The S&P 500 closed Thursday May 12th at 3,930.08, a decline of 18.06% from the January 3rd closing high of 4,796.56. While the S&P 500 has not entered what many people define as a bear market by falling twenty percent, this feels like a bear market. It reminds NPP of the quick bear market in the fourth quarter of 2018 where the S&P 500 fell 19.78% from its September 20th high before bottoming on December 24th. Then as now, the Federal Reserve was tightening monetary policy after easy monetary policy and increasing budget deficits contributed to large equity gains. Just as in late 2018, some strategists are starting to worry about the likelihood of a recession. In fact, real GDP was negative in the first quarter of this year although it follows the fourth quarter of 2021 which saw GDP rise 6.9% and may have been distorted by net imports.
The Federal Reserve stopped tightening and started easing in early 2019 and the market bottomed and moved materially higher until COVID came along. The difference between now and 2018 is that we were not dealing with the aftermath of the pandemic or the risks resulting from the war in the Ukraine. Despite the more troubling macro background, we think the market is getting closer to finding a bottom and interest rates may be close to the top. The main risks remain inflation and stretched supply chains. Inflation has probably already peaked while supply chains have loosened up somewhat and there are incipient signs that commodity prices have topped, at least in the short run.
The combination of expansive global fiscal policy and loose monetary policy beginning during COVID supercharged money supply growth (see chart).
Money supply growth along with stretched supply chains contributed to inflation accelerating to levels not seen in four decades. As you can see in the chart above, year over year money supply growth is now down to the top of the pre-COVID-19 fifty-year range. Even more importantly, M2 only grew 1.52% in the first quarter of 2020 which equates to a 6.22% annual rate, or slightly below the fifty-year average. This compares to 2021 when M2 grew 3.81% in the quarter and 16.14% annualized. NPP believes this will help ease inflationary pressures.
There are still risks that housing prices and rents will not cool off, supply chains will remain clogged while tight labor markets contribute to higher wages and prices. However, except for housing these risks appear to have softened. Housing demand is cooling, while prices and rents continue to climb. The financial system is significantly less leveraged than it was before the GFC and now the problem is too little supply, not too much. NPP does not think that inflation will get to the Federal Reserve’s comfort level near two percent in 2022, but we do believe that inflation will decelerate and end the year near three to four percent and on a downward trajectory.
It is possible that the war in the Ukraine, China lockdowns, tight labor markets etc. will take the market lower. However, with the forward PE multiple on the S&P 500 below seventeen, valuations are suddenly much more reasonable. We think investors will start to come back in once the multiple nears sixteen. This would mean the S&P 500 has another couple percent to fall.
The weakness has been remarkable because earnings growth remains strong. S&P 500 earnings are up 10.03% in the quarter and are 5.06% above expectations according to Bloomberg with a little over ninety-one percent of companies reporting. More reasonable valuations do not mean stocks have to go up, but it does make it harder for them to go down. We do not expect the bottom will be V-shaped as it was during the fourth quarter of 2018, or the COVID-19 crash of 2020. We expect the market to remain choppy until we get closer to the peak in rate hikes. We suspect markets will stabilize once the Federal Reserve signals that rate hikes are more likely to be twenty-five basis points instead of fifty. NPP thinks this happens during the third quarter. Despite an expectation of continued volatility, the outlook for forward returns has improved from the start of 2022.
The rise in rates preceded the equity market sell-off. This has been the worst start to the year for the Bloomberg US Aggregate Bond Index since its inception in 1976. Fixed income investors have experienced a bear market in bonds unlike any since the 1970s and early 1980s inflation period. The slowdown in the rate of ascent and the possibility that rates are peaking are necessary for a stock market bottom. Bonds led equities lower. We think a top or stabilization in bond yields is needed to produce a durable bottom in equity markets.
As opposed to the 2018 stock market bottom, the geo-political background is much more worrisome. NPP does not expect equity valuations to return to levels reached at the beginning of 2022. The upward move is likely to be choppier and not immediate. Nevertheless, we think a buying opportunity is approaching for patient equity and fixed income investors and we are looking at deploying excess cash with the belief that forward returns look much more attractive than they did at the beginning of the year.