Market Decline Accelerates: How to Find the Bottom

Market Decline Accelerates:

How to Find the Bottom

At this writing, the Standard & Poor’s 500 Index is down 16.8 percent year-to-date.  Within this fact, several stocks have gone down less and some have gone down a great deal more. For those who would rather invest in the future than the present, an analysis of the sectors that look to be leaders in the next upswing is in order.

First, some insights into what has done worse than the overall index.  As usual in most stock market retrenchments, stocks with the highest price/earnings (P/E) ratios have as a group gone down the most.  The so-called FANG stocks (Facebook [now Meta], Apple, Netflix, and Google [Alphabet]) have all gone down more than the overall market.  This is somewhat logical, as they all went up more than the market in the last upswing. In a market characterized by high appreciation, it is easy to insist that valuations do not matter and point to the returns of the favored few as evidence.  Alas, there is a difference between momentum and what is being obtained for the price paid.  The stock market is one of the few places where people want more of something that is going up in price and less of what is falling in price.  From this breakdown in logic, all sorts of investors’ losses flow.

The second source of investor losses is not knowing one’s investment time frame.  Even those who “time the market” by getting out at higher prices have to decide when to get back in.  If this is done in a personal account, capital gains taxes accrue.  While there is no disgrace in paying taxes, there is a problem in switching in and out of the same stock in an effort to scalp a few points of gains.  Even if this is done in a tax-deferred account, the transaction costs can eat the portfolio up.

So, if an investor’s portfolio is constructed of stocks and bonds that the investor understands and is comfortable with for some longer term, the remaining issue is where to invest new funds or proceeds from sales.  In a falling market, the additional issue is when.

Market bottoms are only known in retrospect.  A strong day can be followed by a weak one.  Still, there are things to consider, such as the number of stocks making 52-week highs compared to similar lows. A market is considered “recovering” when the number of advancing issues is greater than declining issues for several consecutive days.

For recent investors, the only material decline experienced was in 2020.  At that time, the market plunged over 30 percent in four months, only to reverse and be up for the year. This time, the odds of a quick snap back are lower, with rising interest rates, higher energy prices, and inflation present.  This would suggest the recovery in stock prices will be more protracted.

This is an environment that favors value stocks.  Companies that have strong balance sheets, dividends, and high cash flow would seem to do best in this market.  Higher interest rates alone will prove stiff competition to growth concepts; the ability to find firms that can deliver in a slow growth/high labor cost situation (which will probably be the norm for some time) will be key.

The cost and availability of labor is of special note.  Aging demographics, immigration contraction, and greater use of part-time workers will all impact workers’ pay and productivity for most companies.  This will be less of a trend and more of a regression to the mean.  Labor costs have been abnormally low for a number of years.  A return to average labor factors relative to revenue will likely suppress the bulge in profit margins for many companies but this will be a return to historical averages.

Many investors see the Federal Reserve as the bad guy here.  However, with inflation rampant, something had to be done to reduce demand; normally, this is what raising interest rates does.  One can debate whether the Fed should have acted earlier, but it was evident it had to act sometime.  For the past decade, low interest rates, generous credit terms, and low inflation was the norm.  The non-existent returns on cash forced many into the stock market who would rather not be there.  As this trend reverses, expect some to go back to money market funds, reducing demand for stocks in the process.

The current economy is notable for the increase in the demand for services like vacations, flying, meals, etc., but also for the decline in demand for goods purchased through retailers.  After three years of Covid-19, individuals want to do things.  Most of what goods they need they have already purchased.  There are some exceptions, as some goods have not been available due to shipping constraints, but this is slowly loosening up. 

When markets stop going straight up, one realizes it is a market of stocks and not a stock market.  One should invest accordingly.

The Economy

Many people are judging economic activity by corporate profits.   A better criterion would be corporate sales.  While inflation reduces consumers’ purchasing power, wage increases restore it.  Consumers as a group have strong balance sheets and good cash flow, especially the lower wage earners to whom most of the wage increases have been awarded. 

Looking ahead, it would appear that there is a business slowdown but no recession at this time.  Much will depend on external events like the war in Ukraine with its international repercussions. 

Inflation

Inflation is expected to level off going forward.  Much will depend on the cost of energy and better shipping from the Far East.  As we lap last year, the inflation rate is expected to fall to four percent or less.   Prices are not expected to retreat, but will not keep rising at the rate of the past year.

Interest Rates

One of the few ways the government can regulate demand is in the pricing and availability of credit.  For this reason, expect interest rates to continue to rise and the terms of credit to tighten. Some previous credit candidates will be rejected.

The Stock Market

The stock market is entering a period of re-valuation, as higher interest rates and tightened credit can be expected to both limit growth of companies as well as compress the P/E ratios of the same. 

Prior to the last ten years, about 40 percent of a stock’s return was in the form of dividends.  After a period in which dividends were an afterthought, it seems they are receiving more consideration again. 

Warren M. Barnett, CFA

May 26, 2022 

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