We finished last week in the same manner that we finished the one before, as the Dow Jones Industrials fell nearly 1,000 points on Friday, extending the losing streak for the major market averages to four weeks. The Nasdaq Composite has fallen back into bear market territory, as the bears revel in the repetition of “I told you so,” convinced that a recession and bear market for the S&P 500 are foregone conclusions, but I think the balance of evidence still says no. We are in the process of ridding the market of the excessive valuations that built up from years of near zero-interest-rate policy and abundant liquidity. That process started in earnest near the end of last year, and it was one that I warned about in my outlook at the beginning of 2022. Unfortunately, it comes with collateral damage. When investors take the most expensive growth stocks to the woodshed, investor sentiment goes with it, and a lot of high quality and value-oriented stocks can suffer in sympathy. When the decline broadens, as it has over the past two weeks, it typically happens closer to its end than it does its beginning.
This process of exercising speculative valuations out of the marketplace has intensified with each selloff this year. I asserted at the beginning of 2022 that the highest risk names, as measured by stocks trading at a multiple-to-sales of 10 times or more, would be the hardest hit as interest rates rose. That is exactly what has happened to the $14 trillion in market cap that you see in the chart below, which I shared in The Year Ahead- 2022. Meanwhile, the cheapest quintile of stocks has held up much better.
The poster child for speculative growth has been Cathie Wood’s ARK Innovation ETF (ARKK), which maintains 35 stock holdings that nearly all trade in excess of 10-times sales. This portfolio was down 29% last month and 70% from its high last year. Assuming it can’t go to zero, it has to be closer to its bottom than its top.
My critics claim that I was too early in tilting bullish in February after the S&P 500 declined 12.4% from its January high and called an end to the correction. That assertion did not suggest a vertical move back up, as bottoms are processes and not events. My expectation was that we would not see a more significant drawdown than we had seen up to that point, which is arguably still the case today (-13.3%). The index has gyrated up and down with extreme volatility over the past two months after falling as low as 4,114 on February 24. It could certainly break below that level in the coming weeks and test the 4,000 level, which some are calling fair value. The same lot suggest that an overshoot to 3,800 is where the S&P 500 ultimately bottoms, which would be a 20% bear-market decline from its January high. I am sticking to my guns.
Regardless of what the ultimate low ends up being this year, valuations are becoming far more reasonable. The price-to-earnings multiple for the S&P 500 has fallen significantly through a combination of lower stock prices and higher earnings. I believe fair value to be 17 times my forward 12-month earnings estimate of $240 for the S&P 500, which is approximately 4,080 and consistent with the 10-year average multiple of 16.9.
Earnings continue to surprise to the upside with 55% of the constituents of the S&P 500 having reported so far and 80% besting estimates. The expected growth rate has risen from 4.7% at the end of the first quarter to more than 7% today, and I expect it to continue rising with another 160 companies scheduled to report this week. That should help solidify confidence in expectations for 10% growth or more in 2022.
This week the consensus expects the Fed to raise the Fed Funds rate by 50 basis points from 0.25% to 0.75%, followed by another 50-75 basis points in June and at least 25 basis points or more at every meeting after, resulting in a short-term rate of 3.00-3.25% by the end of this year. That is an extraordinary increase from what was expected four months ago to be a very gradual move up to 2.5% over the next two years.
Investors have been selling risk assets over the past four months in anticipation of the Fed’s rate-hike cycle, which starts in earnest at the conclusion of this week’s meeting on Wednesday afternoon. Financial conditions have tightened to the extent that 2-year Treasury yields reflect nearly all of the expected rate hikes this year, while 10-year yields have risen to 3% in anticipation of the Fed starting to shrink its balance sheet. Mortgage rates have risen nearly 200 basis points, cooling the housing market, while deal flows have slowed significantly, reflecting the end of easy money.
This week’s meeting could be pivotal from the standpoint that investors have been selling the rumor of tighter monetary policy all year long. Therefore, they may buy the news that the Fed is finally following through with its inflation-fighting policy actions. There should be no more uncertainty on that front.
The most important event of the week is the Fed meeting, which concludes Wednesday afternoon with the rate decision, followed by a press conference with Chairman Powell. I will also be interested to see if ISM’s PMI Service index softens for April in the same manner that it did at S&P Global. On Friday we have the jobs report for April.
The percentage of stocks in the S&P 500 trading above their 50-day moving average has fallen below 30%, which has been a reliable indicator of an oversold condition for the index, as it was in February and March.
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