Traders on the NYSE floor, August 11, 2022.
Source: New York SE
As the market reacted in alarm to Fed Chair Jerome Powell’s aggressive comments and firm tone on Friday, I struggled to find an analogous situation that ended well.
My conclusion is that while we’ve seen the S&P 500 bearishly drop over 20%, followed by a 17% rally and now a 6.2% drop, this most closely resembles steep buying and selling waves on the inside feels more like a range as another deep descent to new lows.
If that’s the case, we need to stay afloat during these violent swings. Years ago, when I took my lifeguard exam with the Red Cross, one of the requirements was to tread water for two minutes in a lake traversed by towing speedboats. what is two minutes nothing, right?
No, even two minutes in one place is hard work. Watching the S&P 500 collapse for a few hours can seem endless. It’s like asking investors to tread water in a stormy sea for what feels like an eternity. Keeping your head up, breathing without panic, and staying calm in the current are all difficult tasks.
Inflation at center of choppyness
It’s not too far-fetched to say that the market cares more about inflation than anything else. It is naïve to think that inflation exists in a vacuum where it can just disappear without collateral damage.
Something has to give way, whether it’s the job market, house prices or consumer spending — all of which contribute to the well-being that investors crave. The market rallied when July jobs numbers were nearly double expectations, but 528,000 net new jobs were highly inflationary.
There’s a lot of noise in the markets: OPEC is cutting supply, the labor market remains incredibly tight and the war in Ukraine is dragging on – all inflationary. Layoffs and hiring freezes in high-tech, resumption of grain shipments in Ukraine and home sales stands – all disinflationary.
Depending on what news emerges each day, the stock market can take these bytes of data as very positive or very negative in its fight against inflation, triggering large swings in either direction. Chasing every mood move is a dangerous and often foolish exercise.
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The road to much lower inflation is likely to be littered with damaged earnings and stock prices in the near future. The S&P 500 is down 15% this year, while the Nasdaq Composite is down 22%. So isn’t some of that destruction already priced into stocks?
Second-quarter earnings and guidance — barring energy stocks and some lucky outliers — couldn’t stun anyone. This suggests that we are already in a slowdown and that higher interest rates or the fear of it are having some effect. Inflation continues to gallop, but economies are faltering.
In July, S&P 500 companies saw 285 downward estimate changes for 2023 compared to 164 increases. Much of the upside was in the energy and materials sectors due to changes in commodity prices. Assuming earnings estimates for the S&P 500 hold steady at current levels of $247 per share, the index trades at a price-to-earnings multiple of 16.5 times expected earnings. If those estimates are undercut by 10%, we’re back to a multiple of 18, which isn’t particularly cheap or expensive, even as interest rates rise.
Stocks take place in turbulent times
Until we have more clarity on where inflation is headed, could we be stuck in a trading range capped by the June lows and August highs for the rest of 2022? Is the water-treading scenario?
The “safe” money sticks with what’s worked so far this year: Energy (up 49% year to date), Utilities (up 5%) and Consumer Staples (down 4%) versus a 15% decline in the S&P 500 . These groups still offer strong cash flows, but their prices reflect the hordes of investors who have flocked to their stocks.
However, the consensus is often wrong, so I tend to buy some of the strongest names in the weakest sectors: communications services (down 30% in 2022), consumer discretionary (down 22%) and technology (down 20%).
While not owning energy stocks this year was a huge mistake, the strength in commodity prices rests on the ongoing war in Ukraine as macro weakness weighs on oil and gas demand. Making this bet after such a big rally comes with its own set of risks.
The tables below show a stark contrast between some of the best performing “defensive” stocks like Colgate, Procter & Gamble and PepsiCo versus two of the biggest names in communications services, Meta and Alphabet. Both face weak advertising environments, among other challenges, but trade at significantly lower multiples than their peers, with higher growth rates.
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Another option for investors looking to use short-term idle money is 6-month government bonds, which yield over 3%. By the end of winter we should have a lot more evidence that the Fed has been successful in its efforts. Then we can stop treading water and swim again.
Meanwhile, as someone who played water polo in college can tell you, there’s a lot of kicking under the surface as we tread water. You can take a nasty kick from this position, but you can also score a goal.
Karen Firestone is Chair, CEO and Co-Founder of Aureus Asset Management, an investment firm dedicated to providing contemporary wealth management for families, individuals and institutions.