Risk-reward on stocks edging into balance Risk-reward on stocks edging into balance http://www.federatedinvestors.com/static/images/fhi/fed-hermes-logo-amp.png http://www.federatedinvestors.com/daf\images\insights\article\stones-beach-stability-small.jpg June 28 2022 June 14 2022

Risk-reward on stocks edging into balance

Nearing level to leg back in but staying defensive as Fed attempts 'rocky landing.'

Published June 14 2022
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Last Friday’s nasty inflation print for May, following poor earnings reports from consumer discretionary and technology names the week before, has brought equities closer to a capitulation moment. Though the much watched-fear index, the VIX, has yet to break above our desired 40+ level, Monday’s 25% spike is impressive as a contrarian indicator. Other contrarian ammunition for the bull case includes near across-the-board liquidation, with everything except the very defensive stocks in Consumer Staples and Health Care down more than 3%, the widely reported “crypto carnage,” a 10% plunge in a popular tech-and-meme stock ETF to pre-Covid levels and a bond market finally ignoring Fed guidance and breaking decisively lower toward our 3.5% target on the 10-year Treasury. And one of our favorite contrarian indicators, the percentage of stocks closing trading at a new 4-week low, is close to a short-term buy signal.

While all of this is encouraging, we continue to advise near-term caution. Let’s review three market pluses and minuses as we enter the back half of June.

  1. Time is on the side of the bears. Virtually all near-news is still likely to get worse before it gets better. Inflation numbers are unlikely to break decisively lower till after the summer; Q2 earnings season, nearly upon us, is almost certainly going to lead to downgrades in full-year earnings expectations; and the Fed itself is only 75 basis points into what is likely to be a series of 50 to 75 basis-point hikes over its next three meetings, at least. So, time for sure is on the side of the bears for now.
  2. A number of self-correcting mechanisms could eventually award the bulls. As bad as the current day-to-day environment appears, we do think that by the back half of this year, several self-correcting mechanisms will begin to come into focus. The higher prices that are currently roiling everyone should themselves lead to a softening of consumer demand, overheated by the aggressive fiscal and monetary stimulus measures begun in 2020 and then mistakenly doubled down on in 2021. As more companies announce “hiring slowdowns” and eventually layoffs to address softening demand, wage pressures should ease considerably. Supply chain, Russia-Ukraine and China issues, all fueling the inflation beast, surely will get better in the back half. The overly hot housing market is already showing signs of slowing as higher mortgage rates and record-high prices begin to bite. So, inflation prints should begin to roll over later this summer, and that alone will be a big boost to equities.
  3. “Time” may be on the side of the bears, but “level” is getting much closer to being bullish. With Monday’s spike, Treasuries themselves aren’t far from the 3.5% target set several months ago. Our targeted S&P 500 level for beginning to unwind our defensive positioning has been between 3,600 and 3,750—again, not far off. We think at 3,600, the overall market represents good value, about 16 times our below-consensus S&P earnings forecast for this year, and 15x 2023’s. (As bad as everything seems right now, we expect nominal earnings on the S&P to experience only modest declines, even in a modest real GDP contraction, given that nominal revenues at least should get a boost from the high inflation that is upon us. We think of this “rocky landing” as “an economic recession with an earnings slowdown,” the opposite of recent periods of “economic slowdowns with earnings recessions.”) So, particularly for companies that sell things that people need rather than things that people want, earnings ahead should be OK even as the Fed plays catch-up.

Bottom line: We continue to advise caution as we enter the summer months. In our balanced macro models, we remain double-weighted in cash, overweight value stocks and underweight growth stocks and bonds. At a stock level, we continue to prefer big dividend payers in telecom, energy, pharma and consumer staples. For offense, we are selectively adding to value cyclicals including financials and industrials. We still think it is too early to add to growth stocks and to bonds.

Tags Equity . Inflation . Active Management .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Diversification and asset allocation do not assure a profit nor protect against loss.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

Growth stocks are typically more volatile than value stocks.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

Stocks are subject to risks and fluctuate in value.

There are no guarantees that dividend-paying stocks will continue to pay dividends.

Value stocks may lag growth stocks in performance, particularly in late stages of a market advance.

VIX: The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility.

Federated Global Investment Management Corp.