Looking into the Non-Existent Crystal Ball
As we begin 2022, it may be helpful to remind oneself that stock prices are driven by earnings over the long-term, and by liquidity over the shorter-term. As one moves their time horizon from the short-term to the long-term, the “blend” of liquidity vs. earnings shifts proportionally, but almost never in a purely linear manner. In plain English -- either factor may assert itself in a somewhat random manner more or less than textbook fashion. Short-term earnings surprises may amplify stock price movements, as may changes in liquidity that cause supply/demand imbalances for shares.
Over the last year, both liquidity conditions and earnings have provided dual tailwinds for stock prices. The Fed has already signalled its intention to reduce the stimulative measures both in terms of “tapering” via reducing the rate of open market asset purchases, as well as starting to increase short-term interest rates starting in 2022. Meanwhile, the blistering pace of economic growth may continue, albeit with headwinds in the form of both inflationary pressures and more difficult year-on-year comparisons.
By many measures, broader equity markets (particularly US domiciled) are priced close to perfection. Valuation multiples across most averages remain near peak levels, leaving little margin for error. This amplifies the risk over the shorter-term, as corrections in equity prices are often a function of both earnings declines, but also a deflation in the earnings multiple, or price-to-earnings ratio. A company could deliver a 10% increase in earnings for example, but if the P/E multiple declines from 20 to 15, the return on that stock would be a negative 17.5%.
So what is an investor to do? As suggested in the title, we don’t believe in crystal balls - and would never admit we had one, even if that were the case! What we can do is tilt our investment strategy in a manner that anticipates such risks, and even has the ability to capitalize on opportunities within such scenarios. The following characteristics are currently embedded in client portfolios bases on the thoughts just discussed:
Underweight higher P/E areas of the market, overweight lower P/E sectors or “value-oriented” names
Overweight inflation-oriented assets: Treasury Inflation Protected securities (TIPs) and commodities as well as precious metals
Increased cash buffer, to take advantage of any near-term correction
A third factor that has been present is every major correction or bear market in recent history has been pervasive speculative behavior by individual investors. As the saying goes, “history doesn’t repeat, but it rhymes.” Day trading, crypto currencies, moon shots in meme stocks and pump-and-dump price action in SPACs are a few of the flashing red lights we continue to watch. It remains impossible to accurately predict when this latest party will come to an end, but as always we would prefer to check out early and preserve wealth so that we are positioned to take advantage of the bargains that inevitably appear and often usher in the next cycle of prosperity.
Douglas Beck, CFA
Tailwind Wealth Management