Pendulum swings towards snapping up well-priced shares
Another 10% drop would make the market cheap, as a 15x forward P/E has been a good time to buy
Many global markets have crashed and in recent weeks there were virtually no places in the “vanilla” investment world to make money.
The S&P 500 closed at 4,090 on May 17 after peaking in December 2021 at 4,800. At times like these we actively increase the robustness of portfolios to ensure we are well placed for the inevitable recovery. Many price moves are illogical when markets panic, and we seek to take advantage of these.
While at the index level the drops from highs are material, some shares have held up and many (especially growth) investors have experienced far worse. The S&P 500 is down about 15% year to date, with the recent decline coming close to erasing its 2021 gains. However, it would take a further 15% drop to reach prepandemic levels. Ironically, many “stay-at-home/Covid-19” shares are now below their March 2020 levels, despite their futures having changed forever (for the positive).
Looking at the S&P over a 10-year period provides better context as it shows that drops of this magnitude are not uncommon and supports the “staying invested” mantra. While the emotional response is to run for the hills, each decline was an opportunity.
We have been cautious on global equities for some time, largely because of valuations, which have risen in recent years due to low interest rates. The recent correction takes the S&P 500 down to a forward 17x P/E. It is comforting that this is back in range, albeit by no means a bargain yet. Another 10% drop would make the market very cheap — over the past decade a 15x forward P/E has consistently been a good time to buy.
What is the root cause of where we find ourselves? Several factors have conspired to ignite the inflation fire.
First, cheap money and government handouts boosted demand to record highs. Supply chain snarl-ups and Covid-19 inefficiency (ships lining up outside harbours) meant supply could not respond to high demand and prices increased.
Then came a double blow: Russia’s Ukraine invasion limited coal, oil, and wheat supply and China locked down cities at the first sniff of new Covid-19 cases. The result of this is 8% US inflation.
There is a wall of worry out there, but that is when opportunities arise — the best times to invest are when it feels uncomfortable, and news is bad
Now the Fed is closing the “free-money” taps (by increasing rates and stopping bond buying) and asset prices are predictably responding accordingly. US 10-year bond yields of 3.2% would not have seemed a possibility six months ago. The yield on this ultimate risk-free rate gives global asset pricing direction.
One recent bright light in the market has been a pullback in the US 10-year bond yield, giving hope the yield might have started to price in the outlook. A circa 3% bond yield is about right if long-term inflation settles at about 2% two years out, giving investors a real return.
The Anchor bulls believe all of the above is well-known and priced-in — “we are through the worst”. There is a wall of worry out there, but that is when opportunities arise — the best times to invest are when it feels uncomfortable, and news is bad. After a 20%-25% drop in markets, a snapback is common.
At a sector level big-tech companies have followed their smaller (less-profitable) counterparts downwards after initially holding up. Quality and growth investors have felt pain in recent months, as more boring, defensive businesses held up.
We believe we are approaching the stage where the latter is becoming expensive vs growth, while the premium you pay for quality/growth shares is the lowest in years. Many companies with the best growth prospects are trading at attractive multiples for long-term investors. Conditions are starting to line up for our investment appetite for high-quality shares at reasonable prices.
Conversely, the Anchor bears think there will be little respite from current conditions for several months and there has been “a fundamental shift in rate saying”, which the market will take time to reflect. The concern is that while valuations are starting to reflect these realities, the pendulum could swing some more. Earnings forecasts are still high (S&P — 15% growth for the next 12 months) and have room to be downgraded if growth contracts (by more than the Fed expects) in reaction to higher rates.
US interest rates also need to be put in context and forecast increases are off a very low base. The US Fed funds rate of 3% projected for end-2023 is not particularly high from a historical perspective and capital projects can still earn positive real returns at this level.
The nature of markets is that they reflect the anticipated future relatively quickly — hence the rapid derating we are experiencing. We cannot predict how far the pendulum swings, but we seem to be approaching price levels that are pricing in a poor outcome. Another leg down will present some interesting short- and long-term opportunities.
Investors with no appetite for further volatility or downside in global equity markets have an uncomfortable choice if they cut risk now, locking in losses and forgoing the possibility of participating in a recovery. For those investors, there are alternative investment solutions such as structured products, in which investors willing to forgo some liquidity can achieve some level of capital protection against further losses, while maintaining healthy exposure to any recovery.
• Armitage is CEO at Anchor Capital.
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