By Kelvin Lee, Alonso Munoz
On August 22, 2022, we called the end of a bear market rally after a ~20% increase in equity markets. Since then, the S&P 500 has fallen 25%, breaking through the June lows. So, the question on everyone’s mind is: how much further can we go?
Ok, bad news first. The macro environment isn’t hospitable right now, driven mainly by a stubbornly hawkish U.S. Federal Reserve. Unemployment is still at a low 3.5%, while core inflation continues to rise. That triggers the Fed’s dual mandate requirements, allowing them to tighten and continue raising rates toward our 4.5-5% target (see our last call here). Based on their last dot plot, expect another 75bps hike in November. The balance sheet continues to run off and, until we hit a liquidity event like what the BOE just experienced, the fed won’t be pivoting. OPEC has also cut oil production, forcing a $90 per barrel floor which is going to be reflected in future headline inflation prints. On the S&P500, our fair value model shows more downside. Analysts are anticipating 3% EPS growth for Q3, which is substantially less than the 9% figure in May. We are concerned that longer duration mega caps still have elevated valuations compared to the indices and the rest of their constituents. When these mega caps report earnings at the end of the month, we can expect severe movements in these stocks.
And the good news? We don’t have much more downside to go (knock on wood). Our model anticipates another 6-8% drawdown in equity indices before bottoming. The markets are already expecting a hawkish rate hike path, so any pivots or dovish stance by the Fed could lead to a risk asset rally. And on a broad range basis and with a longer time horizon, we are already in attractive territory to start entering the market. This is a rare and opportune moment for new investors or money on the sidelines. While the indices may be down, individual quality names are trading at significant discounts. Issues such as dollar strength doesn’t affect a majority of the non-multinational companies in the index. It’s often the case that the thousands of derivative products are further exacerbating the downside for stocks, rather than the company’s actual performance. PepsiCo is a good example. The company released financials last Wednesday and posted positive EPS, revenue, and margin numbers.
The more than 10% fall in share price since August was a result of yields and inflation rather than the company’s ability to pass costs to consumers or its financial stability. We believe the latter is a more important metric in evaluation. We are entering a historically positive season for the market, and while it is likely that the nauseating volatility will continue, we will be tracking our portfolio companies closely as earnings season kicks into high gear this week.
To contact the author of this story:
Kelvin Lee at kelvin@hamiltoncapllc.com
To contact the editor responsible for this story:
Alonso Munoz at alonso@hamiltoncapllc.com
