Hold the fort
Our bias is to add to risk. We’re just not there … yet.
It’s been nearly two months since we became more defensive in our recommended PRISM® stock-bond model and it proved to be the correct call. Dividend-paying value stocks and cash, our biggest overweights where we added again in late March, were two rare areas that held up during the April/early May carnage that pushed the Nasdaq into a bear market (down 27% from last November’s peak) and the S&P 500 into a correction. This environment understandably is generating calls from clients and investors wondering where we go from here. Here’s what we are telling them: hold the fort. Our bias is to add to risk; we’re just not there yet, though we’re getting close
What’s holding us back? In two words, “time” and “level.” First, “time.” As much damage as the market has endured to date, the key uncertainty that now plagues us—“soft landing” or “recession”—is unlikely to be resolved before the fall at the earliest. With the economy still running hot, inventories low, labor markets tight and private sector balance sheets strong, it will take far more than two Fed rate hikes to crash-land this jumbo jet. And with inflation—driven by supply shortages and still pent-up demand following the global Covid shutdown—unlikely to decline substantially until later this year, again we will need many more Fed hikes to have an impact. And then there are other big uncertainties out there impacting the soft/hard landing debate. When will China reopen from its current lockdowns, easing supply chain shortages? When will Putin figure out a way to get out of his failed war in Ukraine, which would not only be a huge humanitarian relief but also would ease pressures on commodity prices? And when will higher consumer prices begin to soften aggregate demand? And if this happens, will it be soon enough and strong enough to ease inflationary pressures and help the Fed achieve the desired soft landing, or will it be so dramatic that it sparks a recession? You get the picture. It’s just too early, in our view, to see these major uncertainties resolved to the market’s satisfaction.
Which brings us to the second word: “Level.” With the market largely in mass liquidation mode, our expectation is that our coming shift from defense back to offense is likely to be triggered by achieving a market level that more than discounts a reasonable worst-case scenario. And the good news is, we’re getting close. Though the S&P is only down 16% from its highs, the damage to the broader market has already been more severe. Many ultra-high growth stocks built on revenue models without earnings anywhere in sight are already down 50% to 70%; frankly, we doubt they’ll be recovering anytime soon as investors are now much more skeptical of growth models that don’t ever seem to generate cash returns. Other, more traditional growth stocks, with strong market positions, double-digit revenue growth, and earnings high and still growing, are down 20% to 30% and more, a pretty healthy pullback. Much of this decline, we think, is attributable to a market reset on their fair valuation in light of the 10-year Treasury rate rising to 3.0% (and likely in our view to land at 3.5% before long.) Some of the growth stocks’ decline is also due to their high earnings growth rates decelerating as we exit Covid. But with many traditional growth stocks still trading at mid-20s P/Es, we don’t think we’ve yet achieved a price level there that would represent a safe entry point. And given their cap weighting in the S&P, the big growth names will have to decline further to tempt us to shift into a more aggressive stance.
The good news is that some areas of the market have moved to levels that are now attractive. Many cyclical value stocks whose earnings depend on the economic cycle (think financials, some industrials and consumer discretionary) are also down 20% to 30% and are fast closing in on levels that discount a brief recession, which in our view is bordering on a worst-case scenario given all the economy’s strengths that we’ve previously discussed. And most stable value stocks, though they have already performed well, still trade at attractive dividend yields. We are already overweight both these value categories, but should they get dragged down in a final broad market sell-off to somewhere in the 3,800 level on the S&P, we’d be tempted to add. From there, we’d have 20%+ upside to our intermediate-term market target, which we think would offer attractive compensation for deploying cash in this uncertain environment. We’ll see.
In the meantime, we don’t think time or level merits getting less defensive yet. Of the two, level is closer than time. For now, hold the fort.