Misplaced hope and a tale of two months
Stocks came out of the gate very strong this year, with the S&P 500 gaining more than 6% in January and the most speculative areas leading. Indeed, stocks were boosted as an oversold market met growing investor hopes of a soft economic landing, easing inflation, and a potential pivot from the Federal Reserve (Fed).
Those hopes quickly faded in February. Stronger economic data alongside stickier inflation trends resulted in a sharp jump in interest rates and downward pressure to equity valuations as the Fed’s terminal rate was repriced higher. Subsequently, stocks pulled back about 5% from the peak seen earlier in the month.
The recent action is very much aligned with a key market dilemma we have been highlighting:
- If the economy stays stronger, as we have seen recently, Fed policy is set to remain tighter, and this will weigh on market valuations.
- Or, instead, if the economy weakens, this will pressure profits. Neither of these outcomes are favorable for premium market valuations.
Moreover, at the recent highs, the market was pricing in a lot of good news with little margin for error. Indeed, prior to pulling back, the S&P 500 traded to 4195 and an 18.4x forward P/E. This is close to the 4200 level that our work suggested would likely cap the near-term market upside. For perspective, stocks have only been able to sustain a higher valuation level twice over the past 30 years – during the tech bubble and the pandemic overshoot.
Risk-reward slightly improved but far from compelling
Last month, we used the market rebound to upgrade our view of cash to more attractive given the less favorable investment backdrop.
With the recent pullback, valuations have come in somewhat, the market is moderately oversold, and there are some technical support levels in view, including the 200-day moving average and the December price lows.
However, even though the market’s risk/reward has slightly improved alongside lower prices, the backdrop is far from compelling.
- For perspective, the S&P 500’s forward P/E of 17.6x is still slightly above the 10-year average of 17.2x, and that’s in the context of a high degree of uncertainty around economic growth, inflation, and earnings.
- Forward earnings estimates are hovering near a 52-week low, and downside risks remain.
- The 1-year U.S. Treasury yield has jumped above 5% for the first time since 2007, and the 10-year U.S. Treasury yield, which is hovering around 4%, is nearly double the average of the past decade
- This has led the equity risk premium, or the relative attractiveness of stocks to bonds, to fall to its lowest level in more than a decade. Said another way, even though stocks have corrected, their relative appeal to bonds has worsened.
- Interest rates have risen sharply and restored value in bonds. Our fixed income team is focused on keeping it simple, and we see value in high quality bonds.
- Cash also remains somewhat attractive alongside our long-held view that the Fed is set to keep rates higher for longer.
- Within equities, we favor the U.S. However, last month we upped international developed markets (IDM) by one notch. We remain impressed by the steady improvement in economic, earnings, and price trends underway for these markets. After a decade of negative interest rates in Europe, financials, the largest sector in IDM, is getting a boost.
- Within equities, we maintain a bias for the equal-weighted S&P 500, or the average stock, where relative valuations and technical trends are more attractive. We maintain a favorable view of the industrials sector, which is benefitting from defense and infrastructure spending and reshoring.
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