At a time when both die-hard bulls and die-hard bears are easy to find, I have somewhat conflicted feelings on both the market at-large and the tech sector in particular.
On the one hand, I think — after taking into account valuations, certain macro trends and various company and industry-specific growth drivers — many stocks today present attractive risk/rewards over the medium-to-long term.
On the other hand, I think — after taking into account the steep valuations that still exist for some assets and macro/monetary headwinds that still don’t appear to be fully appreciated by many — the markets are likely to see another washout start before the dust settles. If not in September, then in the next month or two.
Here are some reasons to be bullish about the long-term risk/reward that some stocks have shown so far, and some reasons to be bearish about what the market might do in the next few months.
Reasons to Be Bullish
1. Many Valuations Are Very Low Today (in Tech and Elsewhere).
According to JPMorgan’s Markets Guide, average P/Es for both small-cap value and growth stocks are now comfortably below their 20-year averages, with the latter around 30 % below its August 31 average.
Also, many stocks that are seen as cyclical (and thus considered particularly vulnerable to recession risks) have low P/Es. In tech, this group includes many chip stocks and online advertising plays, though many of these companies have long-term growth drivers that give them valuations similar to those of, say, companies of oil or banks that are highly questionable.
Finally, there are many inflated growth stocks (cloud software firms, Internet marketplaces, etc.) that hold forward EPS and/or EV/sales multiples that are lower than they used to be in 2017 or 2018.
2. Prices of Commodities and Goods are coming down
Perhaps due to a combo of a strong dollar, international macro headwinds (more on that later) and speculative trades unwinding, prices for oil, steel, aluminum, wheat, copper, lumber and various- other major commodities are now well off their recent highs.
In addition, prices for many consumer goods that have seen increased demand over the past two years are cooling. This includes used-car prices, which (although still relatively high compared to their pre-Covid trend line) have fallen since May.
If this continues, easing commodity/commodity inflation significantly improves the likelihood of a proverbial soft landing for the economy. Lower oil prices are especially important, given their impact on consumer confidence and inflation expectations.
3. The Economy Is Doing Better Than Many Feared
Although inflation is weighing on discretionary spending among low-income consumers, overall consumer spending (helped by a still-healthy consumer balance, a strong job market and wealth effects) is not so much hesitated.
Also, even though there have been some layoffs and spending cuts in sectors like tech and retail, some companies are still eager to hire and spend, as job opening data comes home.
Macro conditions could worsen from here — for example, if oil prices rise again or if macro issues abroad begin to have a greater impact on the US economy. But right now, things don’t look nearly as bleak as many feared a few months ago.
4. Executive Commentary Remains Moderately Positive
Following a better-than-feared earnings season, executives at Global 2000-type companies are often still cautiously optimistic about how business is trending.
Executives at banks and payments companies report that credit/debit card spending remains healthy overall. Also, although firms that provide discretionary consumer goods and services sometimes report seeing lower demand and trade-downs among lower-income consumers, they typically do not report that seeing a big drop in demand. And some have signaled that (amid lower oil prices and stabilizing equity markets) demand has improved over the past few months.
And within tech, commentary from execs speaking at the Citi and Evercore conferences taking place last week was decent overall. While there were cautious comments from companies with company-specific issues and/or exposure to softening consumer hardware markets, such as Intel (INTC) , Seagate (STX) and Corning (GLW), the mood is more upbeat among executives at companies like Microsoft (MSFT), Applied Materials (AMAT) , STMicroelectronics (STM) , ServiceNow (NOW) and Airbnb (ABNB) .
Reasons Why There May Be More Short-Term Pain
1. Many Large-Cap Valuations (in Tech and Elsewhere) Remain High
While indicating that small-caps are undervalued, JPMorgan’s Guide to the Markets also suggests that the average P/E for large-cap growth stocks was 22% above its 20-year average as of August 31 .
Within tech, one can still find steep valuations for companies with $10 billion-plus market caps in cloud software firms and EV/clean energy plays, as well as some smaller Internet and chip companies. Outside of technology, one can find several large-cap consumer staples, consumer discretionary, industrial and healthcare-sector companies that are likely to see single-digit earnings CAGR growth over the next few years, but nonetheless sport forward P/Es comfortably in the 20s, if not higher.
All of this brings to mind the action seen on “Nifty Fifty” in the late 1960s and early 1970s. Then, as now, a select group of large-caps seen as unassailable blue-chips became crowded trades and fetched rich valuations. And while history never repeats itself perfectly, it’s hard to ignore how Nifty Fifty valuations came crashing back down to Earth in 1973 and 1974, amid rising inflation and a tightening Fed.
2. Speculative Excess Remains
Meme-stock traders remain eager to gamble, as the recent frenzy involving AMTD Digital (AMTD) and Bed, Bath & Beyond (BBBY) hits home. The total market cap of cryptocurrencies remains over $1 trillion, with a large portion of that spread across dozens of altcoins. And following a series of short-squeezes, a fairly long list of stocks that are still very short sports odd valuations.
If we don’t get some sort of accounting for all this excess at a time when the Fed is burning instead of printing money, it’s going to be quite the plot twist.
3. Markets Seem to Underestimate the Stickiness of Labor and Services Inflation
Average hourly earnings rose 5.2% annually in August, according to the latest jobs report. And while such wage growth is positive for balance sheets and consumer spending, it also contributes significantly to inflation, particularly for labor-intensive services.
Importantly, there are reasons to think that labor/services inflation will not dissipate quickly, giving the Fed good reason to remain hawkish even as inflation cools elsewhere. While job openings remain above pre-Covid levels, the labor force participation rate for people aged 25-54 has returned to pre-Covid levels (the participation rates for in other age groups remains moderately low). Moreover, the growth rate for the working-age population has slowed significantly and productivity has fallen.
However, markets seem to be betting on high labor/services inflation not lasting long. The two-year breakeven inflation rate — this is a proxy for the market’s inflation expectations for the next two years, and is calculated by subtracting the yield for two-year inflation-protected Treasuries (TIPS) from the standard 2 -year Treasury yield – – remains low at 2.7%, even though annual CPI growth was at 8.5% in July and is widely expected to remain high through next spring.
Time will tell, but I think the market’s apparent belief that inflation will return to pre-Covid levels in the second half of 2023 may prove as wrong as its belief throughout much of 2021 that inflation will be short-lived. and does not require Fed tightening.
4. Quantitative Tightening (QT) is just getting started.
In June, the Fed began allowing up to $30 billion worth of Treasuries and $17.5 billion worth of mortgage-backed securities (MBS) to exit its balance sheet each month (by not reinvesting the principal payments it receives in debt). And by the beginning of September, those numbers had risen to $60 billion and $35 billion.
Rate hikes are likely to stop at the end of the year or into early 2023. But that’s because the Fed’s balance sheet still contains $8.8 trillion worth of assets — down slightly from April’s peak of $9 trillion and more well above the pre-Covid level of $4.2 trillion, Jerome Powell & Co. appear ready. which will slowly drain a lot of liquidity from the financial system…and in doing so create upward pressure for yields and curb investor risk appetite in equity markets and elsewhere.
5. China and Europe Present Macro Risks
Between the impact of the draconian Covid lockdown and the fallout from the gradual deflation of a giant real-estate bubble, China’s economy has seen better days. And while the widespread Covid lockdown may not last beyond October (when Xi Jinping is expected to secure a third term as President), the property-bubble unwind appears to have a ways to go.
And for the next few months at least, the electricity crisis in Europe is also a macro risk factor, even if (between potential government actions and the continent’s high savings rate) doomsday predictions look too much In the case of Europe, the impact of the region’s macro woes for US companies is not only related to weaker consumer and business spending, but the top-line impact of further declines in the euro relative to the dollar.
(MSFT and AMAT are holdings in Action Alert PLUS member club . Want to be alerted before AAP buys or sells these stocks? Learn more now. )
Get an email alert every time I write an article for Real Money. Click “+Follow” next to my byline in this article.