- The steep drop in the S&P 500 this year suggests that stocks might be ‘cheap’
- But, in fact, it’s still not easy to find value, while corporate earnings offer another source of risk
- Investors should stay cautious in 2023, focusing on quality and valuation
There’s an old adage about stocks climbing a “wall of worry.” The basic — if inexact — argument is that equity prices can keep rising as long as there are skeptics in the market. After all, those skeptics can be converted to new buyers, providing fuel for a continued rally.
It’s when everyone is bullish that investors need to worry. At that point, there’s simply no one left to buy.
2022, in contrast, seemingly has seen stocks fall down a “wall of worry.” At the beginning of this year, there was a pretty obvious bear case out there.
Valuations went haywire in 2021 amid the boom in SPACs, crypto miners, electric vehicle manufacturers, and other speculative names. The Federal Reserve started the year with a hawkish tone, though, admittedly, very few investors predicted the Fed would raise its key interest rate seven times. Macroeconomic risks were building, with inflation creeping up and a potential hangover from a stimulus-boosted 2021.
Yet, commonly, one of the arguments against being too bearish was precisely that everyone else seemed to be bearish. The case for a steep decline in U.S. equities was easy to make — and perhaps a little too easy.
With 2023 at hand, the bear case isn’t quite as simple as it was 11 months ago. But that bear case still is worth paying close attention to. 2023 probably should be a better year than 2022, but that’s not the same as saying that it will be a good year.
Anchoring Bias
One of the biggest mistakes investors made in 2022 was buying stocks that seemed “cheap” simply because they had fallen significantly. In May, we talked about this risk in the context of Coinbase Global (NASDAQ:COIN). Since then, Coinbase has become an example of the old joke about how a stock falls 90%: it drops by 80% and then by half.
That risk, known as anchoring bias, seems to hold looking at the market as a whole entering 2023. Stocks are down big time — but they’re not cheap. Again, it’s abundantly clear that the market lost its fundamental moorings last year.
Looking forward, the S&P 500, based on consensus estimates, trades at about 17x forward earnings. That’s a reasonable but hardly compelling multiple, particularly given the number of downside risks to corporate profits in 2023. Indeed, estimates for this year have been coming down for some time now.
Corporate Profit Margins
It’s not just a matter of near-term threats like higher Fed rates or a recession. Those factors aren’t that important when taking the long view. Rather, the big concern is not that corporate earnings fall because of, say, a mild recession but that they fall because they return to normal.
Corporate profit margins sit at their most elevated level in 70 years. Even in a highly inflationary environment, U.S. corporations have been able to pass along most of their increased costs to end customers. To this point, at least, consumers have been mostly willing to put up with those increases and keep spending.
At some point, that’s going to change. And if and when the market prices in more normalized margins, that alone can drive further downside. Assuming margins return to pre-pandemic levels, the S&P 500 would be trading at over 20x expected earnings.
Too Many Risks
That’s a multiple that prices in relatively smooth sailing and multi-year profit growth. Neither seems guaranteed or even necessarily likely.
U.S. multinational corporations are dealing with a significantly stronger dollar. The worst of the impacts will be lapped this year, but in-country rivals get a competitive edge from booking their own results in local currency. Supply chain problems worldwide are easing but still not fixed. Recession looms over key international markets, and at some point, the U.S. consumer seems likely to give way as well.
It’s simply difficult to look at the macroeconomic environment with fresh eyes and see U.S. stocks as compelling. The market is cheaper, yes — but not cheap by any reasonable fundamental measure. Risks abound. Sentiment doesn’t seem to signal a bottom, either: we still have not seen the typical “capitulation” that marks a true, multi-year base from which equity markets can bounce.
All told, there’s still an awful lot of risk out there. That doesn’t mean investors need to stay on the sidelines; it certainly doesn’t mean investors should short major indices.
Instead, it simply means that 2023 is going to be a challenging year; one that requires solid analysis, nimble trading, and patience. It seems unlikely that the broad market is going to do the heavy lifting.
*Happy Holidays to all!*
Disclosure: As of this writing, Vince Martin has no positions in any securities mentioned.