Shopping for Quality on Sale… But First, The Fed
By TRG Advisors on May 5, 2022
As expected, the Federal Reserve raised the Fed Funds rate by 50 bps, the first time of this magnitude since 2000. The Fed also announced its plans to reduce the size of its balance sheet, allowing assets to run off at a rate starting at $47.5 billion per month in June and accelerating to $95 billion per month in September. And again this was in line with expectations.
At the press conference Fed Chair Powell was hawkish, saying inflation is “much too high” and that they will move expeditiously to restore price stability. He also cited strong economic trends, including household balance sheets and business investment. We’ve highlighted this consistently throughout the year – the underlying economy is strong and can handle higher rates. At the conference, Powell indicated that they will likely raise rates 50 bps at the next few meetings to fight inflation. As of this writing, the Fed Fund Futures expect the Fed Funds rate to reach 2.25-2.50% by September, which would be the neutral rate. The Fed will likely have to move more than that, given the inflation rate.
Even if inflation is around peak, it’s widespread and here to stay. We view the Fed’s actions as positive – if late – and note that we are not yet back to “normalized” Fed policy. The Fed will continue to watch the data… as will we.
We Think Stocks Are On Sale
There’s an old saying that stocks are the only thing that people sell when they’re on sale.
Valuation plays an integral role in deciding to buy or sell a stock, as it does with any asset. When greed gains momentum, equity valuations tend to get expensive relative to a company’s true earnings potential. Conversely, when the market is struck with fear and uncertainty, an oversold market can create a buying opportunity.
We see a buying opportunity in today’s market.
Since the start of the year, next-twelve-months (NTM) earnings projections have increased by +5.5%. Over the same period, NTM price-to-earnings (P/E) multiples have declined -17.2%. The S&P 500 valuation has now dropped to within one standard deviation (STD) of its long-term average. Stocks tend to follow profits, and with the strong underlying company fundamentals accompanied by attractive valuations, we’re adding to positions where we see sustainable growth ahead.
Chart 1: Valuation Within 1 STD of Average, EPS Outlook Trending Upward1
Value vs. Growth Multiple Differential Back Near Long Term Average
Since 2000, growth stocks have been valued at an average 6 multiple-point premium to value (using NTM P/E). At the end of 2021, that premium had doubled to 12 multiple-points. In other words, growth had become more expensive (near 2001 levels) and value had presented an even stronger relative valuation. Today, the difference is 6.5 multiple-points, near the long-term average.
As a result of the valuation compression, S&P 500 Growth (-18.8%) has underperformed S&P 500 Value (-4.6%) year-to-date. The improved relative valuations provide a buying opportunity for companies, particularly market leaders, that have exhibited strong fundamentals and maintain healthy demand.
Chart 2: Growth P/E Multiples Have Fallen Nearly 3x Value P/E Multiples YTD2
Fighting Fear with Clarity
A number of sentiment indicators, including a rising put/call ratio in April, the number of stocks reaching new 52-week lows and the S&P 500 sliding further away from its 125-day moving average all indicate a fear-driven market.3 While fear has contributed to selling, corporate earnings have actually risen at healthy rates in the first quarter. The S&P 500 is on pace for 10.8% EPS growth in Q1.4 In addition to earnings, we’re seeing greater clarity in markets, which could reduce volatility; the Fed has communicated their path forward, COVID fears are abating (e.g., lifted mask mandates), company supply chain management teams are better equipped and consumer demand data remains robust.
1 Source: FactSet (chart)
2 Source: FactSet (chart)
3 Source: CNN Fear & Greed Index
4 Source: Credit Suisse