Stephen M. Mills, CIMA® Partner
The stock market is currently experiencing one of the worst declines since the first quarter of 2020 when the major stock market averages fell over 30% as the Covid-19 pandemic began to emerge. In the beginning of the year, we felt there was a possibility of a 10-15% correction in the S&P 500 Index.1 It didn’t take long for such a correction to occur. Beginning January 4, when the S&P 500 hit an all-time high of 4818, the benchmark fell 13.4% through close of trading on March 8 when the S&P 500 hit 4171.2 In early April, we thought the S&P could retest the March 8 low but we believed that low would hold. It did not. On Monday of last week, the S&P broke through the March 8 level and finished below 4000 for the first time since March 2021. The benchmark is now down almost 16% for the year.2
From a technical perspective, the S&P Index is clearly in a down trend which could persist for a while longer, in our view. The next level of support for the benchmark is in the 3700 to 3800 range. That represents a potential decline of 5-7% from last Friday’s closing price of 4024. It is difficult to say if the S&P will hit that next level of support but we would not be surprised if it did given the negative sentiment in the market currently. At the same time, it would not surprise us if the market moves higher from Friday’s close based on what appears to us to be an extremely oversold condition.
In our opinion, stock prices are in the process of adjusting to higher interest rates which we feel are being driven by higher inflation. With inflation running at over 8% for the past several months according to the Labor Department’s Consumer Price Index measure,3 interest rates have moved higher in response. Recently, the Federal Reserve (Fed) announced a hike in the Fed Funds rate of .50% after the Federal Open Markets Committee meeting on May 4th.4 The Fed had previously raised the Fed Funds rate by .25% after its March meeting. The Fed also indicated in their statement, that there could be several more rate hikes this year in an attempt to slow the pace of inflation. Stocks initially rallied after the Wednesday afternoon rate hike announcement ending the day with the Dow Jones Industrial Average up 932 points for the day. However, the Dow soon gave back that gain and more over the next three trading days falling over 1800 points through last Monday’s close. This kind of market action is difficult to understand. It suggests to us the market is not trading on fundamentals but more on psychology with fear as the main driver. In our experience, when fear seems to be the primary factor in market movements, we may be approaching at least a near term bottom in stock prices. However, with the Fed clearly is a monetary tightening mode, stocks may continue to struggle until there are positive signs that inflation is slowing and Fed monetary policy becomes clearer.
Generally, rising interest rates are negative for stock prices. The area of the market that is often hit harder by rising rates is the growth stock sector where earnings and revenue growth are typically greater than the average stock and the price-to-earnings ratio (P/E) is higher. The P/E ratio is calculated by dividing the price of a stock by its earnings per share. These types of growth-oriented companies tend to reinvest cash flows back into their businesses instead of paying out dividends to shareholders. These stocks tend to struggle during times of rising interest rates because the discounted value of future cash flows is lower as interest rates rise. In simpler terms, a dollar’s worth of future cash flow is worth less in the future than it is in the present when interest rates are higher. This makes the current value of these companies worth less as interest rates rise. Stocks that pay higher cash dividends tend to do better in rising rate environments because shareholders receive more of the current earnings in cash instead of in the future as is the case for growth stocks.
The performance of value stocks verses growth stocks in times of rising interest rates can be seen by looking the Russell 1000 growth and value indices this year. The Russell 1000 Growth Index, which is made up of higher growth stocks as we discussed above is down 24% so far in 2022 as of the date of this letter while the Russell 1000 Value Index, which is made up of slower growing companies that tend to pay higher current dividends is only down 8% over the same time frame.2 This is the first year that value stocks have outperformed growth stocks since 2016.5 Although the year is still young and there is plenty of time for growth stocks to catch up to their value counterpart, we believe this outperformance may continue for a while as long as interest rates continue to rise.
S&P 500 value stocks are currently trading for about 15 times their expected earnings over the coming 12 months. That is down from just over 17 times in early 2022.6 Meanwhile, S&P 500 growth stocks have seen their forward price-to-earnings ratio drop to below 21 times, from about 28 times since the start of the year.6 The P/E ratio of the entire S&P 500 has fallen from about 21 times earnings to about 17 currently.6
According to data from Credit Suisse, earnings per share for the S&P 500 are on track for 11% year-over-year growth on a 13.5% increase in revenues.6 Yet even with this impressive growth, the S&P 500 Index has dropped approximately 10% since the results started coming in early April.2 It seems that investors are more focused more on Federal Reserve monetary tightening policy than on corporate results. This dynamic may continue to play out for a while longer until there is more clarity on inflation and the Fed’s monetary actions. However, we believe the S&P 500 is getting close to a point that it is very attractively priced for the long-term investor.
There is a great deal of uncertainty facing investors currently. We see financial markets remaining highly volatile in the near-term as investors deal with tightening monetary conditions and the increased possibility of a U.S. recession next year. While we still do not believe the U.S. economy will fall into a recession this year based on our observation of several economic indicators, we think the probability of a mild growth contraction occurring within the next 18 months has risen.
For the long-term investor who has at least a three-year time horizon before needing investment funds, we believe the recent correction in stock prices may present a good buying opportunity. For those investors either currently in a distribution mode or will be in a distribution mode within the next two to three years, we believe portfolios should be well balanced between equities, fixed income and cash.
As always, we greatly appreciate your continued trust and confidence in us and we will continue to work to keep you informed of economic and market developments.
Your Trinity Capital Management Team
Footnotes
- TCM 2022 Market Outlook & Strategy letter, January 10, 2022
- Thompson Charts
- https://www.bls.gov/cpi/
- https://www.federalreserve.gov/newsevents/pressreleases/monetary20220504a.htm
- Wells Fargo Advisors Advisory Services Group Index Performance Statistics.
- Barron’s , “Why Earnings Season Couldn’t Save the Stock Market This Time,” May 10, 2022
The indices presented in this material are to provide you with an understanding of their historic performance and are not presented to illustrate the performance of any security. Investors cannot directly purchase any index.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations
The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.
Past performance is no guarantee of future results
S&P 500 Index: The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock's weight in the Index proportionate to its market value.
Dow Jones Industrial Average: The Dow Jones Industrial Average is a price-weighted index of 30 "blue-chip" industrial U.S. stocks.
Past performance is no guarantee of future results and there is no guarantee that any forward-looking statements made in this communication will be attained.
The Russell 1000® Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.
The Russell 1000® Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.
The Consumer Price Index (CPI) is a measure of the cost of goods purchased by average U.S. household. It is calculated by the U.S. government's Bureau of Labor Statistics.
Investment products and services are offered through Wells Fargo Advisors Financial Network, LLC (WFAFN), Member SIPC, a registered broker-dealer and separate non-bank affiliate of Wells Fargo and Company. Trinity Capital Management, LLC is separate entity from WFAFN.
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