July 2022 | Victoria Bogner, CFP®, CFA, AIF®
For the past six months now, it seems that all the financial news can talk about is recession, rising rates, high inflation, and how it all must have to get much, much worse before it can get better. What they don’t talk about are the things that are going right- because those headlines don’t get clicks. So while retail investors are soaking in the bad headlines and selling low, smart money is buying the dips those retail investors are creating.
Let’s take a look at inflation for instance. For the month of June, the headline Consumer Price Index (CPI) clocked in at 9.1%, an increase from the prior month’s 8.6% reading. That sounds bad, right? But let’s look at core CPI, which takes out food and energy. That went from 6% to 5.9%, a slight decrease. Not only that, but the price of light crude oil has gone from over $120/barrel in June to $97/barrel as of today. That’s a 20% decline in less than a month. If that keeps up, I predict peak inflation is behind us. And if headline inflation starts to come down, that’s probably going to be a big positive catalyst for the stock market.
But even more than that, the market actually doesn’t care about inflation anymore. Why do I think this? When the headline CPI number was released with a dire sounding headline, the next headline to take center stage was that the Federal Reserve may raise rates as much as 1% at their next meeting. That would be a huge jump. Normally The Fed’s interest rate moves are 0.25% or 0.5% if they’re feeling especially saucy. But despite headlines, what did the stock and bond market actually think was going to happen?
Interestingly, the 10-year Treasury yield went down after the CPI numbers were released, not up as one would predict a nervous market would do. For market makers, inflation is already in the rearview mirror. Their focus is on what to buy now that the Nasdaq 100 has fallen 30% from its high.
Let’s take a look at earnings. Is that spelling recession ahead?
The most simplistic definition of recession is two quarters of negative GDP growth. By that definition, we could already be in recession as we speak. Bear in mind that we’re coming from a high level of GDP growth because of the stimulus boom, so it isn’t a shocker that we’re going to see GDP growth lower than that (aka negative growth) to moderate to a more normal level. But when it comes to the market, earnings recession is more important in my opinion.
The chart above and on the left shows earnings recessions going back to 1988. Each bar represents one year. The green bars are years in which earnings fell, and those bars stay green until earnings surpass their prior highs. 2020’s bar is green. But 2021 far exceeded the prior earnings high, and 2022 is shaping up to do the same.
Not only that, but the composition of that earnings growth is healthy.
The chart above shows that the majority of earnings growth this year so far is coming from revenue. That means more money in the door. Part of that is increasing costs passed onto consumers, but from an investor’s point of view, that’s very positive. No signs of earnings recession here, folks.
Let’s take a look from a technical perspective. Here’s just one piece of evidence of many that we monitor regularly. The green line on this chart represents the ratio between value and growth. The pink line is the S&P 500’s price. This chart goes back 1 year.
When the green line is falling, that means that large amounts of money are leaving aggressive growth sectors and being allocated to defensive value sectors. When the green line is rising, it means the opposite. Here’s what’s interesting to note. Where I’ve drawn the orange line on the left is where the ratio began falling while the S&P 500 was still rising. I drew a circle where the market peaked at the beginning of the year. Now look at the second orange line. At the end of May, the ratio began to turn up while the market was still falling. It has continued to rise since then. What that, as well as many other indicators, imply is this: June 20th may have been the low of the S&P 500 for 2022.
That’s a bold statement, I know. What about the (fill in the blank) problem the economy is going through? Here’s what’s important. The economy and the stock market rhyme, but they aren’t totally correlated. The stock market will bottom when the economy is at its worst and everything looks bleak. Also note I said we may have seen the low for 2022. 2023 is another story altogether. We may still have recession next year. But we’ll re-evaluate that when we get closer to it.
For this year, my opinion is that the next six months will look better for stocks than the last six months. I believe year-end will see higher prices than today’s prices. The caveat is that I might be totally wrong. I’ve been wrong before. But the smart money is gobbling up the stocks that retail investors have given up on and to me, that points to higher prices by December 31, 2022. We’ll see if I’m right.
I want to stress that if you’re a long term investor, what happens next month or next year really doesn’t matter very much. What matters is expected return over time. Fortunately, we have several ways to make educated guesses about that.
One of those ways is to look at the price/earnings ratio of the S&P 500.
This chart is showing regression analysis of the S&P 500’s price/earnings ratios compared to rolling subsequent 12 months returns going back to 1997. The goal is to see how P/E ratios correlated to future returns. This measure is meaningless for looking 12 months into the future. But looking at 5 year chunks of time, the answer is much clearer. In other words, based on the current valuation of the S&P 500, what might we expect the next 5 years’ annualized return to be?
It turns out that it’s between 8% and 9%. Said another way, in 2027 it wouldn’t be surprising to look back over the prior 5 years and see that the average annualized performance of the S&P 500 was between 8-9%. If you know that’s the case and you’re a long term investor, do you care what the market does in the next 6, 12, or even 36 months? Not unless you have more cash to invest while the long term returns look so attractive. The right play here is to stay invested in your proper risk tolerance or invest any cash you have on the sidelines that can stay invested for the next 5 years. That’s what the smart money’s doing, anyway.
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