In our previous investment journal, we had discussed the possible baseline scenario of the S&P500 re-testing 3500 (14x on forward earnings, 12% possible downside from today’s S&P500 closing value of 3991), predicated on the concern that the Federal Reserve would be unable to engineer a “soft-ish” landing (in the words of FOMC Chair Jerome Powell). In this type of environment, which is starting to price in the early signs of a mild recession, we want to remind clients that it is ultimately quality, paired with attractive valuations, that always prevails over a full economic cycle, as we have seen from the 2008-2020 market cycle that ended with the pandemic. A few reminders to clients as we navigate this environment:
Markets are forward-looking in relation to the economy, by approximately 6-9 months. By the time a recession is known, it is conceivable that most stocks will have already staged a recovery, in anticipation of more accommodative monetary policy and the attendant recovery.
The US Federal Reserve, the main driver of monetary policy, has two mandates:
- Orderly price stability; and
- Maximum, full, inclusive employment.
Given the inflationary backdrop, the Fed has indicated it will raise the Federal Funds Rate by 50 basis points in June and 50 basis points in July (in addition to the 75 basis points already done). This would total 175 basis points of rate increases, taking us closer to the neutral Fed Funds Rate of 2-3%. If inflationary pressures abate in the second half of this year, and the excesses from demand dissipate, then it is conceivable the Federal Reserve could alter its policy stance to accommodate for a softening demand outlook.
Managing through a down-trending market requires a focus on relative valuation. Google, for example, trades at a valuation of 20x forward P/E and offers 5-year historical earnings growth of 31%, for a Price-Earnings to Growth (PEG) ratio of less than 1, compelling value. In contrast, consumer staple Proctor and Gamble trades at a forward valuation of 25x and offers 5-year historical earnings growth of 9%, for a PEG ratio of 2.8x. Comparatively speaking, assuming its growth is sustainable, Google offers better growth and value characteristics, despite the dislocation we find ourselves in. It is for this reason, Google (and not Proctor and Gamble) is one of our top portfolio allocations.
It was famed investor John Templeton who once stated: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” We believe equity markets continue to climb a wall of worry and that long-term investors will be rewarded for their patience and for the heightened volatility they are now experiencing.
We would like to redefine the word safehaven. A safehaven investment is one that protects against inflation during uncertain economic times, preserves purchasing power, and has business characteristics that are recurring and defensible in nature. We view US large cap technology as a safehaven investment because it sports all these characteristics (as described above in our relative valuation point) at compelling valuations. While we are prepared for further re-tests of equity valuations, primarily attributable to market multiple compression, we would also like to remind investors that risk is not the same thing as volatility. Volatility refers to price fluctuations that are often fleeting and can lead to opportunities, while risk represents the ability of the underlying business to earn above its cost of capital.
Finally, we liken this period to the 2015/2016 rate tightening cycle in which markets were initially down-trending due to the fear of higher interest rates, only to then reverse course in 2016 when it became known that the economy was on solid footing and that higher rates could be accompanied by robust growth. Our investment philosophy continues to identify and evaluate the secular winners that have business models which can prevail in both uncertain and economically prosperous investment climates.
We hope clients have found this piece informative and we welcome your comments.
Warmest regards,
Grace, Samuel, Leslie, Jennifer and Kim