- The market environment has entered a new phase compared to the early part of the pandemic.
- While Omicron and surging Covid cases make headlines, cracks are appearing in the macro outlook with slowing growth.
- The tech sector is particularly exposed to a weaker outlook against lofty expectations.
- There's more volatility in stocks with risks tilted to the downside.
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In a volatile week, the S&P 500 (SPY) closed down about 4% from its recent high. While barely even a correction, the extreme volatility in small-caps and segments of tech have likely raised eyebrows. We won't blame investors itching to buy-the-dip considering the strategy has worked at every turn since the depths of last year with the market sticking to the narrative of a firming post-pandemic recovery. That said, there is a case to be made that we've entered a new phase in the market moving beyond the old playbook that drove positive returns since 2020.
The challenge here is the combination of both new Covid disruptions and mixed economic signals emerging at a critical juncture. Compared to a prior consensus that the economy would be accelerating into 2022, the outlook has instead deteriorated. It's a completely different environment compared to the early stages of the pandemic, and we now believe bad news can be taken as bad for stocks opening the door for more downside. We are particularly bearish on technology which we see as exposed to slowing growth estimates.
The Delta-Variant Is Bearish For Stocks
While the emergence of the Omicron-variant has captured headlines over the past week, the U.S. and Europe is facing a new surge of "regular" Covid cases linked to the Delta-variant. We bring this up because we sense the current Covid numbers have been lost in the messaging with investors focusing on Omicron that could still turn out to be a false alarm while downplaying the ongoing impact of the existing strains that public health officials have been unable to control.
It's unclear where the numbers are headed but the expectation is the situation can worsen into the winter months. In the U.S. local governments are re-implementing Covid restrictions while some countries have gone as far as issuing lockdown orders. Furthermore, Omicron can still represent a tail risk if it proves to be more serious and resistant to current vaccines, adding another layer of uncertainty.
We don't need to play arm-chair epidemiologists. The point here as it relates to stocks is that this situation with a new surge was not supposed to happen. The biggest change has been a recognition that the vaccines lose efficacy over time moving the CDC to recommend boosters for all adults. The insight we offer is that aside from the group of people that have been against the shots, there is likely a new cohort that took the first round but could push back on future doses. This means the cycle of waves can keep repeating and the Covid disruptions are set to be deeper and continue for longer than previously expected.
It follows that sectors directly impacted by the Covid situation have faced some of the deepest selloffs over the past month across airline stocks, resorts, casinos, and cruise lines among the biggest losers. Sales and earnings expectations for these companies in the upcoming quarters should be revised lower into a period where operations should have been normalizing.
Exposed Tech Stocks
Technology stocks have been leading the market over the last several years and ended up getting a boost from the pandemic which helped to accelerate high-level themes like the growth in cloud computing, e-commerce, and mobility. The problem here with this group is that the outlook and current valuations have been driven by lofty assumptions into 2022.
The way we are looking at the tech is that the group remains exposed to cyclical headwinds of a potential slowdown. Whether you want to connect that with Covid or global inflationary trends; a pullback of expectations to GDP growth down to sales and earnings represents a major bearish theme for all industries. We have already seen this impact among the high-beta, high-growth momentum segments of technology like software applications.
Even as the Nasdaq-100 (QQQ) has faced only a modest correction of around 6% from its high, individual names have faced deep selloff already. From highs just over the past month, PayPal Inc (PYPL), Twitter Inc (TWTR), Square Inc (SQ) are down by over 20%, effectively in a "bear market". Thematic high-growth ETFs like the Renaissance IPO ETF (IPO), Global X Cloud Computing ETF (CLOU), and the ARK Innovation ETF have faced similar volatility. To be clear, there are some company-specific factors at play, but the sentiment is missing across the board.
Our explanation for this generalized weakness is in the context of slowing growth. 2020 set a high bar for operating momentum these companies haven't been able to maintain or translate into the same level of profitability. Many of these stocks trade at objectively expensive valuations with limited earnings against double-digit price-to-sales multiples making them sensitive to changing growth estimates. If the expectation was previously to generate a 25% increase in sales or earnings for 2022, for example, there are enough reasons to believe those estimates can underperform against the current macro backdrop.
The big fish that will need to drop for tech and the broader stock market to really break down will be the mega-cap leaders. Names like Microsoft Corp (MSFT), Apple Inc (AAPL), Amazon.com Inc (AMZN), and Alphabet Inc (GOOG)(GOOGL) are still seen as largely immune to Covid disruptions. That said, the bearish case is that there is a downside in this group from a weaker global economy overall. Notably, it was reported Apple is seeing slowing demand for its iPhone which raises questions regarding the strength of consumer spending worldwide. For Amazon, data showing industry retail sales during Cyber Monday and Black Friday down from 2020 doesn't add much confidence.
Sputtering Economic Momentum
In October, the Fed released its updated economic projection for indicators across U.S. GDP growth, unemployment, and inflation. At the time, the headline was that the group was revising lower its outlook for 2021 GDP to 5.9% from 7.0% while bumping its forecast for 2022 GDP to 3.8% from a prior 3.3% estimate. Investors can look forward to the next quarterly update at the December 15th FOMC.
(source: Federal Reserve Bank)
We'll bet that the official projection for GDP is lowered for both 2021 and 2022, citing the ongoing Covid situation. We also expect to see the 2022 inflation (core PCE) and unemployment estimates get a few ticks higher. From a high level, the weaker macro data can slow the operating environment for all companies. These trends are global, and we expect to see weaker indicators across Europe and Asia moving forward.
Separately, the latest November payrolls report adding just +210K jobs against expectations of +550K could be a preview of the trends into Q1 2022. A trend of companies holding off on return to office plans, or buckling down spending against cost pressures, will be difficult to reverse in our opinion.
Putting it all together, we get a poor backdrop for stocks. We're not talking about an apocalyptic collapse, but simply a slowdown at the margin can be enough to add volatility. Compared to the environment in 2020 and the early part of this year, what's missing are the "emergency" stimulus programs and quantitative easing measures. Recognizing those efforts were a big part of the market upside, stocks will be challenged to climb this latest wall of worry.
Structural Inflation Beyond Oil Prices
The other side to the discussion is the implications to Fed monetary policy and the previously signaled plans for tapering. Clearly, if the economy is going to sputter, it provides some flexibility for the Fed to push back on any rate hike timeline. The challenge here is that with the last reported October CPI at 6.2%, the hottest pace in over 30 years, the Fed may not have a choice if inflation continues to surprise the upside.
This week, Fed Chairman Jerome Powell during comments to Congress went as far as suggesting it was time to retire the word transitory as it relates to inflation seeing the trends as more structural. We have covered inflation previously and one of the important aspects of the trends is the relative "stickiness" of prices. Outside of the products directly tied to commodity prices, there is little reason to expect prices for goods and services consumers are buying to start rolling back.
What's more likely is that most companies are still in the process of introducing price hikes to reflect higher costs observed in 2021 and an attempt to maintain margins. In this regard, while the nearly 20% drop in the price of oil from highs may provide some relief to gas and fuel prices, the measure that is more important is the core personal consumption expenditures index (PCE) which specifically excludes energy. In this regard, any positive effect from lower oil will take several months to flow through the economy assuming the price does not bounce back.
One scenario that remains on the table is a slowing economy with elevated inflation commonly referred to as stagflation. On the other hand, there is also a scenario where Covid completely blows over and the economy gets a renaissance of growth. This could actually end up being more challenging for the Fed because inflation would presumably accelerate higher forcing an even more aggressive hawkish tilt. Expect rates to remain volatile with the uncertainty as another headwind for stocks.
The 2022 Pandemic Playbook for Stocks
It's been a very complex and technical period in the market with many moving parts. We talked about the deteriorating Covid outlook, softer economic indicators, uncertainties related to growth, and ongoing inflationary trends. Still, there are other headwinds for the market between the U.S. debt-ceiling deadline, negotiations over the Build Back Better Act, the impact of a strong dollar on emerging markets, geopolitical tensions with Russia, and questions regarding the Chinese economy.
Overall, our take is that it's a poor time to be making big bullish bets on risk assets. Compared to the early stages of the pandemic, a new playbook makes sense.
- "Bad news" is now bearish for stocks. (no room for further QE/ stimulus)
- Inflation remains a risk despite the pullback in energy prices.
- Continued interest rate volatility.
- Favor high-quality strong balance sheet companies over momentum names.
- Value and defensive sectors can outperform growth going forward.
The message here is that we expect more downside in stocks with the NASDAQ-100 leading lower. In our view, there is room for growth and earnings to underperform in 2022 against high expectations. Even with the recent weakness, QQQ is still trading at a level from just a few weeks ago while there are plenty of reasons to believe the outlook is weaker for the market.
We are looking at the $350 price point as our first downside target which we believe could be reached over the coming weeks as a haircut on valuation among large-caps. The buy the dip mentality in the market remains strong so any downside scenario won't be a straight lower. A break below $350 could open the door for a deeper correction down to the lows of 2021 around $300 if conditions materially deteriorate putting the bears back in control.
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This article was written by
Dan Victor, CFA is a market professional with more than 15 years of investment management experience across major financial institutions in research, strategy, and trading roles.
Dan leads the investing group Conviction Dossier, where his focus is on helping investors stay ahead of market trends and inflection points. Dan’s investing vehicles of choice are growth stocks, tactical exchange-traded funds, and option spreads. He shares model portfolios and research to help investors make better decisions, via his Investing Group’s active chat room.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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