the late 1990s.

With the specter of uncomfortably high inflation, rising interest rates, and a somewhat fragile global economy, it would not be surprising to see more market turbulence and potentially more market declines. Like the post Dot.com scenario, companies that exhibit the bedrock fundamental virtues of solid long-term profitability, disciplined capital allocation (including returning capital to shareholders via dividends or buybacks) and well-managed balance sheets will likely continue to lead the market for some time to come.