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Stephanie Link, Chief Investment Strategist and Portfolio Manager, Hightower

Portfolio > Economy & Markets > Economic Trends

Finding Opportunity in Stocks as Multiples Shrink

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What You Need to Know

  • With strong consumer demand, a robust job market, higher wages and corporate earnings growth, the U.S. is unlikely to see a recession in 2022.
  • Core inflation is projected to fall to 4.1% this year and 2.4% in 2023, despite less optimism about reaching those levels.
  • Seek companies with strong earnings that are addressing inflation through increased efficiencies and pricing power.

Concern about soaring inflation, geopolitical tension and interest rate increases leading to a possible recession continue to roil equity markets globally. As a result, we’ve seen contraction in valuation multiples: Next-twelve-months (NTM) price-to-earnings (P/E) for the S&P 500 is now 17.1x, compared with 19.7x at the end of March and 21.5x at the start of the year.

The decline in the Nasdaq composite aggregate valuation is even more dramatic, down to 23.3x from 31.6x at the start of the year. Both indices are now valued below their five-year averages on an NTM P/E basis.

Despite the uncertainty, consumer demand is staying resilient, bolstered by elevated wages, plentiful jobs and higher-than-normal savings. The demand for goods and, increasingly, services is spurring business investment as companies take steps to add capacity and optimize their supply chains to meet demand.

Earnings continue to grow: With more than 90% of companies in the S&P 500 reporting first-quarter earnings, they are now tracking to 12.4% year-over-year earnings-per-share growth for the quarter. That increase is 36% higher than the 10-year quarterly average, which we view as a positive indicator for the U.S. economy.

Margins have held up better than expected, and are down just 2.9% year over year, with seven out of 11 sectors providing upside. Value and Growth styles have both posted similar revenue growth, 13.8% and 13.5% respectively, yet Value is outperforming earnings by 270 bps.

Chart: S&P Quarterly Earnings per share - percentage growth year on year

With fundamentals of strong consumer demand, a robust job market, higher wages and continued corporate earnings growth, we do not believe the U.S. will see a recession in 2022. Median projections anticipate that the Fed can engineer a soft landing, with core inflation falling to 4.1% at year-end and 2.4% in 2023, and the unemployment rate staying steady around 3.6%.

We are less optimistic about inflation coming down to those levels, with CPI and PPI remaining very hot and wages and rents continuing to be elevated; these are the stickier parts to inflation. As for the Fed’s success for a soft landing, that’s a hard call given its track record — since the 1930s, the Fed’s ability to produce a soft landing is just 10%. This means that in the past 11 rate increase cycles, eight ended in (at least a mild) recession, according to data from Merion Capital.

In my portfolio right now, I’m taking advantage of lower valuations to find quality companies on sale. This is not the time to take big sector bets; I’m being highly selective, seeking high-quality companies that hold top positions in their industries, have solid earnings, strong balance sheets, robust cash flow and the ability to pass on higher input costs. Share buybacks and dividends are also an important metric.

The Fed Is Data-Dependent, and So Are We

Consumer demand represents 70% of GDP, and a strong job market plays an important role in supporting consumers’ ability to spend. The U.S. has more job openings than unemployed people. Job openings hit 11.5 million on the last business day of March, the highest level since the Job Openings and Labor Turnover Survey (JOLTS) series began in December 2000.

We currently have 5.9 million unemployed, according to the latest nonfarm payroll report. Labor-force participation is still below pre-pandemic levels, with an unemployment rate at 3.6%. Last month, the U.S. saw notable job growth in leisure and hospitality, manufacturing, transportation and warehousing.

The first-quarter GDP report showed signs that consumer demand is strong despite rising prices. While the headline rate declined versus Q4, when you strip out inventories and next exports, underlying consumption was strong, led by services. Personal consumption expenditures were up 2.7%, and services were up 4.3%. Business investment was the highest since Q2 2020. Notably, final sales to domestic private purchasers accelerated (excluding trade, inventories and government spending), increasing 3.7%, compared with 2.6% in Q4.

The Fed’s challenge is to rein in inflation while protecting the labor market and averting demand destruction. Wage increases are fueling demand but are also one of the stickier parts of inflation. Unit labor costs in the nonfarm business sector increased 11.6% in the first quarter of 2022. Over the past 12 months, average hourly earnings increased by 5.5%, and compensation costs for civilian workers increased 4.5% year on year.

The consumer price index, meanwhile, accelerated 8.3% in April year on year, above expectations for an 8.1% increase. Producer prices soared 11% in April compared with 12 months prior. One of the Fed’s key indicators, the personal consumption expenditures (PCE) price index, increased by 6.6% for the year ended in March, the highest rate since January 1982, and outpacing the figure from February.

Do Your Homework When Picking Stocks

We can expect to stay in a choppy trading range until at least one, or some, of the uncertainties in the market are resolved — soaring inflation, the Ukraine war, the China shutdowns, slowing global growth and fears that Fed rate hikes will lead to recession.

Investors should note that we have just come through an extraordinary time. While the S&P 500 achieved a CAGR of 28% in the last three years, the long-term average is 10%. With expectations in check, we recommend upgrading portfolios to high-quality companies at attractive valuations. This is very much a stock-picker’s market where you need to do your homework.

In the last two months, I have sought to achieve balance in my portfolio while maintaining my barbell with both value/cyclicals and growth at reasonably priced companies. I believe in identifying the No. 1 player in an industry and buying at a discount, focusing on profitable companies with good balance sheets, free cash flow and strong management teams. Top of my list are companies with strong earnings that are addressing inflation through increased efficiencies and pricing power.

I currently favor diversified health care companies that fit my criteria, as well as the services side of the consumer — such as travel, leisure and hospitality — that will benefit from the momentum in the economy and pent-up demand for entertainment and experiences.

I also continue to like energy and financials. In addition, I have my eye on profitable technology companies that have been beaten down in recent market declines, and global tech services providers with strong digital transformation stories. Not on my list? Previously ‘hot’ stocks with no earnings.

American consumers are the most robust in the world. Let’s hope, this time, the underlying strength of the U.S. economy can withstand the tightening necessary to get us back on track.

Stephanie Link is chief investment strategist and portfolio manager at the national wealth management firm Hightower Advisors LLC. She leads the firm’s Investment Solutions Group, which specializes in outsourced chief investment officer services, model portfolios, separately managed accounts, investment research and due diligence for Hightower Advisors LLC. Follow Stephanie on LinkedIn and Twitter @Stephanie_LinkRead her regular market insights here.


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