Assessment of the current situation on the equity markets – September 2022

It thus appears that only macroeconomics still counts on the financial markets and that investors hang on every word of the US Federal Reserve. Inflation is currently clearly the most important factor influencing daily market movements, as the markets fear aggressive interest rate steps by the central banks. For in combination with the high energy costs, a recession and further falling asset prices would then be a foregone conclusion.

An alternative perspective: «peak inflation»

The macroeconomic forecasters appear relatively «self-assured» with regard to the scenario described above. But what if inflation were to decline faster than the markets expect? The research house Alpine Macro has divided the PCE (Personal Consumption Expenditures) inflation tracked by the US Federal Reserve into two categories: supply-driven inflation (rising price, falling volume) and demand-driven inflation (rising price and rising volume). Demand-driven inflation has been declining sharply since mid-year and has already fallen to 1% (see the red chart in the graphic bottom left), while supply-side inflation (blue chart) is still high but likewise trending downwards. «Micro indicators» from companies across various industry groups, such as order backlogs, delivery times, transport and raw-material costs, confirm the picture that supply-driven inflation is already receding.

Source: Alpine Macro

The model calculations of Alpine Macro, which historically have moved very closely in step with supply-driven inflation, even indicate that PCE inflation in the USA will fall to 1% by the end of 2023 (graphic top right, red chart). Monetary policy thus appears to be working, and the front-loaded character of the tightening cycle is likely to take effect through weaker growth and declining price pressure in the fourth quarter of 2022 and in 2023. The question, however, is whether the process is also proceeding quickly enough for the Fed.

High pessimism and volatility offer opportunities

With price declines of -25% in nominal terms and -30% in real terms so far this year, the leading US exchange is already pricing in a mild recession. Indicators that measure investor sentiment are signalling high pessimism.

The Bull-Bear Spread of the American Association of Individual Investors (AAII) has reached a bearish extreme that is higher than during the financial crisis of 2008. According to the latest fund manager survey by the Bank of America, the proportion of portfolio managers underweighting equities exceeds the level of 2008/09. Net short positioning in the S&P 500 is high, and the NDR Daily Trading Sentiment Composite compiled by Ned Davis Research (orange chart below) has fallen below 20%, thereby likewise signalling very negative sentiment, which from a contrarian perspective is positive: since 1995, the S&P 500 Index has risen by 27% p.a. whenever the NDR Trading Index stood below 41.5% (see the table bottom left). When fear is great, it is more likely that prices already incorporate a worst-case scenario – in reality it then rarely turns out to be as bad as feared.

Source: Ned Davis Research

It is not difficult today to sell a pessimistic story. Yet the financial markets are already aware of the negative factors. No one knows, not even the bears, how the future will unfold. However, buying equities amid high volatility and declining markets has, as a rule, proven a successful strategy in the past. The price/earnings ratio (P/E) of the S&P 500 Index has already fallen to a level comparable with earlier recessions. According to Factset, the 12-month P/E for the S&P 500 Index stands at 18 and is thus below both the 5-year average (22.8) and the 10-year average (20.4), see the chart below.

Source: FactSet

In the event of a recession, earnings in the USA are likely to fall by 10% over the coming 12 months. Yet even in such an environment the P/E ratio could rise if bond yields fall to 2.5% or lower. For it is not consistent to forecast a recession and a decline in earnings while at the same time expecting bond yields to remain at 4%.

Selective buying opportunities for long-term investors

Even should a mild recession occur, a large part of it is by now priced into cyclical equities, for example in the technology and industrial sectors, in which many stocks have already fallen by 30 to 50%. As can be seen from the graphic bottom left, cyclical equities have performed markedly worse than defensive equities since the middle of last year. The relative performance thus resembles the price development of past downturns and recessions respectively (shaded grey).

As the graphic shows, cyclical equities have in the past anticipated recessions and marked their low points in the midst of the recession. Market dislocations such as the current one have therefore in the past been outstanding opportunities to invest in attractively valued, more cyclical companies, which as a rule outperformed in a subsequent upturn.

Source: Alpine Macro

The graphic top right shows that the leading index S&P 500, excluding the heavily weighted FAAMG index constituents (Apple, Amazon, Microsoft, Facebook and Google), is valued at a P/E of 12 and is anything but expensive. This time, too, the market has thrown out the baby with the bathwater – a look beneath the mega-cap stocks should therefore be worthwhile.

In the short term, equities are traded on the basis of noise and valuations are largely irrelevant. As a consequence of short-term concerns about supply chains, recession or high short-term comparison hurdles, many high-quality companies in the S&P 500 are trading at attractive valuations. Company leaders evidently see it this way too. Following the recent sell-offs, corporate insiders have once again bought shares in their own companies on a large scale (see the illustration below, second section). Insiders sell shares for all manner of reasons, but they buy for only one reason: because they believe that prices will rise. In view of the historical accuracy at low points (March 2020, December 2018, August 2015, August 2011, March 2009, August 2002), the glass is likely to be not half empty but rather half full.

Source: Fidelity, FMRCo, Haver Analytics, FactSet

Markets are as a rule most inefficient when a macro narrative predominates, when market participants narrow their time horizon and lose focus on the fundamentals of companies. When investors, in search of short-term gains, lose sight of the fundamentals of companies, this opens up opportunities for long-term investors. Rather than macroeconomic forecasts, it is precisely then worthwhile to look at what is essential, namely the «micro environment»: the attractiveness of sectors, industries and individual companies.

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