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Quarterly Perspective

THE DREADED ‘R WORD’

Will Williams
Chairman, President & CEO

The Bureau of Economic Analysis’ (BEA) recent third and final estimate of second quarter GDP came in at an annual rate of -0.6%; this following a -1.6% decline in Q1. While the National Bureau of Economic Research has yet to officially declare that we are in a recession (generally two successive quarters of negative growth meets their definition), there’s no question that the U.S. economy has been contracting through the first half of 2022.

Why does the word recession create such fear in the investment community? Typically, economic slowdowns precipitate meaningful declines in corporate earnings— the primary driver of stock prices. Yet from a practical standpoint, recessions are a common and essential part of healthy economic cycles. In fact, over the past century the U.S. has experienced 16 recessions at a pace of about one every six years and with an average length of 13 months. Fortunately, the duration of economic expansions (averaging 59 months) tends to vastly exceed the duration of economic recessions by a factor of five.

As economists and market analysts evaluate the current economic landscape, most believe we are indeed in the midst of (or at least headed towards) a mild recession. If the two consecutive quarters of negative Real GDP growth aren’t convincing enough, the state of fixed income markets (i.e., the ongoing negative yield spread between long-term [10-year] and short-term [2- year] Treasuries) offers further evidence. The Fed has rapidly increased short-term rates in an effort to squelch inflation. But fixed income investors are continuing to price long-term rates based on an assumption that economic growth is declining and inflation has peaked.

Crisis of Confidence

Looking at the big picture, there appears to be quite a disconnect between existing economic fundamentals and the way markets are responding to the current fact pattern. At DVI, we believe this gap is attributable to the great uncertainty inherent in today’s economy. Investors simply don’t have any confidence that the economy will lies ahead is a more severe and longer-duration economic decline. Year-to-date stock market index declines have been severe—more in line with the investment performance experienced during the 2008- 2009 Great Recession. In effect, current expectations are baking in a significant decline in corporate earnings.

Unfortunately, markets are always burdened by a “wall of worry.” This time is no different due to a host of valid economic concerns, including:

• The Fed raising short-term interest rates at an unprecedented pace;
• Persistent higher inflation rates and their potential long-term impact on wage inflation;
• A European energy crisis that could potentially fuel a severe recession; and
• A strengthening U.S. dollar negatively impacting our exports.

Additionally, the significant geopolitical risk associated with the War in Ukraine can’t be ignored.

P/E Multiple Contraction

By using the S&P 500 ® to evaluate the components of market return for 2022, this crisis of confidence becomes even more apparent. Despite all the economic headwinds, corporate earnings continue to be positive on a year-over-year basis. Because of all the uncertainty, however, investors just aren’t willing to pay a premium for those earnings. All of the recent decline in stock prices (and more) can be attributed to Price/Earnings multiple contraction. In effect, it’s the equity investor equivalent to being on strike. They simply refuse to pay a premium for future corporate earnings until at least some of the wall of worry items referenced above can be assuaged or resolved.

Under market conditions such as these—when there’s a seemingly large disconnect between expectation and reality—our natural bias is to assume much of the bad news is already baked into investor sentiment. If corporate earnings can therefore continue to hold their own and we can catch a break or two on a few of these macroeconomic factors, perhaps we’re closer to the end of this Bear market rather than somewhere in the middle. We continue to focus our efforts on improving the overall quality of our investment portfolios, while maintaining the courage to capitalize on investment opportunities as they arise.

HURRY UP TO SLOW DOWN

U.S. financial markets are gradually adjusting to the unprecedented pace of interest rate hikes, as the Federal Reserve (Fed) strives to contain the current rate of inflation. It’s clear what the Fed is fighting:

• The 50-year historical average for the Headline Consumer Price Index (CPI) is 4.0%;
• Since March 2022, every monthly CPI print has exceeded 8% (with June posting a 9.1% reading);
• However, slight declines in July (8.5%) and August (8.3%) may signal a new downward trend.

We’re all experiencing the effects of this rampant inflation— with widespread price increases impacting nearly all aspects of our daily lives. But as the chart below demonstrates, the pace of this inflation fight has accelerated to levels not seen since the Fed began targeting an Effective Federal Funds Rate in the early 1980s.

Financial markets rarely if ever respond positively to such extreme policy shifts enacted over short periods of time. With the exception of the Energy sector and a few Agricultural Commodities, markets across the globe have suffered significant declines to date in 2022.

When Will it End?

My best guess—markets will begin to settle just as soon as it becomes apparent the Fed is nearing the end of its course on hiking interest rates. Ideally, this will occur without significant damage to corporate earnings growth; providing a strong base for markets to begin the road to recovery.

Additionally, we’re entering a seasonal period that has very positive implications for the stock market. Midterm elections have historically proven to be strong catalysts for stock prices. The chart below measures rates of return for the S&P 500 ® before and after all fifteen midterm elections since 1962.

As you can see, the midterm elections in 1962, 1966, 1970 and 1974 all proved to be pivot points for the market following significant declines earlier each year. Similar to today, these also occurred during a period where interest rates were climbing (e.g., the yield on the 10-year U.S. Treasury note rose from 3.68% in May 1961 to 7.68% by June 1970).

As Big David was fond of saying, ‘this too shall pass.’ Our primary focus will always be on risk management; while striving to be opportunistic whenever and wherever any market dysfunction arises. Thank you for your continued confidence in DVI.

DVI / MCB Partnership Update

In the fall of 2017, David Vaughan Investments, LLC (DVI) and Morton Community Bank (MCB) entered a strategic partnership; marching forward together to enhance the the financial well-being of their clients. Five years later, despite uncertain times and economic headwinds, both financial institutions have grown and prospered to represent one of the largest privately held bank and investment advisory firms based in Illinois. ( As of 12.31.2021, MCB Total Assets $ 4.9 Bln & DVI Assets under Advisement $ 4.6 Bln )

Quarterly Perspective is published quarterly by David Vaughan Investments, LLC. Copyright 2022 by David Vaughan Investments, LLC. All rights reserved. This newsletter represents opinions of DVI and are subject to change from time to time and do not constitute a recommendation to purchase and sale any security nor to engage in any particular investment strategy. The information contained herein has been obtained from sources believed to be reliable but cannot be guaranteed for accuracy.
David Vaughan Investments, LLC | Peoria, IL | Winter Park, FL | www.dviinc.com