Can stockmarkets continue to keep their cool in 2022?

Despite rising commodity prices and higher inflation, equity markets have recovered well from their March lows.

As analyst Ed Yardeni pointed out on Monday: “The S&P 500 dropped 13% from its record high on January 3rd through March 8th. It rebounded 11% through March 29th. Since then, it has lost 3% through Friday’s close” leaving it down 6.5% for the year to date – or just 2.5% in sterling.

The FTSE 100 meanwhile, is up 2.2%.

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Can this perhaps surprising resilience continue?

Can the Federal Reserve avoid pushing the US economy into recession?

“The forward earnings of the S&P 500 remains on a sharp uptrend,” notes Ed Yardeni, “but the forward price/earnings ratio of the S&P 500, having dropped to 18.1 on March 14th, remains relatively high at 19.3, down from an early November 2021 high of 21.5.”

The rest of the world is significantly cheaper on a forward multiple of 13.4, as are the US mid- and small-cap sectors, while the S&P 500 valuation is pushed around two points higher by its top eight tech-related mega-caps.

Yardeni notes that profit margins remain near their record highs but still expects the earnings of the S&P 500 to rise to $240 per share this year (up 15%) and $260 next (up 8%) compared with an analysts’ consensus – on which forward multiples are based – of $227 this year and $240 next. If he is right, the forward multiple will fall to 17 by the end of the year.

On this basis, US equities would be attractive – but he still advises “don’t fight the Fed when the Fed is fighting inflation.”

The determination of the Federal Reserve, America’s central bank, to raise interest rates to combat inflation is becoming increasingly apparent. This points to a federal funds rate of 2.75% to 3% by mid-2023, according to Yardeni, with inflation moderating to 4-5% in the second half of 2022.

The question is, he says, “can the Fed bring down inflation without a recession?” If not, then earnings forecasts will be cut and the valuation multiple will be correspondingly higher. Earnings growth is needed to bring the multiple of the S&P 500 down to attractive levels.

US mid- and small-caps and non-US equities look much more attractive, but are unlikely to perform well unless led by the S&P 500. The resilience of capitalism in the US, its relative political stability and its self-sufficiency in energy argue for a premium valuation, as does its global leadership in innovation. As the saying goes “when America sneezes, the rest of the world catches a cold.”

The prospect of rising interest rates has led to rising government bond yields, with the yield on the ten-year US Treasury recently reaching 2.7%. A rise to anywhere near the inflation rate, currently 8.5%, would be disastrous for the US economy and stockmarket but current yields are so low that they imply significant losses in real terms for bond investors.

Greg Openshein of Verdad Capital is more relaxed, however. “The drawdown of 16% in the ten-year US Treasury that began in July 2020 is now the fifth-worst on record. The average six-month subsequent return from the worst drawdown is 4.9%.” The Fed is now in a cycle of interest-rate rises, he says, and these are normally positive for bond returns.

Don’t worry, be patient

To those who remember the 1970s and 1980s, it is remarkable that after-inflation yields on government bonds are so negative – but it would be wrong to assume that they are irrational.

The experts like to think that they are smarter than markets, but markets are nearly always right. Current yields imply that inflation will moderate rapidly, probably as the increase in commodity prices reverses. If so, the outlook for both bond and equity investors will improve rapidly.

Those who feel lucky might prefer to wait six months before investing, by when some of the uncertainties should have cleared, or wait for renewed market weakness. Both strategies risk missing the boat – and it is always hard to scramble into a rising market. Buying now and not expecting much until later in the year is a safer strategy.

Remarkable value is appearing in some unexpected places. As Sven Borho, co-manager of the £2bn Worldwide Healthcare Trust (LSE: WWH), says “we have seen the biggest bear market in 30 years in the biotechnology sector.” In the last 12 months or so, the S&P biotechnology index under-performed the S&P 500 by 64%, falling by nearly 50% to the level last seen in mid-2015.

“The healthcare sector now trades on a 20% discount to the S&P 500, the same as in the financial crisis. Every single time it has traded at such a discount has been the very best time to be invested, especially in innovation and growth.” This was not the consequence of the pandemic that we all expected.

The technology sector has suffered a sharp fall too, but David Toms, director of research at Hg Capital, puts this fall into context. The value of unprofitable companies relative to sales, he says, has halved in the last year – but that of profitable companies is only down 4%. “Unprofitable companies were growing sales much faster but growth for growth’s sake has been hit hard.” In other words, a year ago, unprofitable companies were valued at very similar levels to profitable ones but now they have reverted to their historic discount.

The software sector, he adds, now trades on 18 times cash flow compared with 14 for non-software, yet the valuation relative to free cash flow is very similar at 28 and 27. This reflects the low capital requirements of the software sector. With double-digit growth in revenue likely to continue, valuations are attractive.

In short, the valuations of many growth stocks are now either attractive or very attractive, having been pulled down by those that have failed to live up to early promise. The vulnerability of these stocks to the economic cycle and rising interest rates is low while long-term growth looks assured. Some of the world’s smartest investors are responding to the opportunity by buying those that have fallen out of favour.

Patience will be rewarded.