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Capital 19 Catch-Up

Weekly Index Movement

S&P500 -3.0%

Nasdaq -4.5%

Aussie All Ords +1.1%

“You make most of your money in a bear market, you just don’t realize it at the time.” – Shelby M.C. Davis

Shelby MC Davis comes from a dynasty of Wall Street value investors and we thought this quote especially relevant for the current situation.

The S&P500 has now been down for seven straight weeks. That is the longest streak of weekly losses since March 2001 and just the fourth streak of seven or more weekly losses in the post WWII period.

What we are experiencing is certainly unusual. The root causes of the weakness have been the hawkish FOMC and increasing concerns over the potential for a recession.

We can see why investors are unhappy. Even the Fed chair sounds like he sees the glass as less than half empty! Powell is talking about a ‘painful’ period of policy normalization, and the Treasury Secretary is telling the public that a soft-landing is ‘conceivable’ with a little bit of ‘skill and luck.’

Someone please send them a four-leaf clover as the fate of the world’s largest economy hinges on them getting this right.

Of course, the media is having a field day with this and predicting a recession. Which is good because they always get it wrong so it means we won’t be having one any time soon.

Regular readers will know we do not think a recession is coming. Yes, some indicators are flashing warnings but none has actually given a positive signal yet.

How can there possibly be a recession when unemployment is at 4%, wages are rising at 5% per year and there are enough jobs advertised to give every single unemployed person two jobs?

So no, there will not be a recession any time soon. Certainly not this year. One day we will have one, that is inevitable, but it might not be for 5 or 10 years and is not something we need concern ourselves with yet.

If there will be no recession, why are stocks being continually sold down?

It all comes down to uncertainty. Investors do not yet have a clear grasp on interest rates and last week corporate earnings were drawn into question.

Time for a little Finance 101 education.

Classic fundamental analysis says a company’s value should be the sum of its discounted future cash flows. If you want to value a company you need to first predict its earnings over say, the next 10 years. Then you discount those futures earnings by an interest rate and they most often use the 10-year bond yield to do this. That is why you will see the media often referring to this 10-year yield.

The bond market is having a hard time getting this 10-year yield right. It is swinging around almost daily with levels of volatility usually associated with significant macroeconomic events like the Greek Debt Crisis of 2011 and the Financial Crisis of 2008.

When analysts can’t get a consistent read on what interest rate to use in their models they have a hard time stating what the value a company’s share price should be.

To add fuel to the fire, last week Target (TGT) and Walmart (WMT) announced earnings and both disappointed, citing inflation causing an increase in costs. This worried investors as it was a sign of the economy slowing.

We will get more reports this week from Costco (COST), Best Buy (BBY) and Nordstrom (JWN). These results could be crucial for the outcome of stocks this week.

At 3901 the S&P500 is not discounting any chance of recession.

If you add up all the earnings for the companies that make up the S&P500 index you get to an earnings figure for the index.

Earnings for Q4 2021 were $55.38 and earnings for Q1 2022 were $53.91. if we take the average of those at $54.65 and then say that figure will be the average earnings all year, then we get a 2022 earnings figure of $218.60.

The 5-year average PE for this index is 18.6 which gives us an S&P500 target of 4066 which is 4% higher than where we presently are.

Of course, if corporate America can show earnings growth then this figure would go higher.

Analyst forecast for 2022 earnings are actually $230/ share as they see growth coming in the second half of the year.

Earnings of $230 puts the index at 4278 using the same 18.6 PE

On the flip side, if we were to enter recession, it would not be unusual to see earnings decline 25% and we would also expect investors to be less willing to pay high multiples so the PE could drop to, say 16.

That gives us earnings of $165 and a PE of 16 for an S&P500 at 2640 which would be 45% lower than the all-time high. This is in the ballpark of the last 2 recessions: 2000-2002 -50% and 2007-2009 -57%

If the market thought there was any chance of recession stock prices would be a lot lower already. The fact they are around fair value indicates the market does not think a recession is likely but is just lowering earnings growth numbers.

Where to from here?

After seven straight weeks of losses and the index sitting around fair value, we don’t think there is a lot more downside left. Markets do tend to overshoot to both the upside and downside so we would not be surprised to see a little more selling first before the recovery begins.

The focus has shifted from interest rates to companies’ earnings, so concentrate on those sectors with earnings growth. We have been saying it for weeks and will say it again, Energy is your friend. You can probably add Materials to that and companies with good and solid dividends (like those that feature in our Dividend Growth Strategy)

In the week ahead all eyes will be on the FOMC minutes release on Wednesday, with investors looking for further confirmation the Fed will deliver another 50bps rate hike next month and in July. On the data front, personal income and spending (friday) will probably point to a slowdown in both household consumption and PCE inflation while flash S&P Global PMIs (Tuesday) are seen falling this month. Other important releases include: 2nd estimate of GDP growth (Thursday), corporate profits, final reading for the Michigan consumer sentiment, Chicago Fed National Activity index, Richmond Fed Manufacturing Index, new and pending home sales and durable goods (Wednesday).

Warning

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.

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