Martin Pelletier: But the truth may be in between
Traders work on the floor of the New York Stock Exchange. Photo by Spencer Platt/Getty Images files There has been no place to hide in the markets this year aside from energy stocks. But they, too, became the last segment to correct, selling off in June before starting to recover in July. Looking ahead, we are keeping a close eye on three key factors that we think will drive the future direction of markets and determine whether the current rally is sustainable or not.
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Interest rates Interest rates have become the driving factor in markets, especially among the longer duration segments such as bonds and technology stocks. Any time there is disappointing economic news, such as last week’s negative 0.9 per cent GDP print, it gets pundits thinking the Federal Reserve will pivot on its tightening thereby sending markets higher. Bad news, in other words, is good news again.
Article content Overall, it wouldn’t surprise us to see an improvement in inflationary pressures in the months to come as we’re already witnessing a sizable drop in commodity prices. For example, corn, wheat and steel prices are down 30 to 40 per cent from their highs putting them at levels seen before the Russian invasion of Ukraine. At the same time, oil and gasoline prices are also falling, easing pressure on the U.S. consumer. In our opinion, commodity prices did get ahead of themselves to the upside, but perhaps they may have overreacted to the downside as well?
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Article content We think it’s important to remember that things are not always as clear-cut as they appear.
Ben Carlson, director of institutional asset management at Ritholtz Wealth Management, summed it up perfectly in a recent tweet: “Welcome to the confirmation bias economy. Want to see a recession? Just look at GDP, rates, inflation, retail & consumer sentiment Don’t want to see a recession? Just look at the labour market, personal income & travel/services.”
The mixed data makes it difficult to determine at what point the pace of rate hikes will slow and eventually end. Complicating matters, we think commodity prices will continue to exhibit volatility, as scarcity of supply and worries over demand create periods of higher and lower inflation. At the same time, we worry that those most exposed to duration are allowing their confirmation bias to take over resulting in one-ways bets all dependent on a Federal Reserve pivot. In reality, we think there are plenty of areas within the economy that can handle higher interest rates as evident by the recent Q2 reporting.
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Article content Corporate earnings Earnings have historically held up relatively well during periods of inflation, if the 1940s and 1970s are any indication. As of last week more than one-third of the S&P 500 has reported Q2 results, including Microsoft Corp., Meta Platforms, Inc., Alphabet Inc., Apple Inc. and Amazon.com Inc.
Again, one can cherry pick the data that best fits your view of the markets. The bearish will look at disappointing Walmart Inc. numbers while the bulls will cite Apple or Amazon’s better-than-expected Q2. Apple announced a beat on both revenue and profit and expects growth to accelerate. Amazon, despite the broader consumer shift from goods to services spending, is still expecting impressive 13-to-17-per-cent growth in post-Q3 revenue. Meanwhile, Walmart with its forward sales expected to come in at six per cent, is slashing prices to try and work through its excess inventory levels.
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Article content Overall, we think this quarter is showing that the pace of growth is slowing in some areas and showing resilience in others. This is important especially considering the magnitude of multiple compression that has already occurred this year.
Valuations From the valuation side, markets have clearly reset, with the S&P 500 P/Es falling from 23 down to 16.9 times (up from 15.3 times reached in June). Based on historical data, it is pricing in 65 per cent of a recessionary correction. While we are not brave enough to say this is officially a bottom, we think it’s definitely worth adding to positions especially among the few who were able to protect some of the downside this year.
Looking ahead, we see a lot of value in certain segments of the market such as the financials sector including Canadian and U.S. banks. We also like some of the S&P leaders like Apple, Amazon and Microsoft that are trading at somewhat attractive multiples especially now that they have just reported.
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Article content Normalized interest rates are the cure, not the problem Fixed-income has been a downturn saviour, but this time is different Let’s turn and burn: How to become a Top Gun investor That said, we are trepidatious about the more speculative tech segments of the market, such as those companies with weak cash flows and dependent on a permanent low cost of capital. So, make sure not to get enticed into adding back excessive duration risk especially as inflation volatility continues.
Finally, we continue to think we are in the early stages of a commodity supercycle with very favorable longer-cycle conditions. The good news is the sell-off in June may have been a second chance for those who missed out on the trade earlier this year
In conclusion, we find it pays to be an optimist when everyone is a pessimist, don’t make bets on central bankers and instead focus on those areas of the market that can make money, generate strong cash flow and grow in a higher interest rate environment.
Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.
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