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While the fourth quarter has only just begun, the end of the year can’t come fast enough for Wall Street. 2022 has been disastrous for investors. The Dow Jones Industrial Average is down 22 percent, the S&P500 has fallen 25 percent, and the NASDAQ Composite has dropped a whopping 33 percent for the year through September 30.
Is there a silver lining? Have the equity markets sounded a bottom? Are markets attractive at these levels? For those tempted by these questions, here are few things to consider.
The past two weeks held a lot of bad news that prompted the most recent sell-off. First, a higher than expected CPI print of 8.3% for August confirmed to the markets what everyone shopping for their own groceries and filling up their gas tanks already knew, which is that inflation isn’t getting any better. In fact, it’s getting worse in what matters most to Americans: housing, energy, and food. This is going to continue to pressure consumer sentiment.
Second, the U.S. Federal Reserve announced yet another 75 basis point rate hike, the fifth increase of the year, bringing the Fed Funds rate to a target range of 3.0 to 3.25 percent. This target is up 300 basis points from just one year ago, and the first time the target range has been above three percent since before the global financial crisis. This is cold water in the face of institutional investors, especially those with leverage.
Other signs indicate that the health of the economy is deteriorating. The Leading Economic Indicators Index fell an additional 0.3 percent for August, having declined 2.7 percent over the past six months. The Fed sharply lowered U.S. GDP growth forecasts for 2022 from 2.7 percent (in June) to 0.2 percent (in September). Unemployment ticked up slightly, although labor markets remain tight for now. The weight of negative economic news is likely to grow, not diminish, going into the fourth quarter.
While it’s true that valuations are well down from their peaks, they remain high compared with historic norms outside of bubble years. The Shiller P/E ratio has fallen over 25 percent, from 37 times earnings at the beginning of the year to just under 27 times earnings today. However, the historical median is 16 times earnings. On this basis, there’s still a lot of air in the balloon, especially in a rising rate and recessionary environment. A forward ratio would look even worse given that corporate margins are likely to be compressed going into next year.
Inflation can be a positive factor for equity values. But right now, recessionary forces and rising rates are exerting the stronger influence. The earnings yield on the S&P500 is just above five percent, compared with a median 6.7 percent historically, implying that the equity market is trailing inflation by at least 40 percent.
In this environment, only higher yielding energy and other commodities stocks give any form of comfort. Oil and other companies should continue to perform well as Europe’s energy crisis continues. Cyclical global miners that have fallen out of favor with the ESG crowd of large institutional investors trade at single digit P/E ratios and double digit cash dividends. Otherwise, it’s hard to get excited about much else being able to resist the tide.
We can only hope that the new quarter brings with it a turn in the markets. However, trying to time the market is a fool’s errand in the best of clear blue sky environments. This season is particularly stormy and difficult. Fundamentals are still deteriorating. Geopolitics have entered a dangerous new phase, with reason to believe that the risk of surprise news from Russia or China may be to the downside.
While we’d all like to see this parade of horribles come to an end, it doesn’t feel like the bottom is in yet.
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