Focus on Equities: Staying the Course in Turbulent Market Conditions
- It appears that FOMO has been reduced to one letter, F. Fear surrounds inflation, rising interest rates, and the potential for a recession —all of which have spooked the equity markets.
- With an increase in economic uncertainty, it is difficult to envision how the next three to six months might play out, which can be unnerving to investors.
- Following this market sell-off, future returns from equities look more promising than they did just six months ago.
- We believe the long-term financial potential of owning a portfolio of high-quality businesses can far outweigh the more challenging periods.
The S&P 500 lost ground in the second quarter, delivering a total return of negative 16.1%. Foreign stocks, as measured by the MSCI ACWl ex USA Index, declined 13.7%. Small- and mid-cap U.S. stocks traded lower, with the Morningstar US Small-Mid Cap Index down 16.1% for the quarter. Dividend stocks also declined this quarter, with the Dow Jones US Select Dividend Index down 7.4%.
Staying the Course in a Turbulent Market Environment
Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.
—Sir John Templeton*
It wasn’t long ago, starting around mid-2020, when it appeared that some market participants started to suffer from FOMO, or fear of missing out. We raised questions about some of the resulting pockets of euphoria in prior Focus on Equities letters, such as special purpose acquisition companies (SPACs), increase in options trading, Robinhood, and money-losing IPOs. At the mid-point of 2022, it appears that FOMO has been reduced to one letter, F. Fear surrounds inflation, rising interest rates, and the potential for a recession—all of which have spooked the equity markets.
The average U.S. consumer is feeling squeezed, too. It is easy to understand why inflation is top of mind for the general population after a visit to the grocery store or gas station. Inflation readings in recent months are hitting 40-year highs as the Consumer Price Index rose 8.6% year-over-year in May. The war in Ukraine has contributed to commodity price increases and created a series of new supply-chain bottlenecks.
Inflation appears more persistent than the Federal Reserve anticipated, so in response they have raised their benchmark interest rate three-quarters of a point to a range of 1.5%-1.75% in their June meeting. Fed Chair, Jerome Powell, also stated that either a 50-basis-point or a 75-basis-point increase seems most likely at their next meeting.
These are undoubtedly big developments. In response bond yields have increased meaningfully, with both short- and long-dated maturities moving significantly. Notably, the benchmark 10-year U.S. Treasury note yield increased from roughly 1.5% to 3.0% from the start of the year through June 30.
The net result is uncertainty. The Federal Reserve continues to attempt a balancing act of reining in inflation without stifling economic growth too much. Moreover, it is difficult to envision how the next three to six months might play out—which can be unnerving to investors. The equity market does not like uncertainty or negative surprises, and we’ve had both. When stock prices are moving steadily higher, market participants often take a long-term perspective to justify investment decisions. However, when markets tumble, the opposite is often true—they focus on the next three to six months instead of the next decade. Our investment team remains focused on assessing the competitive advantage of businesses and the durability of future cash flow generation over the next five to 10 years.
What we wrote in last quarter’s Focus on Equities letter still applies:
Given the unusual economic circumstances, especially rising inflation, we expect upcoming corporate earnings results to have more variability and less predictability than usual. This could cause greater price fluctuation than we’re accustomed to for some portfolio holdings, even when there is minimal impact on the intrinsic value of the business.
Rising input and labor costs may prove to be temporary for some companies and longer lasting for others. In our analysis we look to strike a balance between not overreacting to short-term results and incorporating new information.
We believe stock market “chaos” creates opportunities as prices can diverge significantly from business values. Our approach to investing in equities is founded firmly on the premise that the intrinsic value of a business, at times, can differ materially from its market price. In simple terms, we look to buy stocks when the price trades at a discount to the value of the business. Conversely, we aim to sell stocks when the price far exceeds intrinsic value.
In our Select Equity Portfolios, we have a natural bias toward—and preference for—investing in high-quality companies. We define high-quality as having sustainable competitive advantages, strong balance sheets, and shareholder-friendly management teams. We believe a business with these characteristics can weather any potential economic headwinds better than the average firm.
Following this market selloff, future returns from equities look more promising than they did just six months ago. That said, we don’t have any special insight on how the stock market—or any individual stock—will perform over the next month or year. As history has persistently demonstrated, prices can swing both well above and below intrinsic value, sometimes for extended periods. Yet, for risk-tolerant investors with a proper investment horizon, we believe the long-term financial potential of owning a portfolio of high-quality businesses can far outweigh the more challenging periods with volatility and market corrections like we’ve experienced so far in 2022.
We recommend consulting with your financial advisor, who can help you make sure your current asset allocation is appropriate for your risk tolerance and is on track to help you reach your long-term financial goals.
As always, we thank you for your business.
*Templeton, L.C. & Phillips, S. 2008. Investing the Templeton Way: The Market-Beating Strategies of Value Investing's Legendary Bargain Hunter (New York: McGraw Hill).
Opinions expressed are as of the current date; such opinions are subject to change without notice. Morningstar Investment Management shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use. This commentary is for informational purposes only. The information, data, analyses, and opinions presented herein do not constitute investment advice, are provided solely for informational purposes and therefore are not an offer to buy or sell a security. Please note that references to specific securities or other investment options within this piece should not be considered an offer (as defined by the Securities and Exchange Act) to purchase or sell that specific investment. Performance data shown represents past performance. Past performance does not guarantee future results. All investments involve risk, including the loss of principal. There can be no assurance that any financial strategy will be successful. Morningstar Investment Management does not guarantee that the results of their advice, recommendations or objectives of a strategy will be achieved. This commentary contains certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason. Past performance does not guarantee future results. Morningstar® Managed PortfoliosSM are offered by the entities within Morningstar’s Investment Management group, which includes subsidiaries of Morningstar, Inc. that are authorized in the appropriate jurisdiction to provide consulting or advisory services in North America, Europe, Asia, Australia, and Africa. In the United States, Morningstar Managed Portfolios are offered by Morningstar Investment Services LLC or Morningstar Investment Management LLC, both registered investment advisers, as part of various advisory services offered on a discretionary or non-discretionary basis. Portfolio construction and on-going monitoring and maintenance of the portfolios within the program is provided on Morningstar Investment Services behalf by Morningstar Investment Management LLC. Morningstar Managed Portfolios offered by Morningstar Investment Services LLC or Morningstar Investment Management LLC are intended for citizens or legal residents of the United States or its territories and can only be offered by a registered investment adviser or investment adviser representative. Investing in international securities involve additional risks. These risks include, but are not limited to, currency risk, political risk, and risk associated with varying accounting standards. Investing in emerging markets may increase these risks. Emerging markets are countries with relatively young stock and bond markets. Typically, emerging-markets investments have the potential for losses and gains larger than those of developed-market investments. A debt security refers to money borrowed that must be repaid that has a fixed amount, a maturity date(s), and usually a specific rate of interest. Some debt securities are discounted in the original purchase price. Examples of debt securities are treasury bills, bonds and commercial paper. The borrower pays interest for the use of the money and pays the principal amount on a specified date. The indexes noted are unmanaged and cannot be directly invested in. Individual index performance is provided as a reference only. Since indexes and/or composition levels may change over time, actual return and risk characteristics may be higher or lower than those presented. Although index performance data is gathered from reliable sources, Morningstar Investment Management cannot guarantee its accuracy, completeness or reliability.