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Stephanie Link

Portfolio > Portfolio Construction > Investment Strategies

Finding Quality on Sale in an Uncertain Market

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What You Need to Know

  • Staying calm, focusing on quality and being selective will help value-seeking investors make the most of this part of the market cycle.
  • For investors with excess cash, securities are on sale, and there are pockets of opportunity across multiple sectors.
  • In the choppy market, defensive sectors such as health care, staples and utilities can be attractive.

With the S&P 500 down more than 21% year-to-date, investors are understandably concerned about current volatility, grim economic forecasts and an inflation rate that remains at 40-year highs. The Federal Reserve’s 75-basis-point rate hike on June 15 confirmed that the central bank is now scrambling to play catchup in its efforts to curb inflation.

While watching the market turn bearish has been difficult for advisors and their clients, it’s important to recognize that now is an opportunistic time to either invest or stay invested.

Staying calm, focusing on quality and being selective will help value-seeking investors make the most of this new, better risk-reward part of the market cycle. While the jury is still out as to whether the Fed can execute a soft landing, much uncertainty has been taken out of the equation now that the Fed has affirmed its aggressive rate-hike plan; higher rates and a slowing economy are now priced in.

For investors with excess cash, securities are on sale, and there are pockets of opportunity across multiple sectors. Valuations are now broadly below historic averages: Forward price-to-earnings for the S&P 500 is 15.5x, compared to 21.5x to start the year and well below the index’s five-year average of 18.9x.

We’re finding quality on sale and scrutinizing the economic data, particularly around consumer demand, to find areas of attractive growth in a slower economy.

Consumer Demand & the Macro Backdrop

While demand has shifted throughout the pandemic and into this year, so far it remains resilient. Second-quarter earnings will give us a bird’s-eye view into how both consumers and businesses are reacting to inflation and higher rates.

We do expect second-half earnings estimates to be broadly revised lower from the current upward-trending S&P 500 FY22 consensus of 10.5% year-on-year growth in earnings per share (10.5% y/y is higher than the historical average).

While demand has been strong and supply issues are getting resolved, the economic slowdown and the Fed’s tightening policy could lead to more revisions going forward. We also expect the strong dollar to be a headwind which has been confirmed from a few early earnings reports.

Despite 24 months of expansion in both services and manufacturing activity — as reported by the Institute for Supply Management (ISM), a leading indicator for the U.S. economy — the Fed projects the pace of U.S. economic growth to be below 2% through 2024.

While demand for goods accelerated during the pandemic, that demand has now shifted to services. Consumers are coming under pressure from both high inflation and rising rates, even as some supply-chain issues show signs of resolving.

We’re closely watching consumer-demand data to see if spending stays resilient. We believe it can, based on healthy household balance sheets, the strong job market and rising wages. This sets the stage for a soft landing but ignores two significant challenges in bringing down price levels: supply-chain issues and the stickier components of inflation.

The Fed does not have control over shortages related to supply-chain problems. It will continue to struggle to rein in costs for energy, materials, food, shelter and labor. Food and energy combine for over one-fifth of the consumer’s wallet share, while shelter costs represent roughly one-third. With widespread job availability and negative annualized productivity growth, wages are continuing to rise in tandem.

Sectors to Watch in a Choppy Market

We are currently favoring companies with strong pricing power and free cash flow in an environment where we believe inflation will remain elevated and supply chains will continue to be challenged.

Areas on our radar screen are energy, which has been a favorite for almost a year, and companies exposed to improved efficiencies in agriculture and the necessary capex cycle to address shortages.

We are being selective across all sectors where we invest. In the choppy market, we find low-beta defensive sectors — health care, staples and utilities — to be attractive.

Meanwhile, the significant pullback in valuations for high-quality discretionary, communication services and technology names offer opportunities to buy quality on sale. In financials, rising rates support higher interest income, and while investment banking activity has slowed, trading operations have been in high demand amid the volatility.

We advocate for a barbell approach that captures a variety of potential catalysts amid a choppy market. We also advocate for investors to remain calm, focused and stay invested. In each of the past four Fed tightening cycles, the S&P 500 ended higher one year later, with the S&P 500 median return +6.2%.

The Fed projects its target rate to be 3.4% by year-end, indicating roughly 175 basis points further in rate hikes this year. This rising-rate environment has negatively impacted the broad fixed-income and equity markets, but especially longer-duration growth assets.

Growth names, particularly non-earners, tend to be more impacted by rising rates and higher labor costs. We’ve advocated for investors to remain short duration, avoiding exposure to leveraged, long-horizon growth names, and capturing current income growth from companies with healthy balance sheets, pricing power and attractive shareholder return programs.

Reminding clients to stay focused on the long term is critical when the market turns bearish. According to Hartford Funds, stocks lose on average 36% in a bear market and, by contrast, gain 114% during a bull market.

Further, the length of a bear market tends to be just 9.6 months, while a bull market, on average, lasts 2.7 years. Bear markets have occurred roughly every 5.4 years.

It’s important to stay invested during these bear markets because half of the S&P 500’s strongest days in the last 20 years occurred during a bear market, while 34% of the market’s best days took place in the first two months of a bull market.

Timing the market is difficult and often unfavorable, since missing out on these best days is likely to have destructive effects on long-term compounded returns.

2022 has been challenging. At current valuations and with the prospect for greater economic clarity, now is the time to block out emotion, stay focused and seek opportunity.

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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