For some, US Equities have been long held as overweight in portfolios. For Canadian investors, US equities have served as an avenue to diversify away from the TSX’s predisposition towards Energy and Financials and into multi-national leaders across the balance of sectors. Unfortunately, with a 20-30% drop in US indexes, investor sentiment has taken a toll. Coming off a dreadful year with low expectations, a much welcomed 6% rally in the SP500 began in January 2023. That said, at the time of this writing, the US market has already given back more than half of this gain and continues to throw doubt on what may lie ahead.
As the equity market proves to be in a transition period, false starts and head fakes may be common. Although markets have historically and reliably recovered from previous drawdowns, long-term investors must still contend with the chorus of Bears, who believe there may be another leg lower. This is not to imply that the Bears are destined to be correct, but rather, the Bulls need to be able to provide a counter as to why one could stay invested in spite of the bearish concerns.
Below we outline the bearish views. As you read below, ask yourself, why should each of these points not pull me to the sidelines? The most stable investors are those who can justify their bullish case while incorporating and responding to the bearish arguments. If you are unable to do so yourself, reach out to an advisor who may offer the perspective that could help you invest with reason and confidence.
The Case of the Bears
A Delay in a Fed Pivot
Earlier in the year, the market was anticipating rate cuts to occur before the end of the year, however, the recent hotter than expected data in retail spending, inflation, and labour have caused yields to rise and eliminated the prospects for cuts. Market participants have also hoped to see the US fed to at least take a pause in rate hikes by the spring, however, the yield market currently reflects an increased likelihood of another 75 bps of rate hikes between now and the June/July meeting. Taken all together, higher yields should continue to pressure the economy and markets.
Rates could Stay Higher for Longer
If core US inflation continues to be sticky, it is likely that the Fed will refrain from cutting rates but rather keep them at an elevated level for a longer period of time. This would impact corporate borrowing and limit business capital investment. Moreover, elevated rates would cut into corporate earnings, which are already in decline.
Unattractive Market Valuations
Even with the decline in prices, corporate earnings have also declined, which leaves PE ratios and valuations high. Hence, simply investing because markets are lower may still not justify stepping into stocks. The current consensus forward earnings are trading at 17.9x P/E, which is above the 20 year average of 15.7X. Inflation needs to be much lower in order to justify valuations at the high end of the historical range.
Pressure on Corporate margins and Earnings
Should the Fed continue to raise rates, the greater the risk of overtightening and tipping the economy into a recession. Any prolonged economic weakness would exacerbate an already declining earnings trend. Should a recession be avoided, investors must still contend with sectors like energy and financials, whose equity performance outperformed in 2022 but are now beginning to experience lower earnings revisions. Without support from yesterday’s heroes, earnings growth for 2023 should continue to remain weak. At this moment, the consensus forecast is for only a 2.2% YoY earnings growth with further downside risk if a recession materializes.
In our view, the case from the bears is both compelling and valid. Investors need to be able to contend with these points prior to investing in equities, otherwise, one’s confidence can be easily shaken in periods of volatility. Speak to your advisor if you need help interpreting the intimidating uncertainty of this market.