Business Cycle Evolution Leading to Shifting Trends in 2022
Business Cycle Evolution Leading to Shifting Trends in 2022
The US economy showed a substantial rebound in the fourth quarter of 2021 following a rather abrupt slowdown in the third quarter. The key underpinning for equity markets throughout the past year has been the strong earnings recovery, which continued apace in Q4. The most impressive earnings recovery emerged from the energy sector, which led the S&P 500 with a price gain of nearly 55%. We’ve maintained a strong overweight to the energy sector over the last 18 months, and we continue to believe the sector remains undervalued and underappreciated by the market.
As we’ve discussed previously, earnings have been supported through the combined stimulus measures provided by fiscal and monetary policy. That extraordinary support was necessary to prevent a depression and restore confidence in the face of an economic shutdown due to the COVID crisis. Today that stimulus is no longer needed, and it’s set to be meaningfully reduced in 2022. This is expected to lead to a significant deceleration in the rate of economic and earnings growth and may serve to move inflated asset prices lower.
The Benefits and Consequences of a Strong Labor Market
Achieving maximum employment has been the Federal Reserve’s (Fed’s) primary goal since the onset of the crisis, and it’s largely been realized. As we enter 2022, U-3 unemployment is running at just below 4%, as shown by the dotted orange line in the chart below. Further, labor has enjoyed strong wage gains, as the solid blue line depicts. A large contributing factor to higher wages and lower unemployment has been the shrinking workforce. Therefore, while the unemployment rate is low, job openings remain high and there is strong competition among employers for qualified workers. As a result, labor has more negotiating power today than at any time since the 2007-2009 financial crisis.
An undesirable consequence of tight labor conditions is inflation. While some inflation, like the price of lumber or used cars, is the result of supply imbalances and will naturally dissipate, other inflation is more persistent and generally only cured by slowing demand. Most economists see high and rising wage growth as a sign of more persistent inflation. And while sharply rising labor costs suggest some risk to corporate profit margins, the more important concern is the spiking trend in consumer prices that has resulted. This is currently being seen in the Consumer Price Index (CPI). Core CPI has more than doubled since March 2021, as we see in this chart.
The surge in inflation is a result of the Fed’s focus on maximizing employment without showing significant concern for the other side of its dual-purpose mandate, price stability. Inflation concerns have now taken center stage as an accelerated tapering of the Fed’s balance sheet and expedited interest-rate hikes represent key features of the Fed outlook. Both measures are designed to remove stimulus and decelerate growth. Today the Fed faces a difficult challenge: slow demand enough to bring inflation into check without tipping the economy into recession.
Index Concentration: Two Sides to Every Mountain
Against this backdrop, valuations remain relatively high across most global equity markets and appear to be at an extreme within a narrow and concentrated subset of the S&P 500. That subset would be the largest 10 companies based on the market values of their stocks (known as Mega-Caps). As you’ll see in the chart below, this group of companies has only been this richly valued at one time during the last 25 years, and it was at the peak of the Tech Bubble.
As the chart illustrates, this group of companies very recently traded hands at an eye-popping 40 times earnings as expressed by the median P/E ratio. The following table from JP Morgan suggests that the average forward P/E ratio for the group currently resides at 33.2 times earnings, representing a premium of nearly 70% when compared to the remaining stocks in the index and the average historical range for the Top 10 stocks.
The overwhelming share of the Top 10 stocks comes from the technology sector. That list includes Apple, Microsoft, Google, Facebook, and Tesla. All are exceptional companies. However, all are exceptionally expensive from a valuation perspective. We would not envision the same kind of dramatic unwind of today’s leading tech companies that we witnessed in the collapse of the Tech Bubble. Nonetheless, their valuations, which have been supported by low interest rates, leave them most susceptible to a significant price correction as interest rates are set to rise.
These Top 10 stocks also represent a potential risk for the overall market due to high levels of concentration found in market indexes. The Top 10 now represent over 30% of the S&P 500’s market cap. This is the most concentrated the index has been since the 1970s, and it’s grown worse over the last year. Buoyed by healthy earnings growth, investors have continued to pile into these brand-name stocks throughout the year, bidding their valuations to hyper-inflated levels.
It’s worth noting that while the Top 10 stocks posted healthy earnings growth in 2021, the rest of the index grew earnings even faster. The upshot is that the Top 10 experienced relative P/E multiple expansion while the rest of the index became more attractive from a valuation perspective. Nowhere was this more evident than in large-company value stocks, which populate our portfolios. Last year, the market performance of these stocks and the growth of their earnings outpaced their large-cap growth counterparts. Yet the average P/E ratio for these companies ended the year at 15.8 times forward earnings. That’s far less expensive than large growth-oriented companies (30.6 P/E) in general and the Top 10 Mega-Cap stocks in particular (33.2 P/E).
Divergent trends often lead to compelling investment opportunities. While the market has climbed one side of the mountain to the P/E ratio heights reminiscent of the Tech Bubble, we believe we’re likely to witness a meaningful descent for highly valued growth-oriented companies as the supportive conditions fade. We’re already seeing signs of weakness in speculative and momentum stocks, including recent IPOs (Initial Public Offerings) and SPACs (Special Purpose Acquisition Companies), which can prove to be a leading indicator of more widespread volatility. On the other hand, the opportunity for reasonably priced value stocks remains favorable, and we are well positioned to capitalize.
The Focus on Absolute Returns in a Dynamic Process
The inherent risk of high levels of concentration in the S&P 500 should be concerning to most investors, but many of them aren’t even aware of the magnitude of their exposure. Index fund investors are buying more and more of the narrow group of Mega-Caps with each deferral into automatic investment plans such as 401(k) and 529 plans. This trend exacerbates the concentration problem, and many are contributing to it unknowingly. With such lofty valuations, the forward return expectations for expensive equities are exceedingly low if not negative.
For investors focused on relative returns, reducing exposure to areas of the market experiencing strong relative performance is anathema to them even if their portfolios are being subjected to rising risks. A focus on absolute returns enables the conscientious investor to reduce exposure to individual asset classes once the forward return expectations begin to look unfavorable, even if momentum may carry them higher for a while. Executing a dynamic process focused on absolute returns allows the opportunistic investor the ability to avoid undesirable risk and identify and capture quality investments when they’re out of favor and offer attractive fundamentals. We continue to find value in selected traditional market assets and timely non-traditional alternatives. Thankfully, our investment team has extensive experience dynamically managing assets in both universes.