By Ben Norris, CFA, Securities Research Analyst, Associate Vice PresidentPrint This Post
Stocks once again sold off on a Friday afternoon to close a volatile week in U.S. equity markets (see last week’s recap). The major indices finished the week mixed with the S&P 500 (SPX) and NASDAQ Composite (COMP) losing 1.5% and 3.2%, respectively while the Dow Jones Industrial Average (DJIA) managed to gain 1.2%. SPX’s weekly loss was enough to wipe out the prior week’s gain. For those keeping score, SPX has recorded a loss in seven of the last nine weeks and was down nearly 24% year-to-date on Friday. In comparison, the DJIA has lost just 17% while COMP has lost an agonizing 34%. This divergence can be explained by the difference in performance between growth and value stocks so far in 2022.
Investors haven’t been able to watch or read financial media in 2022 without pundits discussing the historic rise in interest rates. Investors tend to believe that future earnings are less valuable in a higher rate environment. This is partially because earnings are less certain in a rising rate environment, but more importantly future earnings are worth less when discounted at higher interest rates. A typical growth stock has much more of its value associated with future earnings than a comparable value stock. Value stocks tend to be more mature companies and have more certain earnings and lower growth prospects. For these reasons, value stocks have fared very well in 2022 – the DJIA is comprised of 30 relatively mature companies while COMP is comprised of nearly 3,800 companies many of which are classified as growth stocks – hence the ~17% difference in performance so far this year.
Overall, U.S. stock market valuations have fallen from the historically high levels reached early in the pandemic. SPX reached a forward price-to-earnings (P/E) ratio in the mid-20s before falling to the mid-teens recently. Admittedly, valuations were stretched particularly in stocks investors believed were poised to reap long-term gains from pandemic lifestyle changes. Stocks in software and consumer goods were some of the beneficiaries. But eventually investors (and consumers) realized that not all pandemic gains were sustainable and adjusted accordingly. It took interest rates rising at an unprecedented pace for investors to realize their mistakes. The yield on 10-year Treasuries has risen from ~0.5% in spring 2020 to more than 4% recently. This is the first time that 10-year Treasuries have yielded more than 4% in 14 years.
Looking forward, I’m concerned that the Fed is poised to make a policy mistake by raising rates too much too late. The Fed is projecting that their target interest rate will peak at roughly 4.7% in 2023 versus the current 3%to 3.25% range. Higher rates may mean that stock valuations will continue to come down or at least stay in their current range. If the global economy enters a recession, as many notable corporate leaders have warned, stocks may suffer continued losses. The third-quarter earnings season, which began last week and picks up steam this week, should provide some insight into the state of the global economy. If earnings and forward guidance come in worse than expected, and the Fed indicates they are continuing with their plans to pursue aggressive rate hikes, investors could be in for a difficult end to 2022.
The inflation data released last week certainly points to a Fed that will favor higher rates for longer in an effort to tamp down rising consumer prices. The Producer Price Index (PPI) was released on Wednesday and registered a 0.4% monthly increase for September versus the 0.2% that was forecast. Investors largely ignored the data and hoped that Thursday’s Consumer Price Index (CPI) reading would bring better news. Unfortunately, CPI data was also a disappointment. Headline CPI showed an 8.2% year-over-year increase for September versus the 8.1% expected. Similarly, Core CPI (which removes the influence of food and energy prices) increased 6.6% from a year earlier versus the 6.5% expected. The percentage of 6.6% is a 40-year high for core inflation. Also on Thursday, U.S. jobless claims showed that the American labor market remains stubbornly strong despite the Fed’s best efforts to cool the hot labor market. Even with bad news, investors pushed stocks higher – SPX gained 2.6% on Thursday. Friday seemed to bring more rational thinking from investors as SPX lost 2.4%, marking the fifth consecutive Friday loss for the index.
Putting everything together, I think the third-quarter earnings season will be pivotal in determining the next direction for stocks. It’s clear that inflation is stickier than expected and that the Fed will have to continue raising rates as a result. If earnings can come in better than expected, or even in line with expectations, stocks will have a better chance of remaining above their recent lows and potentially finding a path higher into 2023.
In addition to a busy slate of earnings we’ll get updates on the housing market, industrial production, jobless claims, and inflation expectations this week.
|Tuesday 10/18/2022||Industrial Production Index (Sept.)||-0.2%||0.1%|
|Capacity Utilization (Sept.)||80%||80%|
|NAHB Home Builders Index (October)||46||44|
|Wednesday 10/19/2022||Housing Starts (Seasonally Adjusted Annual Rate)||1.54M||1.54M|
|Fed Beige Book|
|Thursday 10/20/2022||Initial Jobless Claims||228K||230K|
|Continuing Jobless Claims||1.37M|
|Leading Economic Indicators||-0.3%||-0.3%|
|Existing Home Sales (SAAR)||4.80M||4.70M|
|Friday 10/21/2022||Index of Inflation Expectations (5-10 years)||3.1%|
|Index of Inflation Expectations (10 years)||2.2%|
Links to previously published commentaries can be found at benjaminfedwards.com/Latest Investment Insights/Weekly Market Commentary/Market