Markets, Economy, Portfolio Management Update Winter 2022
Despite recent slowdown in economic growth related to Omicron effects, the U.S. economy remains in expansion mode. The CNBC Survey of Economist is projecting a median 4.3% real economic growth in 2022. A peak in Omicron cases and effective viral vaccines could bring about yet another Spring re-opening phase. Supply bottlenecks and shortages are a work in process that eventually fixes itself resulting in a moderation of inflationary pressure. Inflation pressures are peaking but will linger. Investors should consider high quality companies with pricing power offering dividend growth. Prepare for higher market volatility stemming from Fed tightening, geopolitical risks (Russia), slowing China economy, and the midterm elections. The period before midterm election is known for corrections due to uncertainty of outcomes. I would be a buyer in any midterm election correction.
After three years of higher returns do not expect stock markets to deliver double digit returns this year. Expect a modest single digit results accompanied by above average volatility as the Federal Reserve tightens. Uncertainty of Mid-term election results will also add to market volatility. Moreover, historically high equity valuations limits future returns especially under a monetary tightening regime. Stock multiples are compressing under the specter of rising yields. Even so, Stocks, in a volatile year, should outperform Bonds based on a backdrop of above average real economic growth and normal earnings growth.
For stock investors, the speed of the increase in interest rates is key to whether the S&P 500 Index takes a path higher or lower. If the tightening cycle is not gradual, then S&P 500 Index moves lower, and recession risks rises in late 2023. The Fed does not want to engineer a recession by hiking more frequently than each quarter this year. However, the Fed is behind the inflation curve skewing the risks towards a faster tightening cycle. A slowing economy should moderate inflation easing pressure on the Fed for faster monetary tightening.
Current year earnings and sales growth for S&P 500 projected to normalize from lofty levels in 2021. FactSet projects earnings growth of 9.4% and sales 7.6%, figures associated with a Bull market. Despite concerns about inflation, supply shortages, higher energy cost, and labor shortages, net profit margins are at record levels. Earnings growth is supported by a backdrop of historically easy financial conditions, low unemployment, low debt service levels, household wealth, historically low interest rates, and so on.
Consistently high ISM readings suggest corporate earnings announcements will meet expectations.
Economists are trimming their economic growth forecasts partly due to Omicron variant hit to the economy. Goldman Sachs said each one percentage point drop in GDP growth would roughly reduce S&P 500 earnings per share by $7. The latest retail sales report disappointed thanks to Omicron’s impact on demand and supply. The peak in Omicron variant is critical to consumer demand and stock prices. Following past peaks in COVID-19 variants, pent up demand surged in sectors of economy held back by it. I expect an economic rebound this Spring and Summer. Still weighing on markets will be higher cost of labor adverse impact on profit margins.
Its looking like a “Sell in May and Go Away” year given Midterm election is coming coupled with Fed tightening regime. The period from late-April through the end of September in year two has seen the largest drawdown on an average basis of the entire cycle. Midterm elections tend to cause higher market volatility during election years. LPL research reveals that the S&P 500 Index declines on average 17% going into Mid-term election day. After election results are in the S&P 500 Index generate above average returns over next twelve months.
After the initial shock of Fed tightening announcements, investors do well on average, despite the negative impact on equity valuations. Research by CFRA shows that the S&P 500 Index has risen eleven times in the past twelve tightening cycles since 1950 with an average annualized rate of 9%. Moreover, during tightening cycles when intermediate yields rose 1.5 percentage points since 1950, the S&P 500 Index averaged an annualized gain of 12%. History suggests buying the dip could be a profitable strategy this year sometime before October. Until then a more balanced strategy between short-term bonds with a tilt towards quality equities is the way to navigate 2022 markets.
US economy grew at 5.6% rate in fourth quarter 2021 and 5.8% for 2021! Supply chain constraints, labor shortages, and Omicron related slowdown effects have modestly slowed down the world’s largest and most resilient economy. Economic growth rate will remain higher than normal but has peaked as fiscal and monetary stimulus is waning this year. Overall, consumer demand, household wealth, low employment, easy credit conditions, provide a backdrop for sustained expansion in 2022. Recession risks are quite low.
The yield curve is a closely watched recession warning indicator. Historically, inversions of the yield curve are coincident with the topping out of the economic cycle and mean forward returns as well as economic activity are likely to be low. Presently, there is room for hikes before the Fed inverts the yield curve. When the Fed ends its emergency bond buying in March, I would expect long term bond yields to add to recent gains. The Yield curve by year-end will be flatter but not inverted. Inversion creates conditions for a recession. Previously, virtually all recessions had an inverted curve. For now, credit spreads remain calm as economic growth remains strong. I always keep a closer eye on credit markets which lead economic fundamentals.
Portfolio Management Update
I’m gradually reducing overweight in equities towards neutral by quarter end. Large-cap Growth stocks are not likely to repeat last year’s performance. It is time to balance between Large-cap Growth and Value stocks. Market and macro-economic conditions suggest that Value outperforms. This year is a return to normalcy for earnings, economic growth, yields, and inflation compared to history. Normalcy supports equity markets. The US economy is moving away from Mid-cycle fundamentals towards early Late cycle. Portfolios will remain underweight in bonds until the Ten-Years Treasury yield peaks this cycle.
TINA is still the playbook for investing in 2022. Inflation rate of change is peaking but inflation will remain elevated. S&P 500 stocks have done well in inflationary periods. When inflation has averaged 2-3% stocks averaged 14.2% annualized average returns. When inflation rose to 3% level returns fell to 10.8%. Stocks returns are negative when inflation is persistently above 6% according to Bloomberg.
A gradual Federal Reserve tightening cycle is friendly to real assets such as stocks. In general, given rates and yields modestly rise, stocks typically outperform bonds. The greatest risk to stocks is a faster tightening cycle that inverts yield curve thereby precipitating a recession. Which one we get depends on inflations future path.
I am buying stocks that do well in rising rate world that can raise prices. Inflation is not going away soon. In a period of rising inflation own real assets such as stocks and not bonds and cash-equivalents. In a market environment with higher inflation, I prefer reasonably valued large-to-mid size companies characterized by high profit margins, sustainable earnings growth, and dividend growth. I sold high Price/Sales stocks except for a few small positions.
I think dividends will play a bigger role in investor returns this year given. Earnings per share growth leads greater dividend growth rates by three quarters. I anticipate higher dividend payouts this year particularly in Energy stocks flush with cash that will not be reinvested into oil drilling and exploration. Goldman Sachs research projects firm oil prices in the 70’s or higher. The is structural shortage and US energy policy is extremely supportive of higher energy prices.
I have bought Value stocks. Value stocks tend to outperform Growth stocks in periods of economic strength, rising rates and higher inflation. Growth stocks are more expensive than Value stocks. At current levels, the ratio between the Value P/E ratio and the Growth P/E ratio at its current level has only been lower during two other periods over the last 25 years.
The US economy is slowing from hyper growth rate to an above average rate of growth this year. It is not projected to grow at stall speed which would require a more defensive tilt to stock holdings. It is too early to hide in defensive large-company stocks found in utilities and consumer staples. The shift upwards in the Yield curve implies that the U.S. economy is entering its early Late cycle economic stage that favors energy, basic materials, and financials into several rate hikes. The late cycle sectors are cheaper and offer more growth than the defensive sectors.
My favorite sectors are a mix of Value sectors and Growth sectors: Energy, Financials, Healthcare, Consumer Discretionary (re-opening III as Omicron fades and employment rises), and Technology. Analysts are most optimistic on Energy, Communication Services, Technology, Healthcare, and Consumer Discretionary this year. Those sectors are economically sensitive ones, except for healthcare and not defensive ones such as Utilities, and Consumer staples. Although the Utility stock dividends may appeal to income investors, their already high valuations compress if interest rates rise. Furthermore, sales growth is extremely low. Sell-side analysts are bearish on Utilities more than any other sector. The same is true for many consumer staple stocks.
Earnings and sales growth are highest for Industrials, Consumer Discretionary, Energy, Communication Services, Technology, and Healthcare. Those are the sectors to have at least a market weight exposure. I have added Financials to that list which typically are more profitable in a rising interest rate environment. Energy and Financial sectors have the highest profit margins among eleven sectors reporting. Both sectors rank at the top in sales and earnings growth for this year.
I really like Healthcare. Healthcare valuations are trading at attractive levels compared to S&P 500 Index at full valuations. Healthcare stocks have exceedingly high profitability, pricing power, and are insensitive to rising rates. Demand will still be there when rates are one percent higher. In addition, Pharma stocks are raising dividends 4-10% annually. I screen for stocks that have high ROE, high FCF, and healthy Financials.
I trimmed Technology from an outsize overweight to overweight. Technology sector underperforms when rates rise. A one percentage point increase in Fed Funds rate decreases Technology stock valuations by 10-20%. The high multiple Tech stocks have gotten slammed. Valuations are still at a premium but sales, earnings, free cash flow, and margins justify premium valuation.
I also like Energy a classic late cycle sector. The underinvestment and restrictive development policies could keep supplies limited and prices trending higher over the long term. Earnings revisions for Energy Sector are the highest among all sectors. Furthermore, current geopolitical risks favor higher oil prices if Russia escalates tensions in eater Ukraine.
Its time start adding to our underweight position in developed foreign stocks based on a regression to the mean trade. U.S. equities are selling a premium to foreign equities. The ratio of the S&P 500’s P/E Ratio to the MSCI World Ex US Index is currently just under 1.49 which means that US stocks trade at nearly a 50% premium to the rest of the world compared to an average of 4% over the last 25 years. The Omicron variant is projected to peak in February thereby opening the world economy this Spring again. Foreign central banks are removing stimulus and global bond yields are rising a sign of better global growth ahead. If US dollar weakens against basket of foreign developed economy currencies than foreign stocks should perform well.
When the Fed starts tightening, it is wise to buy high quality bonds versus non-investment grade bonds. Return of your money becomes more important than extra yield on your low-quality fixed income investment. When Fed tightens, credit spreads tend to widen, and volatility in bond market picks up. Credit defaults and downgrades projected to be below average for 2022 so I still favor credits over Treasuries. I will remain overweight in Adjustable-Rate Senior Bank loans. A modest widening of credit spreads would not be a problem for economy and markets given current tightness of spreads.
I have a significant underweight in Treasury exposure. Purchases of U.S. Treasuries has started to decline as the Fed is ending its asset purchase program in March. Treasury prices are declining, and yields are rising. Eventually, quality bonds will offer an attractive entry point. When the 10-Years Treasury yield peaks it is time to extending the duration of the bond component to high quality long and intermediate corporate bonds. Inflation will be retreating when the time comes. I continue to increase cash-equivalent and high-quality short-term bond positions in response to market volatility.