Risk/reward greatly improved as selloff appears overdone 

Market Perspective

January 24, 2022

Key takeaway

The weight of the evidence in our work suggests the market’s risk/reward has greatly improved. The market selloff appears overdone near term and is likely within a few percent of finding support.

What happened

As we discussed more recently, investors appear to be concerned about the timing and pace of monetary policy tightening, the persistence of inflation, and potential profit margin pressure. And now we can add building geopolitical tensions surrounding Russia and Ukraine.

Consequently, the S&P 500 is currently down 11% from its early January peak, while other areas of the market, such as small caps and growth, are down even more.

Our take

Pullbacks are never comfortable, because they come with bad news. This time is no different. But pullbacks are the admission price to the market. Moreover, our work shows that following shallow pullback years, such as 2021, the following year tends to have deeper pullbacks, with an average maximum average intra-year pullback of 13%.

So while the 11% current pullback feels abnormal, history suggests it’s typical. The surprise in our view, is less that we are seeing a pullback this year, but how quickly it came right out of the gate to kick off 2022.

The good news is our work suggests markets have already gone a long way to pricing in some of these concerns. The bar has been lowered to a point at which a little bit of good news could go a long way. Recall, markets tend to bottom on fear. And we are seeing abundant fear in the market.

  • The percentage of individual investors who consider themselves bullish has fallen sharply to just 21%, the lowest level since July 2020, according to the most recent survey from the American Association of Individual Investors (AAII).
  • The Volatility Index (VIX), also known as the fear index, has spiked to the highest level since January of last year and prior to that in October 2020, right before the election. On each occasion, the market rallied over subsequent months. The demand for downside market protection in the options market, or the put/call ratio, has spiked to the highest level since March 2020, during the depths of the pandemic.

From a fundamental perspective, the S&P 500’s forward price-to-earnings ratio has de-rated from 21.5x to 19.0x currently. This is the lowest level since early during the pandemic.

If we stress test our assumptions, and consider that the S&P 500’s P/E contracts to 18.5x against $225 forward earnings estimates or remains at 19.0x against a lower earnings number of $220 that brings us to fundamental support around 4160-4180, which is less than 2% away from current levels.

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