At a time when both die-hard bulls and die-hard bears are easy to find, I have pretty conflicted feelings on both the market at-large and the tech sector in particular.
On one hand, I think — after taking into account valuations, certain macro trends and various company and industry-specific growth drivers — many stocks now present attractive risk/rewards over the medium-to-long term.
On the other hand, I think — after taking into account the steep-to-frothy valuations that still exist for some assets and macro/monetary headwinds that many still don’t seem to fully appreciate — markets will likely see one more washout commence before the dust settles. If not in September, then in the next month or two.
Here are a few reasons to be bullish about the longer-term risk/rewards presented by some stocks right now, and a few reasons to be bearish about what the market might do over the next few months.
Reasons to Be Bullish
1. Many Valuations (in Tech and Elsewhere) Are Now Pretty Low
Per JPMorgan’s Guide to the Markets, average P/Es for both small-cap value and growth stocks are now comfortably below their 20-year averages, with the latter about 30% below its average as of August 31.
Likewise, many stocks seen as cyclicals (and thus considered especially vulnerable to recession risks) sport low P/Es. In tech, this group includes many chip stocks and online advertising plays, even though a lot of these companies have long-term growth drivers that make granting them valuations similar to those of, say, oil companies or banks very questionable.
Finally, there are a lot of bombed-out growth stocks (cloud software firms, Internet marketplaces, etc.) that possess forward EPS and/or EV/sales multiples that are well below what they sported in 2017 or 2018.
2. Commodity and Goods Prices Have Been Coming Down
Perhaps due to a combo of a strong dollar, international macro headwinds (more on that later) and speculative trades unwinding, prices for oil, steel, aluminum, wheat, copper, lumber and various other important commodities are now well off their recent highs.
In addition, prices for many consumer goods that saw demand spikes over the last two years have been cooling off. This includes used-car prices, which (though still pretty elevated relative to their pre-Covid trend line) have fallen since May.
Provided it continues, easing commodities/goods inflation significantly improves the odds of a proverbial soft landing for the economy. Lower oil prices are especially important, given their impact on consumer confidence and inflation expectations.
3. The Economy Is Doing Better Than What Many Previously Feared
While inflation has weighed on discretionary spending among lower-income consumers, total consumer spending (aided by still-healthy consumer balance sheets, a strong job market and wealth effects) hasn’t wavered too much.
Likewise, though there have been some layoffs and spending cuts in sectors such as tech and retail, quite a few companies are still eager to hire and spend, as job-opening data drives home.
Macro conditions could deteriorate from here — for example, if oil prices surge again or if overseas macro issues begin having a bigger impact on the U.S. economy. But for now, things aren’t looking nearly as bleak as what many feared a few months ago.
4. Executive Commentary Remains Fairly Positive
Following a better-than-feared earnings season, execs at Global 2000-type firms still often sound cautiously optimistic about how business is trending.
Execs at banks and payment companies report that credit/debit card spending remains healthy overall. Likewise, though firms providing discretionary consumer goods and services sometimes report seeing lower demand and trade-downs among lower-income consumers, they typically haven’t reported seeing a huge drop-off in demand. And some have signaled that (amid lower oil prices and stabilizing equity markets) demand has improved over the last couple of months.
And within tech, commentary from execs talking at the Citi and Evercore conferences taking place over the last week was decent on the whole. While there was cautious commentary from firms with company-specific issues and/or exposure to softening consumer hardware markets, such as Intel (INTC) , Seagate (STX) and Corning (GLW) , the mood was more upbeat among execs at companies such as Microsoft (MSFT) , Applied Materials (AMAT) , STMicroelectronics (STM) , ServiceNow (NOW) and Airbnb (ABNB) .
Reasons Why There Could Be More Short-Term Pain
1. Many Large-Cap Valuations (in Tech and Elsewhere) Remain Elevated
Though indicating small-caps are undervalued, JPMorgan’s Guide to the Markets also suggests the average P/E for large-cap growth stocks was 22% above its 20-year average as of August 31.
Within tech, one can still find steep valuations for firms with $10 billion-plus market caps among cloud software firms and EV/clean energy plays, as well as among a handful of Internet and chip companies. Outside of tech, one can find quite a few large-cap consumer staples, consumer discretionary, industrials and healthcare-sector companies that are likely to see single-digit revenue growth CAGRs over the next few years, but which nonetheless sport forward P/Es that are comfortably in the 20s, if not higher.
All of this brings to mind the action seen in the “Nifty Fifty” in the late 1960s and early 1970s. Then as now, a select group of large-caps seen as unassailable blue-chips became crowded trades and obtained rich valuations. And while history never perfectly repeats, it’s hard to ignore how the Nifty Fifty’s valuations came back to Earth in a hurry in 1973 and 1974, amid soaring inflation and a tightening Fed.
2. Speculative Excess Remains
Meme-stock traders remain eager to gamble, as the recent craziness involving AMTD Digital (AMTD) and Bed, Bath & Beyond (BBBY) drives home. The total market cap of cryptocurrencies remains above $1 trillion, with a large chunk of it spread out among dozens of altcoins. And following a barrage of short-squeezes, a pretty long list of heavily-shorted stocks once more sport outlandish valuations.
If we don’t get any kind of reckoning for all this excess during a time when the Fed is burning rather than printing money, it would be quite the plot twist.
3. Markets Seem to Underestimate the Stickiness of Labor and Services Inflation
Average hourly earnings were up 5.2% annually in August, per the latest jobs report. And while such wage growth is a positive for consumer balance sheets and spending, it’s also contributing heavily to inflation, particularly for labor-intensive services.
Importantly, there are reasons to think labor/services inflation won’t go away quickly, which in turn gives the Fed a good reason to stay hawkish for a while even if inflation cools off in other areas. While job openings remain well above pre-Covid levels, the labor-force participation rate for people aged 25-54 is back to pre-Covid levels (participation rates for other age groups remain moderately below). Moreover, the growth rate for the working-age population has slowed sharply and productivity has fallen.
Markets nonetheless seem to be betting high labor/services inflation won’t last long. The two-year breakeven inflation rate — it’s a proxy for the market’s inflation expectations for the next two years, and is calculated by subtracting the yield for two-year inflation-protected Treasuries (TIPS) from the standard 2-year Treasury yield — remains below 2.7%, even though annual CPI growth was at 8.5% in July and is widely expected to remain high at least until next spring.
Time will tell, but I think the market’s apparent belief that inflation will be back around pre-Covid levels by the second half of 2023 could prove as misguided as its belief during much of 2021 that inflation would be transitory and require no Fed tightening.
4. Quantitative Tightening (QT) Is Just Getting Started
In June, the Fed began allowing up to $30 billion worth of Treasuries and $17.5 billion worth of mortgage-backed securities (MBS) to come off its balance sheet each month (by not reinvesting principal payments it receives on the debt). And at the start of September, those numbers were respectively upped to $60 billion and $35 billion.
It’s possible that rate hikes will stop by year’s end or in early 2023. But with the Fed’s balance sheet still containing $8.8 trillion worth of assets — down just slightly from an April high of $9 trillion and far above a pre-Covid level of $4.2 trillion, Jerome Powell & Co. look poised to gradually drain a lot of liquidity from the financial system…and by doing so create upward pressure for yields and curb investor risk appetite in equity markets and elsewhere.
5. China and Europe Present Macro Risks
Between the impact of draconian Covid lockdowns and the fallout from the gradual deflating of a giant real-estate bubble, China’s economy has seen better days. And though it’s possible extensive Covid lockdowns won’t last beyond October (when Xi Jinping is expected to secure a third term as President), the property-bubble unwind appears to have a ways to go.
And over the next several months at least, Europe’s electricity crisis is also a macro risk factor, even if (between potential government actions and the continent’s high savings rates) doomsday predictions look overdone. In Europe’s case, the impact of the region’s macro woes for U.S. companies isn’t merely related to softer consumer and business spending, but the top-line impact of additional declines in the euro relative to the dollar.
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