Vladimir Putin’s decision to invade Ukraine is a challenge to the western ideology most of us identify with. It seems like a childish attempt to see how much he can get away with, whether he can control the narrative. In today’s media forward world, it’s difficult to nuance the invasion of another country as anything but cruel. A country, its economy and its cultural history is purposefully being destroyed, for no reason. The war echoes the famine Russia created in Ukraine in the 1930s with ostensibly similar political motives.
It’s not just the immediate outcome but also the extended fallout from the war which is unclear. Certainly food and energy prices will be effected for the foreseeable future, particularly in Europe. Many commodities and metals have also been compromised directly, through broken supply chains, or indirectly, through sanctions and other political motives. There are concerns that there may be a more disruptive financial crisis looming among the large banks providing credit for the commodities business with Russia.
Amidst all this, the US stock market is making a gallant effort to sort itself out. Having fallen at a harrowing rate the first two months of the year, it seemingly found its feet on March 14th. All of a sudden, the tone of the market changed. Prices (S&P500) closed at 4,173 that day, and by March 31st had risen 8.5%. This left the market with a return of 3.6% for March, reducing the year-to-date loss to 4.6% and bringing prices back above the 50- and 200-day moving averages enough to allow the market’s technical analysts a nice deep breath.
Looking back, the market has primarily been attempting to digest the imminence of higher interest rates. Interest rates (the US 10-year Treasury) have been falling for 40 years; in August 1981 the US 10-year yielded over 15% and in August 2021 it yielded 1%. It’s now more than doubled in the last six months. More extreme, the yield on the US 2-year note skyrocketed 1.6% in Q1, the largest jump since 1984. The point is the market has been struggling to factor in the Federal Reserve’s tightening campaign and it looks as though the bulk of this has now been priced into both bonds and stocks.
There is some cause for optimism looking forward, with spring approaching and data on the virus continuing to improve. The employment numbers are strong and getting stronger. Jobs are abundant and people are earning better wages and benefits. This strength may persist as the labor supply remains constrained (boomers retiring, lasting effects of COVID and reduced immigration). Inflation will taper off as supply chains repair and energy prices sort out. In my opinion, this is largely a matter of time. One concern is the Federal Reserve potentially acting too strongly in raising rates, as the war and a move toward de-globalization may naturally slow growth and bring inflation under control. Stocks are better valued now with the P/E ratio on the S&P 500 having dropped roughly 20%, and the P/S ratio now in the 2.5x range, which is historically a reasonable level. Year-end earnings targets remain in the $240-a-share range for the S&P 500. At an opportunistic 20x forward P/E multiple the year-end price target for the S&P 500 would be in the 4,900 range, roughly 10% higher than today’s level.
We are focusing on stocks that are not likely to face a disruption in their future earnings outlook from the primary constraints we see: higher input costs including energy, a more reluctant consumer as measures of sentiment are exceedingly low, and continued supply chain constraints (though the microchip sector appears to be normalizing). We are reviewing stocks in several sectors, including real estate, health care and technology. I think quality stocks remain the best house on the block. We are also finding more attractive fixed income, at these improved yield levels, for the first time in several years.
Please do not hesitate to call if you have questions or would like to review your portfolio. It is also tax time, so please let us know if we can be helpful in that regard. We are here when you need us.
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.