Reasons to Remain Positive

May 17, 2022

The S&P 500 Total Return Index is now down roughly 15% year-to-date, with the Bloomberg US Aggregate Bond Index not far behind, down roughly 10%. The main causes of the dual equity and bond downturns have been the same all year:

 

  1. Inflation: The March Consumer Price Index (CPI) of +8.5% was the highest since 1981.1
  2. Monetary policy tightening: The Federal Reserve is expected to raise the Fed Funds Rate from its current 0.8% to over 3.0% by March 2023.2 Importantly, the need to fight inflation is preventing the Fed from coming to the market’s rescue like it has in prior downturns.
  3. Supply chain issues: Labor shortages and China’s zero-COVID policy continue to wreak havoc on global supply chains.3
  4. Russia/Ukraine: Apart from the humanitarian tragedy of this situation, its main effect on markets is to make supply chain issues and inflation even worse.

 

While the news changes daily on these four major issues and they are all interrelated, the key drivers remain the same as we have already discussed in our previous blog posts (found here). Rather than rehash these issues, today we want to focus on reasons to remain positive:

 

  1. Investor and consumer sentiment is currently very gloomy: Why is this a positive? Remember that what makes a company’s stock go up or down is primarily whether the company does better or worse than investors’ expectations. A company can post 50% earnings growth and the stock drops because investors thought they would grow 60%. The same is true for the market as a whole when looking at forecasts for global macro events and data. Therefore, when expectations are low, as they are now, it creates a lower bar to clear. Both the University of Michigan’s Consumer Sentiment Index (March 2022 level was the lowest since August 2011) and the American Association of Individual Investors Sentiment Survey (April 2022 Bull-Bear spread was the lowest since March 2009) are currently at very gloomy levels typically associated with above-average future market returns. 4,5
  2. The worst of inflation may now be behind us: While April’s CPI of +8.3% was an extremely high level, it was down from +8.5% in March and is expected to fall further as we start to lap the higher prices from last year. The breakeven future inflation rate for 5-year U.S. Treasuries has recently fallen from a peak of 3.6% in late-March to 3.0% yesterday.6 If the year-over-year inflation numbers come down as expected, the Federal Reserve will be under less pressure to severely tighten monetary policy, removing a major headwind for the market.
  3. Valuations are less expensive: The S&P 500 forward price/earnings (P/E) ratio recently fell below its 10-year average for the first time since Q2 2020. At 16.6x, it is now roughly on par with its 25-year average and is well below where we started the year at over 21.0x.7 While earnings expectations may fall slightly in the coming months, company valuations on traditional earnings and cash flow multiples now look much more reasonable.
  4. Quality companies can weather high inflation: We are now basically done with Q1 2022 earnings season, and many companies proved that they could exert their pricing power to grow revenue and offset inflated expenses. For example, Coca-Cola said price increases and packaging mix more than offset a mid-single digit inflation headwind.8 Proctor & Gamble’s CFO noted that consumer demand has been much more favorable relative to P&G’s price increases than history would suggest.9 While ideally expenses would remain in check and thus this higher revenue would drop straight to the bottom line, if companies are able to grow revenues and keep margins flat in the face of high inflation, their stock prices should perform well.

 

In summary, markets are doing what they are supposed to do, adjusting expectations when significant new information presents itself. Prices should be lower now than they were six months ago, when inflation and monetary policy forecasts were much more benign, supply chain issues were improving, and Russia/Ukraine was not yet a major issue. We have been adjusting our company valuation models and clients’ portfolios accordingly throughout the year. Historically, an opportune time to buy stocks is when news is negative and sentiment is very low, as markets tend to do very well when situations improve from a low level or things turn out better than feared. We remain steadfast in our belief that the best path to long-term investment success is to stay the course, avoid trying to time the market, and remain fully invested at a target risk level best suited for your individual circumstances.10

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