• We are almost halfway through earnings season.  Earnings announcements are always important but maybe more so this quarter due to investors’ eagerness to see how inflation, including wage growth, is affecting companies’ bottom lines and outlooks for 2022. 
    So far, earnings have come in about 5% above expectations with 30% growth year-over-year.   Future guidance has been mixed.   Some companies (for example, Apple) have gone virtually unscathed from inflation pressures.  Others are feeling the effects of both input costs and wage growth (for example, McDonald’s).  
    Earnings growth will decline this year.  Bears say earnings growth deceleration is a big problem for the market, maybe even a bigger problem than inflation.  We disagree.  Earnings growth for 2022 is still forecast at 9%, a very strong number after 2021’s unsustainable earnings surge. 


The S&P 500 was down 5.3% in January, but many benchmarks were down more.  The average stock in the Russell 3000 is down more than 20% from its 52-week high.  Is this a stumble or a collapse under the weight of rising inflation, higher interest rates, and high P/Es? 

First, a little perspective on the volatility we are seeing.  The average annual drawdown is 16% (intra-year peak to trough, source: CRSP Data).  Even though January was volatile, the S&P 500 didn’t fluctuate as much as an average annual drawdown (of course, the year is young).  Last year the maximum drawdown was 5.5%, a very calm year.  This is the normal year for volatility.  Last year was the aberration. 

In our view, the main reason the stock market is correcting is investors fear the Fed will go too far in fighting inflation and choke our economy into recession.  The Fed is tightening monetary policy with a three-pronged approach: 

  1.  An end to quantitative easing in March – no more flooding the economy and markets with liquidity; 
  2.  Interest rate increases likely to begin in March – the market expects four rate hikes this year and three next year (one-quarter percent each time); 
  3.  The start of quantitative tightening soon, the opposite of quantitative easing.  The Fed will sell bonds from inventory and start reducing its $9 trillion balance sheet.  This will reduce liquidity. 

Investors are assuming the worst – the Fed will commit a policy error.  Sure, it could happen, but it is way too soon to be assuming the Fed will fail.  Investors are using this as a convenient excuse to sell stocks in an over-extended market.  The market was long overdue for a correction. 

When corrections occur there is a progression of which areas of the market get hit.  It is almost always poor quality first.  This time they took out the microbubble stocks first (for example, meme stocks, IPOs, SPACs, crypto).  Then it was high growth technology companies (in sales) with no earnings and poor balance sheets.  Some stocks in this group are down 50-70%.  Then small caps.  Then, finally, quality stocks have recently come under pressure.  Many good quality stocks are now down 20-30% off their 52-week highs and look interesting.  Corrections and bear markets take good stocks down with the bad.  Many times only the good stocks come back. 

Is the correction over?  Of course no one knows when the bottom will occur and at what level, but the rally over the last few days is encouraging.  Maybe the market’s re-pricing of risk is complete?  Investor sentiment has plunged, so prices are reflecting very bearish investors. 

What should long-term investors do during volatile periods like this?  First, stay the course.  Last month we shared a Peter Lynch quote saying “you can’t make money in stocks if you get scared out of them.“ Second, compile a wish list of stocks you want to buy at your target prices.  Use that list either to invest residual cash or as replacement stocks for tax loss harvesting candidates in taxable accounts.  Finally, remember that sentiment, not fundamentals, is driving stock prices in the short-term.  Stay disciplined and execute your investment plan.  Don’t get caught up in the market’s crisis of the day.  It will detract from good long-term investment results.