The Great Normalization
The S&P 500 struggled again in the second quarter, falling by more than 16% and leaving the index down nearly 20% for the year – its worst first half since 1962. While there are several reasons for the market’s poor performance, including rising inflation, Fed tightening, and fears of a recession, we think the overarching explanation is the unwinding of the Covid economy, a process that we call “The Great Normalization.” The pandemic created several distinct but related economic distortions, including excess liquidity, abnormally strong demand, and unusually low interest rates, and each one is in the process of finding a new equilibrium in real time.
For equities, the Great Normalization has triggered a sea-change in market valuations. Specifically, multiples for the S&P 500 have compressed from about 22x earnings at the beginning of the year to about 16x at the time of this writing. The most common reason offered for the unwillingness to pay a higher multiple on earnings is the rise of inflation and interest rates. On this point we agree. The laws of finance dictate that higher discount rates result in lower valuation multiples. While we do not see an end to the tightening cycle this year, with the market trading in-line with its 30-year average P/E, we suspect most of the damage from multiple compression has been done.
However, we do not think valuations are contracting solely due to rising rates, as some sectors have held up remarkably well, particularly consumer staples and utilities. In our view, rising risk premiums have also contributed (though not uniformly), likely due to concerns over both the direction of the economy and persistent geopolitical issues. Recall that as risk premiums rise, valuations fall, and vice-versa. With so much economic uncertainty hanging over the market, investors have understandably become more cautious and are only willing to accept higher multiples for less risky (i.e., less cyclical) stocks, which are generally perceived as safer in volatile markets.
As we approach the upcoming earnings season, the impact of risk premiums will become even more significant. Investors are rightly concerned about the combination of slowing demand and rising input costs. The economy clearly benefitted from the $3+ trillion of fiscal stimulus pumped into consumers’ pockets in 2021. The result was a forward pull of demand and an inelasticity to rising prices. In the wake of the depletion of stimulus checks and the increasing cost to fill a tank of gas, consumers are suddenly more sensitive to high prices and are pivoting away from discretionary items into staples.
We saw a preview of these factors during the earnings cycle in May when several big box retailers lowered their outlook due to rapid changes in customer preferences, excess inventory, and rising supply chain costs. Consumers were suddenly no longer interested in flat screen TVs, and in some cases were even trading down from full to half gallons of milk. Should these issues become evident more broadly across the economy, the earnings outlook for the remainder of the year is most certainly lower. Whether that happens, the degree to which it might happen, and whether much of that risk has already been discounted in the market all remain to be seen.
Looking out a bit further, we remain vigilant to signs of further slowing in the economy. It is generally viewed that Fed tightening cycles have a 12-18 month lag before affecting the economy. Given the more aggressive nature of this tightening, which is happening concurrently with an already slowing economy, we would not be surprised to see the impact of this cycle appear more quickly than in the past. Early signals bear this out. For example, we are already seeing a significant decline in mortgage applications caused by a near doubling of mortgage rates over the past six months.
Whichever direction the economy eventually takes, we remain committed to the idea that globalization is waning. Bloomberg recently reported that the number of reshoring/onshoring/ nearshoring mentions by companies more than doubled from a year ago, and the construction of new manufacturing facilities has increased 116%. This is an example of why we remain optimistic that a downturn will be shallow, but it also points to why the U.S. likely faces structurally higher inflation and interest rates compared to what we have become accustomed to since the Great Financial Crisis. This will likely provide a market-driven restraint to the valuation excesses we are recovering from currently.
All of this leads us to remain cautiously positioned, but we also see a rapidly expanding opportunity set. Because prospective returns are more favorable when the starting point is a lower valuation, we cannot help but notice the disparity between a company like Alphabet, a stock that trades at 16x next year’s earnings, where earnings are expected to grow by 66% through 2025, and Proctor & Gamble, a stock that that trades at 23x next year’s estimates and is expected to grow earnings by 30% through 2025. While we recognize that Alphabet’s earnings may be at more cyclical risk than P&G, it would appear that the market has already discounted much of this in current stock prices. Should there be no recession, or a mild one, then much of this discounting of equities would appear to be overdone.
The net of it all is despite the near-term challenges and market volatility, we are excited about what the future holds. We are seeing an increasing number of industry leaders with attractive valuations, and we are sharpening our pencils. The trick, as always, is “when,” and we will look at how stocks respond to the coming earnings season and economic reports for clues.
© Osterweis Capital Management
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