16 May Capital 19 Catch-Up
Weekly Index Movement
Aussie All Ords -2.1%
Remember the ‘good old days’ during COVID when stock prices seemingly did nothing but move higher? Equities persistently traded higher following the March 2020 low through last November. During that period the world was learning to operate around a deadly virus and central banks were following an extremely “easy-money” policy.
The US Federal Reserve changed all that in January when they quickly changed stance on interest rates. Gone was the “no rate rise until 2024” message and in came the “we will do whatever we need to in order to get inflation down to our 2% target”
The Australian RBA is following suit, albeit, with a more moderate tone.
Don’t get us wrong, we’re happier than anyone that for most people, life is normal again, The market has been another story. Moving beyond COVID has meant moving beyond what has possibly been the easiest period of monetary policy any of us will ever experience, and markets have had trouble adjusting to the new reality.
Performance of major equity averages since last week’s FOMC meeting rank among the most severe short-term sell-offs the market has ever seen, and the S&P 500 and Nasdaq have now declined for six straight weeks! For both the S&P 500, Nasdaq, and the Russell 2000, 52-week lows were the norm this week, and in the case of the Nasdaq and Russell 2000, the recent plunges took them back to levels not seen since November 2020. Who would have ever thought that coming out of COVID would prove to be more difficult for markets than COVID itself?
The current backdrop could easily be the most complicated backdrop that investors have ever faced, so our hope is to put things into perspective.
We all know inflation is the problem and that it is being driven by 3 factors
- Spike in energy prices caused by the Russia-Ukraine war
- Lockdowns in China because of their zero-covid policy affecting supply chains
- Tight labour markets driving up income
But……what if inflation was to moderate?
Last week’s CPI numbers put headline inflation at +8.2% for April, which was slightly lower than the +8.3% for March. This might not sound like much of a decrease, but at least it is going in the right direction.
The Fed tends to look at what they call Core Inflation. This is inflation without the food and energy sectors. Core Inflation came in at 6.2% in April and 6.5% in March so is showing a similar path to Headline Inflation.
Inside this Core figure was Rent which came in at the highest reading since March 1991. But we have reason to believe this factor could well slow in coming months.
This graph shows the correlation between the rent figure in inflation (dark blue) and an index created from Available To Rent lists (light blue). There tends to be a six-month lag which is useful because it means we can use the Apartment List figures to get an idea of where inflation rent is heading.
As you can see, this measure predicts rent inflation to reduce to around 3%.
Then we have the lockdowns in China.
China has been hit hard by the combination of highly transmissible Omicron variant cases and COVID-Zero policies. Hyper-aggressive lockdowns have been effective at stemming the spread, and Chinese leadership has staked its legitimacy on these policies. So far, those policies are wreaking havoc on domestic Chinese economic activity, but they are working. With case numbers dropping significantly in the last 3 weeks, Chinese factories and more importantly, shipping ports should soon be back to normal.
You can build a case to say inflation returns to 3% by year-end. Indeed, Goldman Sachs predicts year-end inflation will be 2.3% and Bank of America predicts it will be 2.6%.
We believe core-inflation will indeed moderate over the course of 2022. We won’t have to wait until the end of the year to get the benefits. Any signs of a reduction in inflation will see traders switch gears and buy stocks again.
The dreaded “R” word is doing the rounds again.
We don’t see any risk of recession this year. All indicators point to Q2 GDP evening out the negative Q1 GDP to result in a flat GDP for the first half of 2022. Forecasts are for full-year GDP growth to be around +2%. That is not a recession.
That’s the fear side of the equation dealt with. What about the positives?
Earnings forecasts are still for companies to earn more in 2022 than they did in 2021.
91% of S&P500 companies have now reported Q1 2022 earnings and those earnings came in at +9.1% actual year-over-year growth.
FactSet has the S&P500 earning $241/share over the next 4 quarters as opposed to $214/share for the last 4 quarters.
Growing company profits tends to lead to increasing share prices.
Except when the market gets all emotional and forgets logic. Right now investor sentiment is extremely low.
Surveys from Investors Intelligence, AAII and NAAIM show retail investors are extremely bearish and at levels not seen since 2016.
At current levels, investors aren’t just looking at the glass as half empty, but with net bullish sentiment barely above 35%, they’re looking at it as two-thirds empty.
As you can see, sentiment levels are rarely this bad.
Now take a look at what has happened to stock returns in the past once sentiment gets this bad. Apart from the GFC (which we will claim as not relevant to today’s environment), bearish investing sentiment has been a great time to buy stocks
If you want to go out and buy stocks, then where should you start?
Bank of America recently ran some interesting valuation analysis which tells us small caps are where you want to be looking for bargains. This favors our Top 30 Strategy.
B of A points out that the Russell 2000 forward p/e ratio recently fell to 12.5, the Russell MidCap p/e fell to 15.6, and the Russell 1000 p/e (larger-cap names) fell to 17.6.
Large caps and midcaps now trade at the lowest levels since the pandemic. Small caps trade below pandemic levels and they are the cheapest they have been since 2011. Small caps are 20% below average and just one percentage point above GFC lows. Large caps and midcaps valuations remain 10-15% above average.
They are also offering the best guidance. Combined, this suggests that small-cap may be a good place to look for buys.
Put another way, the ratio of the forward p/e of the Russell 2000 (smaller names) vs. the Russell 1000 (larger names) has fallen to 0.71, a 30% discount to the long-run average of 1.01x.
This is the cheapest relative p/e since 1999-2001. “For long-term investors, valuations imply ~12% annualized returns over the next decade for the Russell 2000 vs. low single-digit annualized returns for the Russell 1000,” says Bank of America. Also note that this past earnings season small-cap companies posted bigger earnings beats and much better guidance than large-cap names.
Lastly today, we’d like to remind everyone that market pullbacks are part of the game. Based on history, here’s how often you could expect drawdowns:
- Down 10% – once per year
- Down 20% – roughly once in four years
- Down 30% – approximately once in 10 years.
At the lows on Thursday, the S&P500 briefly touched the down 19.5% level.
We look at it this way – we’ve had to wait 4 years to get an opportunity this good and we don’t want to miss it and have to wait another 4 years for the next one.
Stock values can go down as well as up. It is possible to lose 100% of your investment in a stock. Any advice given by Capital 19 is general advice only and does not take your personal circumstances into account.