Valuations

Thanks to the 2009-2021 experience, an entire generation of investors can’t distinguish between a stock market that’s down in price and one that’s actually “cheap.” The current bear market seems on course to make that distinction relevant again.

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Some have speculated that 2022 might have been the kick-off for a decade-long era in which the broad stock market indexes will make essentially no progress, like 1966-1982. However, that earlier experience provided opportunities within other market segments, which will also stand a much better chance in coming years. 

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The balanced portfolio strategy of allocating 60% to equities and 40% to fixed income generated a highly satisfactory 7.9% annualized return over the last 30 years. Despite the excellent returns earned by investors following this strategic model, the past couple of years have seen a parade of articles with headlines such as “Is the 60/40 Portfolio Obsolete?” and “Is the 60/40 Dead?” Given the central importance of this moderate allocation strategy to investment industry practices, we felt a closer look at the 60/40 portfolio was in order.

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We think the U.S. economy will slip into recession sometime in the next year, but the level of “excess savings” provided by pandemic aid renders the already difficult task of timing more elusive than ever.

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We’ve heard no references lately to the famous “Fed Model” for stock market valuation. We think we know why: The model’s usual proponents probably don’t like its current verdict—which is that stocks are far more expensive than at the early January market peak.

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How far might the S&P 500 fall in a recessionary bear market? The 2002 and 2020 stock market lows were both produced by “recessionary” bears; based on history back to the 1920s, those two lows stand out as the priciest bear market bottoms on record—and it’s not even close.

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If there’s a polar opposite to “Goldilocks,” this must be it. Not too hot and not too cold? What about both? Job growth and inflation are hot enough to force the Fed to follow through on its hawkish promises. But the leading indicators continue to warn us of oncoming cold. The odds that the porridge settles at the right temperature, without an intervening recession, look longer by the day.

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We won’t dispute that investors were not genuinely frightened at the June market lows, or that fears have evaporated following a 13% rally in the S&P 500. The distress is understandable: For 26 traumatizing days in 2022, our S&P 500 Normalized P/E multiple traded below its 1957-to-date top decile!

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The 2022 bear market is the 13th cyclical bear since 1950, and it’s already joined the mightiest half of its predecessors based on the fact that it’s actually contained a bear-market rally. Six of the prior 12 bear markets weren’t interrupted by even one rally of at least 10%.

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The bear was a mere cub back in March when we examined the historical record of buying S&P 500 dips in the -10% to -12% range. “Blindly” buying them turned out to have mediocre returns, but we illustrated that the positions of various business-cycle indicators could help one determine whether or not catching the proverbial “falling knife” was warranted.

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We apologize for that terribly misleading teaser of a title, but the bills for the stock-market mania of 2020-2021 are piling up. Inflation is one of them, lately increasing each month as relentlessly as cable TV used to. And for the 10% of households who own 90% of the stocks, market air-pockets such as June’s are like “surprise” medical bills: There’s rarely just one

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The most brutal bear markets occur when falling earnings are accompanied by shrinking valuations, producing a compound negative effect on stock prices. Investors in 2022 have (so far) avoided this double-whammy in that valuations have taken a hit, but EPS estimates are holding strong. We are intrigued by the notion that 2022’s bear market has, to date, been all about valuation compression rather than earnings weakness. Investors are coping with the problems of the day by letting the air out of bubbly valuations, and this report takes a closer look at the valuation squeeze underlying the current selloff.

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Throughout most of the COVID rebound, market bulls told investors (correctly) to ignore valuations and simply ride the liquidity tide. But with that tide now flowing out (and at possibly its fastest speed ever), guess what the one-time liquidity junkies see as a reason to stay in stocks? Yes, cheaper valuations!

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Stock market corrections are the result of falling valuations and/or falling earnings, and when both conditions appear together, investors are in for a rough ride. Thus far, the 2022 selloff has been confined to compressing P/E ratios, and we launched a research project to take a closer look at shrinking stock valuations in this market downdraft.

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Losses in the Russell 2000 Growth Index and the NYFANG+ Index have topped 40%, and the only true equity rockstar, spawned by a 13-year secular bull market, has watched her fund’s value drop by more than three-quarters. Yet there’s still a televised debate as to whether this decline is even a bear! Could there be a more devious creature on the face of the planet?

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Lent ended last week, allowing Christians to resume the intake of unhealthy foods. But rather than a nice, thick T-Bone steak, we’d suggest sampling one of the few items that’s fattened investors’ accounts in 2022—the Donut!

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Investors considering a position in the Consumer Discretionary sector need to be aware of what they are buying: a basket in which one-half consists of mature, modestly-valued consumer brands, while the other half is two mega caps with excellent growth profiles and high absolute valuations. It would be a mistake to view this sector as a homogeneous set of companies.

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Just after yesterday’s close, we loaded our precocious bull into an SUV and drove to the local veterinary clinic for a two-year checkup.

Our bovine buddy drew some sympathetic stares while we were waiting in the lobby. Noting our bull’s droopy eyelids and gray facial hair, an assistant informed us, “You know, you didn’t actually need to bring him here. We now have a mobile euthanasia service.” We just smiled, and waited for the veterinarian, who is said to be a specialist in this new super-species of bull.

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The concept of “mean reversion” used to help build massive fortunes. Of late, a better mantra has been “maximum attraction,” as valuations and bullish psychology have matched or surpassed excesses of the Y2K Tech bubble. Meanwhile, corporate profit margins, once dubbed “the most mean-reverting series in finance” by Jeremy Grantham, have now topped those seen near the Y2K top by more than 50%.

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In early 2018, we thought the market was expensive, but certainly not a bubble. Today, the trouble is not just high P/E multiples, but the sustainability of the “E” itself—with profit margins nearly 20% higher than ever before. Whether one believes U.S. Large Caps are engulfed in a bubble or not, we have a P/E ratio for you.

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