After the strong move in the equity markets last week, attention has turned from guessing how much lower stocks can go to guessing whether the rally can be sustained and by how much? The important point to keep in mind is both exercises are just guesses. No one has privileged access to the future, a future which involves what Keynes called irreducible uncertainty. No one knows how long the war in Ukraine will last nor what its outcome will be. No one knows how high inflation will go nor when it will begin to subside. No one knows if oil prices will stay over $100 or begin to decline or even double from here. No one knows how many times the Federal Reserve will raise rates nor what impact, if any, reducing its balance sheet will have on the economy.
What we do know is that the stock market operates as a real-time information processing entity that continuously incorporates the changing beliefs about the future into today’s prices. The value of all the companies in the market reflects investors' collective expectations of the future of the key macro and micro economic variables. The abrupt change from falling stock prices to then having the best week since November 2020, including spectacular increases in 3 days of 50% or more from the lows in many Chinese stocks, was the result of market-friendly comments from Chinese officials, coupled with a well-signaled and discounted Fed rate hike of 25 basis points and some hope of progress for a negotiated settlement in the Russian war on Ukraine. The rally was strong evidence that portfolios, particularly those of momentum investors and others with short time horizons, already reflected deep pessimism and were caught off guard when their expectations about incremental information proved wrong.
As investors assess the probabilities of different outcomes, they are confronting a regime change in the economy, in capital markets, and in geo-politics that most have not seen in their professional lifetimes. Headline inflation is the highest in 40 years, real interest rates are also the most negative they have been in decades underpinning strong and rising commodities prices, and the Fed has indicated they will do “whatever it takes” to bring inflation down. There is a war raging in Europe that few believed would occur and whose path so far has confounded those who thought Russia would secure a quick victory. Although it is in everyone’s interest to end that conflict, that does not mean it may not escalate to levels that would dramatically lower stock prices. If a solution can be agreed on in the relatively near future, then sharply higher stock prices would likely ensue. While the outcome is unknown, it appears the geo-political ramifications will play out over many years and not a few months.
Where does all that leave us? Even after last week’s move, stock prices remain down year-to-date, and I believe there are many good values in the market. I also believe that a strong US economy with low unemployment, plentiful jobs, rising wages, the strongest real growth in many years, and a Fed that has begun to raise rates makes it likely that a rotation to value stocks from the growth stocks that led the market for the past 10 years has begun. Other attractive areas in my opinion are energy (whose prices do not reflect oil even in the $70s, much less over $100), Chinese stocks (whose valuations appear too low, particularly when the government is easing and says it wants to help the market), financials (which mostly benefit from rising rates), housing stocks (whose valuations in the low- to mid-single digits do not reflect even a modest continuation of the current fundamentals), as well as travel related names such as airlines and cruise ships (which should see years of strong demand due to robust consumer balance sheets and a solid economy). Mega-cap tech leaders such as Amazon and Meta are also attractive. Finally, looking at a basket of names down 50% or more from their 52-week highs will likely uncover some long-term bargains.
March 20, 2022
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