Broker Check

Changing Landscape, Altered Forecast

| May 16, 2022

Planning is important. But it’s also worth remembering that plans are rarely set in stone. And when circumstances change, sometimes adjustments are needed.

Heading into 2022 we set our projections for the stock market thinking the S&P 500 would sit around 5,250 for the year and the Dow Jones Industrial Average would be around 40,000. This was based on our capitalized profits model, which takes the government’s measures of economy-wide corporate profits and discounts them by our 10-year Treasury note yield expectations to determine fair values for stocks.

Given the recent surge in long-term interest rates, the model has shifted. Our capitalized profits model now indicates that the U.S. stock market is fairly valued for the first time in more than a dozen years.

It’s critical to remember how the 10-year Treasury yield finished 2021 around 1.5%. At that time, we used a 2.5% yield to discount profits and determine our projections. Using that 2.5% yield suggested the fair value of the S&P 500 was that projected 5,250.

But as we sit here currently, the vicious selloff in the bond market has pushed the 10-year Treasury yield to roughly 3.1%:

And it’s sent bonds tumbling even further:

So, using the current 10-year yield of 3.13 (as of this writing) and fourth quarter profits suggests the S&P 500 at 4,100 is approximately fair value. Just to be clear though, our capitalized profits model is not a trading tool. When we say the market is valued fairly, that means there is an equal chance that it goes up or down in the future.

Stock markets at fair value should be expected to rise over time as long as corporate profits rise as well. This earnings season gives us some level of comfort that the market has a better chance to increase through the end of the year, even taking into account the current fair market valuation.

As we near the end of this earnings season, according to FactSet, 87% of the companies in the S&P 500 have reported actual results, and of those companies, 79% have reported actual earnings per share greater than analyst estimates. That’s better than the five-year average of 77%.

Additionally, FactSet said analysts expect earnings growth of 4.8% for the second quarter, 10.6% for the third, and 10.1% for the fourth. This earnings outlook helps provide confidence that markets will gain more than normal based on where they are at current fair value.

Beyond earnings, there is more data to support markets going up rather than down to finish out 2022.

First, investors are already pricing in a recession for this year or early 2023, though we don’t see one starting that soon given that current Federal Reserve policy is still quite loose. This is a classic swell of worry that can help boost stocks because the bad news in the near term is already over-priced in.

Second, it's clear some investors are concerned about a wider war in Eastern Europe. However, we think there's a greater chance the Russia/Ukraine war will be contained without a widening of the conflict throughout the rest of Europe.

Lastly, from a domestic political standpoint it appears the stars are aligned for large Republican gains in the House and Senate. While Republican wins are definitely not always good for equities (far from it), a GOP Congress creates a divided government. And as we all know, gridlock is good for markets:

Putting it all together, we think there's a recipe for a rally into year-end with the S&P 500 ending the year at 4,900 and the Dow at 39,000. Even with everything going on, actual equity fundamentals remain strong especially after the recent selloff.

And while that projection would be something for equity investors to enjoy, it's not a reason to become complacent. If the Fed ends up tightening too much, we could fall into a recession (i.e.- a “hard landing”), which would shift the investment outlook again.

The Uncertainty Cure

The true issue for investors today is uncertainty. It creates fear and can usher in hasty decisions. The CBOE Volatility Index ($VIX), a measure of market volatility (higher $VIX value = more volatility), is reflecting the current situation:

We’re seeing it too in MAPsignals’ trusty Big Money Index (BMI), which tracks “big money” investors like institutions. It has nosedived:

The BMI slide is easier to understand when you look at the highly aggressive selling, especially over the last few days (see far right of the below chart):

This is uncertainty at work. But remember, this will pass (only to give way to new ambiguity). That’s why having a plan as an investor is so important.

From an investment perspective, there are some things to know so you can navigate through what’s happening right now.

Holding cash in a highly inflationary environment is a surefire way to lose buying power. Similarly, buying bonds at current rates will lead to negative real returns.

Investors who lean conservative in terms of risk tolerance should focus on dividend growth stocks, which tend to be strong, cash-positive firms. This strategy generates income and can preserve capital relative to riskier plays. It offers opportunities for capital appreciation too.

Longer-term investors who are willing to take on more risk should seek beaten-down stocks of profitable companies with solid cash flows, low debt, and demonstrated growth in sales and earnings. The technology sector is one such pond to fish in right now.

Regardless of your appetite for risk, perhaps the most important thing to do is set up an investment strategy where interest rates, sector technicals, and other fleeting measures do not carry significant weight when making investment decisions. A solid plan helps take the worry out of the equation.

Why does that matter?

Because worrying doesn’t generate wealth. But what does have a good chance of creating wealth is enacting a stable investment plan, adjusting as needed, and being consistently disciplined over time.

Securities sold through CoreCap Investments, LLC.  Advisory services offered by CoreCap Advisors, LLC.  Cornerstone Financial and CoreCap are separate and unaffiliated entities.