Are We There Yet?
August is not typically thought of as a profitable month in the stock market, and this year was no exception. Prices, measured by the S&P 500, fell 4.2% for the month and are now off 16.1% year-to-date. August is the height of summer vacation and often the low in stock market activity.
One thing I’m seeing is a general lack of conviction. When investors lack direction, the best course of action is to remain patient and wait until the signals coming out of the market begin to form a clearer path. In fact, according to Bespoke Research, August was only the fourth instance since 1928 when stocks were both up and down 4% at some point in the same month. My sense is that now is not the time to make any big bets or to tilt our portfolios in any one direction.
The current backdrop has not changed, only intensified. Since the Jackson Hole Economic Symposium, the Fed is signaling it is intent on raising rates to stave off inflation while jawboning a little more vigorously. Rising rates has been the market’s biggest concern since the start of the year. In fact, the price correction we have seen thus far in 2022 is directly related to the rising interest rate backdrop. Meanwhile, macro-economic data indicates the economy is weakening with real GDP dropping -1.6% in Q1 and -0.6% in Q2 ’22.
On the negative side, the Fed is expected to raise rates by another ½ to ¾ percent when it meets on September 20th, and it has taken a stern, hawkish tone. There are indicators from recent earnings calls that some firms are experiencing profit margin degradation (high inventories, wage pressure and freight delays). While COVID is in many ways behind us, China continues with its zero COVID policy; it is enforcing lockdowns that are taking a toll on economic output and effecting the worldview of China as a reliable global actor. Finally, the war in Ukraine appears entrenched and Russia’s response has been to inflict an energy crisis on Europe.
On the positive side, measures of inflation are tempering. Personal Consumption Expenditure (PCE) figures appear to have crested and JOLTS data and wage growth look as though they are beginning to “normalize.” Logistics are repairing with container shipping rates (Baltic Exchange Dry Index) and lumber futures having dropped back to summer ’20 levels. Consumer sentiment appears to be rebounding and the market is showing technical signs of recovery with its 50% retracement off its June lows.
In my opinion, stock prices are fairly valued considering the forward P/E ratio at 16.6x is slightly below the 25 year average of 16.8x. Expected forward returns remain positive and earnings growth has been strong, up 5.6% ytd, according to FactSet Research. Earnings estimates for S&P 500 operating earnings are of $226 per share in 2022, $244 in 2023 and $265 in 2024. With four months remaining in 2022, investors will be most concerned with any signs of change to 2023 earnings estimates.
From a big picture perspective, we are grinding through a challenging year for most financial assets; stock prices are down 16% ytd, placing this year among the top “bad” years since 2000. What is uniquely different this time is the high positive correlation between stocks and bonds. This year’s drop in stock prices has accompanied the sharpest drop in bond prices in the last 46 years (as measured by the Bloomberg US Aggregate – AGG) according to JP Morgan. As difficult as this is, I don’t expect these conditions to persist. I expect to see lower but continued economic growth and that inflation will taper off. Optimistically, this backdrop is favorable for growth stocks, our preferred category.
By early next month we ought to have more clarity on the path of future Fed interest rate hikes, the biggest thorn in the side of stock and bond prices this year. A pause in such hikes would offer some well needed relief. In the meantime we wait and continue to hold quality growth stocks with an eye toward strong free cash flows and dividends, an approach that has served us well over time.
Please feel free to reach out if we have not been in touch. We are happy to review your portfolio with you, and any changes you may have with your financial planning needs.
Take good care,
Bruce Hotaling, CFA
The views and opinions stated herein are those of Bruce Hotaling, are of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S & P500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation.