It was another ugly day in financial markets. The S&P 500® Index closed down 4% on Wednesday—marking its worst day since 2020, wiping out the strength from the prior three sessions and dragging the year’s peak-to-trough decline back down to 18%.
What sparked the market selloff?
Concerns about inflation adversely impacting the consumer and corporate profitability appeared to drive the weakness. Two major U.S. retailers, Walmart and Target, reported earnings results this week which sharply underperformed consensus expectations. The consumer staples and consumer discretionary sectors led today’s decline, trading down around 5% and 6%, respectively. Separately, a measure of CEO confidence from The Conference Board also dropped sharply today, with 68% of U.S. CEOs expecting that the Federal Reserve (Fed) will eventually trigger a recession.
Our guiding principles during times of volatility
We have been writing about inflation, Fed hawkishness, elevated recession risks and how it informs our investment strategy extensively in recent weeks. In volatile markets, two core principles guide our thinking.
First is the importance of having an investment plan or strategic asset allocation that is designed to meet your goals AND sticking to it during times of stress. One of the worst decisions that individual and professional investors can and do make is to panic and sell with the herd. Consider for a moment the investment merits of sitting in cash right now. The average interest rate being paid on checking accounts is still near zero and inflation is raging. That is as close as things get in this business to being a guaranteed negative real return—an erosion of purchasing power.
Second, and precisely because of the emotional biases that can impact our investment decisions, we believe a structured approach is critical to guide any tactical asset allocation decisions. At Russell Investments, we evaluate the cycle, valuation and sentiment characteristics for all new investments. In the case of U.S. equities right now, here’s our outlook:
- Cycle: We have downgraded our outlook in recent months to reflect a rapidly maturing business cycle. The U.S. labor market is overheating, and the Fed is quickly pivoting toward a more restrictive monetary policy setting. These two hallmarks of the late cycle leave us more cautious about the outlook. We judge recession risks to be higher than normal, and this sets a very high bar on the other elements of our investment process to drive any positivity.
- Valuations: The 18% peak-to-trough selloff in the S&P 500® Index has started to chip away at the very expensive price multiples for U.S. equities. However, even with the drawdown, U.S. shares are not yet in a range that we would judge to be consistent with fair value. This means that, in our view, the upside/downside risk profile for U.S. equities does not yet appear to have a strong positive skew.
- Sentiment: Our contrarian indicator, which aggregates information from market technicals, investor positioning and investor sentiment surveys suggests market psychology is starting to push into panic territory. This is a powerful tactical signal in our investment process but has not yet breached the same extreme levels of capitulation that we witnessed back in 2018 and 2020.
The importance of sticking to a strategic plan
The bottom line is that we continue to dispassionately monitor the volatility in financial markets for any opportunities that might emerge. Given the compounding uncertainty from elevated U.S. inflation, higher interest rates, the ongoing war in Ukraine, higher commodity prices and the COVID-19 lockdowns in China, we have set a high bar for adding to risk in portfolios. So far, that patience has been rewarded. We are sticking to the plan.