S&P 500 Down 5%, How Low or High Can It Go?
The stock market has rallied hard for a year now so this recent 5% pullback is relatively minor when you consider that the stock market has doubled since the lows of March 2020. The index was at 2,191 in March 2020 after the Covid 19 outbreak. The s&p 500 today is at 4,534.
The Federal Reserve put in place a ‘bazooka’ which basically underpinned the stock market, artificially keeping interest rates low and allowing risk assets to flourish.
Next week, the Federal Reserve will have a two day meeting and they will discuss the inflationary threat to the economy. Jerome Powell has already stated before congress that the word ‘transitory’ needs to be removed from the description of inflation and that they will need to consider increasing the ‘tapering’ process of asset purchases.
Some economists believe that the Federal Reserve is already too late and has made a serious misjudgement in policy. We know now that the Federal Reserve is changing its focus to the inflationary threat.
They will start with speeding up the ‘tapering’ process of asset purchases and then will look to interest rates. The yield curve has already started to flatten in the expectations that near term rates are about to go higher. Currently the markets are pricing in 2 rate hikes next year with a third not far off.
What does this mean for stocks?
Bearish View
- The valuation mechanism for stocks without a track record in profits and earnings will most likely get pummelled as investors use a discounting cash flow model to evaluate value. When the interest rate goes up the cost of capital goes up leading to lower valuations.
- The cost of borrowing goes up for companies which will lead to lower profit margins for companies refinancing debt at higher rates.
- Consumer demand weakens die to lower disposable income. This will have a negative impact for some stocks.
- The psychology of the Federal Reserve Put gets removed.
I would still be a buyer of (selected) stocks on market pullbacks. But broadly speaking the S&P 500 may have a bit further to fall.
Speaking of the broad market S&P 500, we can apply some maths to see where it may go. Looking at history if stocks simply revert to the mean we could see 17% come off the S&P 500 index.
S&P 500 would normally trade at 17 times earnings. Estimated EPS for S&P 500 stocks is $220. That would give a 2022 year end target price of 3,740 (17% lower from Fridays close) assuming EPS is $220.
This may not happen, it is impossible to tell but you as an investor should at least know how low the broad market index can go.
Bullish View
- It is hard to get very bullish with the current news flow but stocks will still be cheap relative to government bonds even with 2 rate hikes next year.
- The reopening trade …. beaten down stocks on the latest Covid 19 news could have a significant run up if the Omicron variant poses a lower risk than anticipated. Airlines and Leisure stocks may get a huge boost.
- The Santa Claus Rally – history shows that stocks tend to do well on the run into Xmas. The previous highs at 4,740 (5% higher) will be a clear target and then 5,000 (10% higher) behind that. However Interestingly enough, the last time stocks didn’t perform over he Xmas period was when the Federal Reserve raised rates by 0.25%!
In summary, expect relief rallies and big selloffs until we know more about what the Federal Reserve plans to do. Lots depends on how aggressive the Federal Reserve will be at tackling inflation.
There are still great value stocks out there and this recent selloff and future selloffs will create opportunities to buy them. Err on the side of caution for now and put some cheap insurance in play via Bear Puts for your portfolio.
Pick stocks wisely, look for value and be wary of companies with excessive levels of debt.
Happy Investing
Stephen