While valuation is generally not the best timing tool for maximizing short-term returns, it remains the most proven coincidental indicator of forecasting longer-term market returns. The chart below measures U.S. equity valuations on eight different metrics. Currently seven are flashing red with price to cash flow in the orange territory. Those that argue that index valuations remain attractive base their argument on relative valuations compared to depressed interest rates. With rates now heading higher, the conviction in this argument is waning.
Source: Strategas Research Partners
We have been arguing for some time that the main investment risk now lies where the weight is greatest – the mega-cap technology names. The correction in the most speculative segments of the market is well underway though it probably still has further to run. It will take a crack in the performance of the mega cap darlings before the indices record a significant decline given their historically high weighting. The graph below charts the valuation of the top eight constituents of the U.S. market. This group still commands a greater than 8x sales to market cap ratio (all-time high) and sells at close to 40x earnings. This earnings season will be crucial to their near-term prospects as it will require stellar results to just prop up current valuations. The +20% plunge in the shares of Netflix on Friday despite ‘decent’ results, is an indicator of the changing investor mood towards high expectation stocks in an environment of rising interest rates.
Source: Ned Davis Research
This valuation correction is commencing at a time when U.S. investors – retail investors at the very least – are already ‘all in’. The chart below, produced by Ned Davis Research and based on quarterly data from the Federal Reserve, shows that households in the U.S. have built their equity allocation to the highest level since this metric started to be measured in the 1950’s. The U.S. equity market is overvalued and over owned and, as such, extremely vulnerable to a correction.
Source: Ned Davis Research
We have shown the chart below on numerous occasions to highlight the growing internal weakness of the tech-laden Nasdaq index. Fewer and fewer names have been responsible for the index highs achieved since mid-2021. The percentage of stocks in an uptrend has deteriorated sharply in the first three weeks of 2022 and the index now stands -12% for the year and with less than 50% of its constituents in an uptrend.
Source: Bloomberg Finance
Economically, we appear at a crossroads. There is enough uncertainty about the durability of the recovery to wonder whether (or when) the market might begin to price in a late-2022 or early 2023 mid-cycle slowdown. Compounding matters is the uncertain path of short-term interest rates. There is little doubt now that both the Administration and the Fed recognize the need to tighten monetary policy to address the potential for persistently high inflation. The question now is the pace and the manner in which such tightening can and will occur. The expectation for a moderate and gradual increase in U.S. rates during 2022/2023 may prove optimistic if inflation readings do not moderate soon. The chart below measuring wage inflation in the U.S. will be a particularly important chart to monitor this year. The longer that wage inflation climbs higher, the greater the pressure that will be felt by authorities to become more aggressive in their monetary tightening.
Source: Strategas Research Partners
We do reside in the camp that holds that supply disruptions will eventually be worked through and that this will partially alleviate the inflationary pressures. However, as the anecdotal headlines below show supply disruptions are persisting and, in the current environment of strong demand, companies are not hesitating to push through price increases to protect their profit margins. The longer this persists, the more difficult the task of the Fed to stop inflation becoming entrenched in the more sticky areas of the economy such as wages and rents.
Source: Bloomberg Finance
Our base case for 2022 remains one of decent global economic and corporate profit growth. This should support the move higher in those equities which do not suffer from excessive valuations. Obviously we monitor very closely the rising risk to this base case. One of the important indicators that is raising a red flag to this outlook is the performance of the Consumer Discretionary sector which has outperformed consistently for so long and has correctly forecasted the strength of consumer spending. As the two charts below reveal, this outperformance has recently ceased and the sector now has the fewest % of stocks in a short-term uptrend (first chart). We suspect that the strength in Energy is finally starting to have a negative impact on discretionary spend. This relationship will need to be watched closely given the importance of consumer spending to the direction of global economic growth.
Source: Strategas Research Partners
Source: Bloomberg Finance
