Moderating Valuations - Deploying Capital

Recent Turbulence

Inflation, interest rate hikes, employment, Federal Reserve taper, new omicron pandemic backdrop, Washington wrangling, supply chain disruptions, and travel restrictions are culminating and resulting in the current market swoon. September saw a 4.8% market drawdown for the S&P 500, breaking a seven-month winning streak. November saw negative returns, and thus far, December is off to a bad start. Prior to the September meltdown, stocks were very overbought and at extreme valuations as measured by any historical metric. Heading into September, valuations were stretched across the board, with the major averages at all-time highs and far away above pre-pandemic highs.

The recent two-week stretch over the November/December transition was met with heavy and vicious selling. Valuations have moderated overall and cooled investor enthusiasm, especially in the more speculative momentum stocks in cloud software, SPACs, and recent IPOs. The technical conditions (RSI and Bollinger Bands) are shaping up for a strong relief bounce that may coincide with the infamous Santa Claus rally. The tremendous volume of selling has inflicted damage across the board, indicating that valuations do, in fact, matter after all. Many opportunities are presenting themselves, and being too bearish may prove ill-advised over the long term.

Vicious Selling

As of the beginning of December, a third of the S&P 500 is off at least 15% from its high, and nearly one in eight Nasdaq stocks logged a new 52-week low. Furthermore, the CNN Money Fear & Greed Index, a composite of market-based indicators that gauge risk appetite across stocks, bonds, and options, dropped to its 2021 lows, seen during previously equity pullbacks. It has only tended to plunge below this when the market is in near-crash mode, such as December 2018 and March 2020.

As such, financial technology, certain software stocks, e-commerce apps, fading trends, sports-betting plays, and stay-at-home plays have been absolutely decimated by 20%-50%-plus. PayPal (PYPL), Visa (V), Square (SQ), Robinhood (HOOD), Docusign (DOCU), Peloton (PTON), Beyond Meat (BYND), and Twitter (TWTR), to name a handful of stocks in this bucket.

Deutsche Bank noted, "The equity sell-off since last over the two-week November/December transition remained modest, in keeping with regular 3-5% pullbacks that have occurred every 2-3 months historically. However, this was accompanied by the sharpest weekly decline in equity positioning since the collapse back in March 2020 at the beginning of the pandemic."

In general, when overall earnings are expanding, so far, consensus for 2022 is for 8.8% growth, stocks tend not to suffer deep and lasting downturns. The first hike tends not to end a bull market. Years when the S&P 500 has been strong heading into November typically add to gains, and that fourth-quarter seasonal tailwinds tend to blow unless financial conditions are tightening. I think markets are over-reacting to the omicron backdrop, and stocks are primed for a bounce after this excessive sell-off.

Deploying Capital

For any portfolio structure, having cash-on-hand is essential. This cash position provides investors with flexibility and agility when faced with market corrections. Cash enables investors to be opportunistic and capitalize on stocks that have sold off and become de-risked. Initiating new positions or dollar-cost averaging in these weak periods are great long-term drivers of portfolio appreciation. Many household names are off 10%-50% from their 52-week highs. Even the broad market indices such as Dow Jones (DIA), S&P 500 (SPY), Nasdaq (QQQ), and the Russell 2000 (IWM) are significantly off their 52-week highs. As a result, buying opportunities have been presented, and deploying some of the cash-on-hand is prudent. During these correction/near correction periods in the market, putting cash to work in high-quality long equity is a great way to capitalize on the market weakness for long-term investors. Absent of any systemic risk, there's a lot of appealing entry points for many large-cap names. Don't be too bearish or remiss and ignore this potential buying opportunity.

The Negative Sentiment

Supply chain disruptions, specifically in the shipping channels, have led to rising freight costs that have escalated shipping costs dramatically for many companies. They include not only freight but also higher labor costs, rising demand for transportation and products, plus shortages in computer chips, oils, and chemicals, and higher commodity prices.

The Federal Reserve indicated that the central bank is likely to begin withdrawing some of its stimulatory monetary policies before the end of 2021. This pivot in monetary policy by the Federal Reserve sets the stage for the initial reduction in asset purchases and downstream interest rate hikes. As this pivot unfolds, risk appetite towards equities hangs in the balance. The speed at which rate increases hit the markets will be in part contingent upon inflation, employment, and of course, the pandemic backdrop. Inevitably, rates will rise and likely have a negative impact on equities.

Conclusion

Inflation, interest rate hikes, employment, Federal Reserve taper, new omicron pandemic backdrop, Washinton wrangling, supply chain disruptions, and travel restrictions are culminating and resulting in the current market swoon. Prior to September, these markets were at frothy levels as assessed by any historical metric. As of the beginning of December, a third of the S&P 500 is off at least 15% from its high, and nearly one in eight Nasdaq stocks logged a new 52-week low. Furthermore, the CNN Money Fear & Greed Index dropped to its 2021 lows; it has only tended to plunge below this when the market is in near-crash mode, such as December 2018 and March 2020.

During these correction/near correction periods in the market, putting cash to work in high-quality long equity is a great way to capitalize on the market weakness for long-term investors. For any portfolio structure, having cash-on-hand is essential. This cash position provides investors with flexibility and agility when faced with market corrections. Cash enables investors to be opportunistic and capitalize on stocks that have sold off and become de-risked. As investors grapple with the prospect of downstream rate increases, pockets of vulnerabilities throughout the market have been exposed and present buying opportunities via deploying cash-on-hand within your portfolio structure.

Noah Kiedrowski
INO.com Contributor

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