Call us 'cautious bulls'

Following our market memo of last week, where we outlined some of the higher-than-normal uncertainties ahead for investors (i.e., the Ukraine War outcome and whether the Fed will achieve a “soft landing” or instead provoke a recession), many readers wondered about our year-end outlooks for this year and next. The short answer: both have been lowered, with a wider-than-normal range around the targets than we previously had. 

The reason: even in our base-case scenario (the Fed nails the soft landing and the war grinds to at least a lower decibel level), raging inflation that’s being further exacerbated by the conflict is adding to margin pressure on stocks. This was behind our decision last week to modestly pare S&P 500 earnings growth forecasts to $220 and $250 this year and next, respectively, from the previous $230 and $260. With the war making inflation worse, we also think the Fed will have to ramp up the number of hikes it makes this year, pushing our year-end projection for the 10-year Treasury yield to 3.0% from 2.5%. This, and rising risks of either a Fed mistake or an unexpected re-escalation of the war, means the ongoing compression on stock valuations is likely to continue. When we add this all up, out macro team sees the S&P rising only modestly from here, to 4,800 by the end of this year and 5,100 by year-end 2023.  

Though the implied returns in stocks are even lower single digits than our previous targets (5,300 and 5,500, respectively, this year and next), we do think stock returns will prove more positive than bonds. Thus, we are maintaining a modest equity overweight, though we have trimmed positions in our PRISM® model three times in the past seven months. The latest came last week, lowering our equity position to 57%, 3 points above neutral or 30% of the allowable maximum overweight of 64%.

We used each reduction to take profits and raise cash. As noted last week, the model’s overweight effectively is a three-part barbell of defensive value stocks, whose earnings should hold up even in a higher inflation/lower growth environment; cyclical value stocks, where many names we like are off 20% and we think are over-discounting the risk of recession; and easy-to-deploy cash, which remains preferable to bonds in this environment and stands at an overweight 6%, double its neutral 3% weight. 

The quarter ahead will be interesting. A lot of bad news already has been factored in, but it’s hard for us to conceive of better news coming. Inflation numbers keep getting worse, estimates of Fed hikes ahead continue to climb and we expect that margin guidance will be hard to come by as companies themselves face a more uncertain backdrop. Though not forecasting another correction near term, we are comforted to hold extra cash in this cloudier-than-usual environment. We’d look to review our cash overweight again if a correction does occur or, alternatively, if something unexpectedly good happens. We could get that via a rollover in the inflation prints and/or a sudden announcement of a peace deal in the Ukraine. We’ll see. 

In the meantime, we think investors need to set their expectations for more muted equity returns over the next two years, and to set their investment allocations accordingly. There are times to be a raging bull, times to be a cautious bull, and even a few times to be a growling bear. For now, call us cautious bulls. Given the long-term odds of success in stocks, that’s still better than the last alternative.