Sure, There’s Nonetheless A Bullish Case For Shares
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The stock market has kicked off 2022 with a big selloff, a sharp contrast to the rally and enthusiasm at the start of last year when seemingly every investing thesis was working. Record inflation, Fed policy uncertainty, rising interest rates, mixed economic indicators, and ongoing Covid disruptions are all good reasons to explain the current risk-off environment. There is a sense that this time could be different compared to the old tried and tested “buy the dip” strategy.
We’ve been part of this chorus highlighting emerging weaknesses in key areas of the market. That being said, even as being bearish has become in vogue, it’s an important part of the investing process to consider the other side of the discussion. On that point, we still see a bullish case for stocks this year, and the current weakness can ultimately set up a new buying opportunity in several beaten-down segments of the market. We look at what’s driving the selloff and what could kickstart a turnaround.
Why Stocks Are Selling off
Going through the numbers, the S&P 500 (SPY) and NASDAQ-100 (QQQ) are lower by about down 8% and 13% from their recent highs, an otherwise historically normal correction. In this regard, the key difference over the last few weeks has been the widespread weakness across sectors even among mega-cap leaders. Amazon.com Inc (AMZN), Microsoft Inc (MSFT), Home Depot (HD), Nike Inc (NKE), and JPMorgan Chase & Co (JPM) are all off by more than 10% over the past month. We’ll note energy and materials have relatively outperformed.
Data by YCharts
The selloff has been deeper in more speculative “high-growth” segments of the market highlighted by extreme volatility in ETFs like the Invesco Nasdaq Next Gen 100 ETF (QQQJ), Global X Cloud Computing ETF (CLOU), Renaissance IPO (IPO), iShares S&P Global Clean Energy Index ETF (ICLN), or the Ark Innovation ETF (ARKK) with losses accelerating more recently.
Data by YCharts
Part of the challenge here goes back to the new phase of the “post-pandemic” recovery, considering many companies that were early winners in 2020 got a boost of demand from themes like “stay at home” and remote work, and are now facing the prospect of normalizing growth into difficult comps. That’s the case with high-profile examples of stocks that have crashed like Netflix Inc (NFLX) and Peloton Interactive Inc (PTON) which are attempting to transition into a new operating environment.
Elevated and persistent inflation has been a major theme over the past year, surprising expectations and even catching the Fed off guard. The current messaging from the last FOMC meeting is to expect a rate hiking cycle while rolling back the accommodative monetary policies that contributed to the broader economic recovery. The December CPI at +7.0% y/y, the highest level since 1982, is problematic for several reasons. First, it ends up representing a major cost pressure on companies, which translates into weaker margins and soft earnings. For consumers, higher inflation eats up discretionary budgets as a headwind for household spending in all sectors.
The other consequence of inflation and the impending rate hikes is that interest rates have already begun to climb higher and back to the pre-pandemic level. An outlook for a higher cost of credit including mortgages and auto loans can work to slow inflation but also has implications for the growth outlook and equity valuations.
All this is against the backdrop of what has been a deeper and long-lasting impact from the Covid pandemic than previously imagined. There was a point last year, around Q2, when the U.S. was averaging under 10k cases per day and celebrating the initial vaccine rollout that many likely assumed the pandemic was effectively “over”. Putting it all together, it’s been a poor scenario for risk assets to start the year.
Can Stocks Still Rally in 2022?
Even recognizing the downside risks and what are real headwinds, we don’t believe the setup right now represents a “disaster” or real market crash akin to something like 2008. There are several factors that can turn this around:
1) Omicron Can Mark the End of The Pandemic
Any bullish case for stocks must consider that the pandemic will end and there are signs that this latest wave of record infections can represent a turning point. Reports suggest the Omicron variant is extremely contagious yet causes milder symptoms compared to other strains. This supports a view that Covid can move into an endemic phase, meaning it will remain a public health issue but not necessarily a crisis. It appears governments around the world are already moving in that direction.
Compared to 2020 when every infection and localized outbreak was seen as an emergency, the understanding now is that the existing vaccines are largely effective at preventing death. Even cities and municipalities with the most restrictive measures at the start of the pandemic have relaxed Covid rules. Rising vaccination rates worldwide coupled with millions that have recovered from the disease support the possibility of herd immunity.
As it relates to stocks, investors can look forward to the next few months when cases are sharply lower in the U.S., driving a new round of “post-pandemic” reopening sentiment. For industries like travel and leisure that may have been impacted by Omicron since December, the silver lining is that it opens the door for a stronger recovery through next year. We can expect improving consumer confidence and a pick-up in the labor market going forward. All in all, the second half of 2022 will look stronger compared to right now and supportive of risk assets.
2) Valuations Appear Reasonable
The data we’re looking at shows that the S&P 500 is currently trading with a P/E around 24x on a trailing twelve months basis. Notably, this is significantly lower compared to the peak valuation when the index reached a P/E of 35x in early 2021. The context here considers companies with temporarily depressed earnings in 2020 skewed valuations higher as the stock prices began rallying in anticipation of the forward outlook. Strong earnings growth over the past year in all sectors has helped to normalize valuations.
One criticism that is often part of the bearish case claiming “stocks are in a bubble” would point to the current P/E as significantly higher than historical averages including the 10-year average multiple closer to 20x as well as measures going back several decades closer to 16x. The counterargument we offer is to simply look at the current composition of the S&P 500 which is dominated by tech. The sector represents 25% of the index and likely more considering other companies technically classified as consumer discretionary or financials are still a form of technology. Simply put, tech “is the market” and the most important sector for the overall economy.
The S&P 500 today looks a lot different from when Warren Buffet began investing in the 40s and 50s when the stock market was dominated by railroads and industrial manufacturers where a P/E of 20x may have been expensive.
The reason technology companies deserve a structurally higher valuation is the dynamic that a new product or service can be instantly leveraged across millions of customers worldwide as an addressable market. The way a tech company scales is just not possible by traditional goods and services translating into higher margins. The companies that represent the bulk of the S&P 500 and NASDAQ-100 are currently profitable and maintain a positive long-term growth outlook. In other words, it’s justifiable that the “stock market” trades at higher sales and earnings multiples now compared to the historical average.
A similar point can be made about the S&P 500 dividend yield which is near a historically low level of around 1.3% recognizing that several of the largest holdings don’t even pay dividends. Few would have predicted Tesla Inc (TSLA) or Meta Platforms Inc (FB) would be top-holdings in the S&P 500 ten years ago. We can argue that some of these names along with Apple Inc (AAPL), Amazon.com Inc (AMZN) face company-specific challenges and have some downside, but this is nothing like the crash of 2001 when the tech sector was just bleeding cash. Valuations are fine.
Data by YCharts
So with that, the current selloff has been able to at least move valuations lower. Beyond the tilt of mega-cap names within the broad market indexes, a glass half full type of approach could claim that some of the small-caps that have shed more than 50% of their market cap are even cheap at this point.
3) Earnings Growth Remains Positive
A key driver of the stock market over the past two years has been earnings growth and the trend is expected to continue. We mentioned the S&P 500 trading at a P/E ratio of 24x, if we consider the bottom-up EPS estimates as an aggregate of all companies within the index, the forecast is for 9% earnings growth this year to $223.66 and 10% in 2023 reaching $245.82. The estimate for 2022 implies a forward P/E of 19x which is particularly attractive considering it matches the 10-year average within the discussion in our section above.
Of course, if macro conditions get weak enough, we can assume some downside to these estimates. Still, assuming Wall Street is currently too aggressive and overestimating the earnings momentum by 10% this year, a forward P/E closer to 22x is still supportive to equities. Keep in mind that 2021 was still a transitional year within the pandemic. Several industries most directly impacted by the pandemic in 2020 and the first half of 2021 are benefiting from an earnings momentum beyond quarterly noise.
Despite rising cost pressures, a tight labor market, slowing growth; companies have many options to pull the proverbial level of profitability. Call it managing Capex and cutting expenses, accounting gimmicks, or even strategy changes; don’t underestimate the ability of major corporations to drive earnings.
Moving forward into the current Q4 earnings seasons, results and guidance from the tech leaders will be an important test for the market. Recognizing the market is always forward-looking, we can make the case that weakness into the early part of the year for a wide variety of reasons can be sort of brushed under the rug and blamed on Covid as a justifiable excuse. The upside would be that it sets up a stronger 2023 against soft comparables.
4) The Fed Can Still Walk Back
Many of the market trends right now including spiking interest rates go back to the Fed’s December meeting. A lot has changed in the period since, including softer December payrolls reports, disappointing retail sales, falling consumer confidence; not to mention the Omicron surge that only really started in the final weeks of the month.
The upcoming FOMC meeting set for January 26th will be closely watched. It’s possible that the deteriorating conditions open the door for the Fed to turn down the urgency of an aggressive rate hiking cycle. The scenario we are describing is that instead of the market-implied four or more rate hikes this year, the Fed instead adjusts the signal to something less aggressive like 2-3 rate hikes or pushes back the liftoff citing the emerging risks in the economy.
At the end of the day, the Fed will need to weigh its mandate to maintain stable prices and promote maximum employment against the highly volatile financial market conditions. A much further selloff in the stock market or surging interest rates can end up jeopardizing the broader economy. A message that the economy remains “strong” but a bit below expectations from transitory disruptions can be a good balance to help support risk appetite.
In terms of market turning points, we also won’t be surprised to see stocks rally on any decision in a “sell the rumor” buy the news type of dynamic. As it relates to stocks, it’s possible that the selloff has already priced in much of the headwinds facing growth and macro right now. Considering stocks have been fighting against rising rates, a pullback or at least some stability can also be positive for stocks in the near term.
It’s clear that the market is in a highly complex and technical moment and facing several headwinds. We expect the volatility to continue and believe it makes sense to maintain a cautious approach. Without downplaying the real risks facing the market, we believe there is room to begin dipping into potential turnaround opportunities in beaten-down names. A strategy of trading in small size and averaging into positions can work in this environment.
Anyone that has been investing long enough knows that the trading action can change quickly. Often in the darkest hour defined by “blood in the streets”, the market ends up pulling off a seemingly miraculous reversal as the start of a new rally. One or two green candles could be enough to create a completely new narrative.