“2022’s selloff is a valuation story so far, but if profits decline, it’ll be more than that.”
Said a wise man, on Wednesday.
That man was me, and I’d note that whatever wisdom I can legitimately lay claim to was hard-won, the product of a yearslong battle with myself. When it comes to impeding personal progress, I was a worthy adversary.
Self-deprecating humor aside, I do know some things by now. That happens if you survive long enough. One thing I know in 2022 is that, if wage pressures in the US economy don’t abate and input prices stay elevated, the only way for corporates to avoid margin compression (outside of automation, anyway) is to raise prices to consumers.
The problem with that is straightforward: Consumers are workers when they’re not consuming. That means one key source of margin pressure is inextricably bound up with the mechanism by which management teams seek to offset that same pressure. Self-referential dynamics don’t usually turn out well. Just ask Terra.
During the first four months of the year, the surge in US real yields bled the most expensive stocks via multiple contraction. The figure (below, from Goldman) illustrates the point at the benchmark level.
The de-rating in the most expensive S&P 500 names was particularly dramatic. In January, the richest stocks traded at a premium of almost 26x. By May, that premium was down to 16.1x, roughly consistent with the long-term average.
“The market’s YTD correction is largely the result of de-rating of these extremely overvalued names,” Credit Suisse’s Jonathan Golub wrote, earlier this month.
The valuation compression stage of the bear market may or may not be over. Certainly, there’s room for multiples to contract further in the event the Fed continues to turn the proverbial screws. But this is well-worn territory by now. The next question is whether slower profit growth — or even a profit recession — will entail another leg lower for stocks, as deflated multiples are applied to lower earnings.
Earnings growth topped estimates for Q1 in aggregate, but a number of high-profile guide-downs, particularly within mega-cap tech, suggested top and bottom line forecasts may need to be trimmed.
Cue SocGen’s Albert Edwards. “My thinking is that most commentators are rightly focused on the vulnerability of the US tech sector to rising bond yields by dint of that sector’s ‘Growth’-style credentials [but] no one has been making the argument that the sector would implode because profits would begin to disappoint for these ‘Growth’ stocks in a slowdown — and most dangerously, in any recession,” he wrote, on Thursday.
I’ve made that argument on any number of occasions. Edwards recapped a familiar thesis which revolves around the notion that, much as occurred during the dot-com bust, some purported “growth” shares will be exposed for the cyclicals they are.
“I absolutely believe the turmoil that US tech and internet stocks, including the FAANGs, are now experiencing is something similar to what was seen in 2000/01,” Albert said. “Back then Nasdaq — and TMT more generally — collapsed as a long overdue recession flushed out cyclical stocks masquerading as ‘Growth’ stocks,” he added, noting that “the profit disappointments in US tech during the 2001 recession were such that the whole sector collapsed.” The figures (above) help make the point.
An even bigger risk is that in the confusion, even the real growth stocks get jettisoned, either as a source of funds in a pinch, or simply because panics aren’t conducive to rationality.
As Edwards put it, recalling the dot-com crash, “the carnage back then was indiscriminate and the genuine ‘Growth’ babies were thrown out with the cyclical bathwater.”