Valuation & Sentiment
The S&P 500’s price-to-forward earnings ratio stands at 16.7x, which is in line with its 10- year average. Current consensus expectations are for earnings to grow just under 5% in 2023, which is a marked improvement from the expected decline in Q4 2022 earnings. Many believe that 2023 estimates will continue to decline and potentially exhibit negative growth if we enter a recession. So, while the P/E multiple’s level typically would indicate reasonable equity valuations, it is less informative today given the uncertain earnings outlook.
Investment Outlook & Strategy
Before delving into our views and expectations, a brief primer addresses the question, “What are the Fed mandates”? From a Fed publication: “The Federal Reserve Act mandates that the Federal Reserve conduct monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Even though the act lists three distinct goals of monetary policy, the Fed’s mandate for monetary policy is commonly known as the dual mandate.”
In 2022, declining values in virtually all asset classes – bonds, stocks, and real estate – were primarily caused by the Fed and other central banks. After previously viewing inflationary pressures as “temporary”, the Fed took its foot off the gas pedal and slammed on the brakes when it became evident that inflationary pressures were not abating as expected. The pandemic and supply disruptions caused prices to rise and labor participation to decline, then more fuel was added to the fire by energy prices surging (pun intended) in response to the Russian-Ukraine developments.
While the above facts and history are of interest, the main question is, “Where do we go from here?” Though we cannot accurately predict the future, our knowledge and experience lead us to the following observations and expectations.
We sense inflationary pressures will reach the target levels of the Fed by the end of the year, yet we do not know if the Fed will make a mistake by being overly restrictive, which would put the economy in recession. If a recession develops, then it is likely to be relatively mild as the imbalances evident in past recessions are not currently present.
Assets repricing to higher interest rates was discomforting and painful, yet it was necessary and inevitable if we want a healthy economy. While it was laudable that the Fed and federal government supplied trillions of dollars to the economy and financial markets in response to the pandemic, excessive stimulus has a way of inflating asset values and causing bubbles. The demise of cryptocurrencies (FTX), SPACs, and deflated values of stocks without earnings are healthy developments as they purge speculation and correct the misallocation of investment capital.
We welcome higher interest rates as they are a vivid indication that things are normalizing. Now savers and investors can earn meaningful returns on bonds and bank CD’s. Interest rates that were near zero or negative were manifestations of economies on life support—not a desirable situation.
Stocks now trade at reasonable and attractive valuations providing buying opportunities for long-term, patient investors. Importantly, our view is that the environment has changed from being a “Stock Market” to a “Market of Stocks”. Stated differently, we envision a sea change that favors individual security selection over market indices (index funds).
Whether we experience a recession or not, whether the stock market rises or declines in the next few weeks or months, from current levels fixed income securities and common stocks are priced to provide competitive returns in the years ahead.