For months, the tension has been building. Sooner or later we knew the Fed would need to start actively fighting inflation, and when that happened, stocks priced for a zero-rate world would look precariously overextended.
This week, the Fed drew a clear line. We’re probably going to get a quarter-point rate hike by May . . . and then another by July . . . and at least one more before Thanksgiving.
A year from now, overnight lending rates could be a full percentage point above where they are today. If you’ve been conditioned to get nervous when long-term rates creep above 1.5%, that scenario might look like the end of the world.
After all, the S&P 500 is currently priced at an inflated 21X projected earnings. Normally we start to get nervous above a P/E ratio of 18 or 19.
For the market as a whole to revert to that level, earnings need to be shockingly good in the coming year or the S&P 500 needs to dip at least 15% before its valuation makes sense again. Yikes!
But if this is the beginning of the end of the world, why are stocks down only 0.5% since the Fed got serious? The answer may surprise a few people on Wall Street along with the rest of us.
Go Back Six Years
The last time stocks were priced for a zero-rate world was back in late 2015, right before the Fed finally felt that the economy was healthy enough to stand on its own again after the 2008 crash.
Back then, the S&P 500 reached a then-lofty 20X multiple and corrected 11% once interest rates started rising. But that’s as far as the losses got, and by June the bulls had gotten back to work with a vengeance.
After all, earnings kept growing despite the Fed’s occasional taps on the brake. In 2016, the “E” side of the P/E calculation climbed a healthy 9% and then jumped another 16% in 2017.
As a result, in the time it took short-term rates to tighten by a full percentage point (sound familiar?), the S&P 500 gave shareholders an end-to-end 15% gain even though valuations across the market dropped from 20X earnings to more like a 17X multiple.
That ratio no longer felt so intolerable. People like Jeremy Siegel even argued that it felt cheap in a world of low taxes, sustainable growth and rapid technological advances.
Admittedly, the Fed is under the gun this time around so the tightening cycle looks like it will be significantly more accelerated . . . but the world didn’t exactly end in 2015, did it?
We saw a correction and a quick recovery. Economic growth wasn’t exactly robust, but it was enough to keep stocks moving higher from there.
As of today, I’m looking for similarly mild earnings growth in 2022. We might see the S&P 500 earn 6% or even 7% more next year, which is enough to take the market multiple down to a 20X ratio from there.
That’s not fantastic, but it’s well within the market’s modern tolerance. It’s not a crash signal.
Is there a danger of a correction once the Fed starts moving? Definitely. But corrections create buying opportunities for people who can evaluate risk and reach for reasonable returns.
I can do that because I am not a prisoner of the S&P 500 and its weightings. When I see a stock is cheap relative to the market as a whole or growing fast enough to justify a premium price, I can buy it.
And when that stock reaches its true potential, I can sell, liberating that capital to roll into new opportunities. Index fund investors can’t do that. They’re trapped with what the index tells them.
Here’s a good rule of thumb: if you’re nervous about the Fed, sell any stock that isn’t either priced below 18X earnings or growing faster than 7% in the coming year. Rotate the money into stocks that meet one or both of those criteria.
With that kind of portfolio, you’ll be in a better place to withstand the rate shocks when they come. And you definitely won’t be on the sidelines watching the recovery leave you behind.
Six years isn’t long to you and me but Wall Street is run by children now. I was talking to a fund manager today who laughed when I said the average investment bank analyst has been on the job for two years.
“The average fund manager has been in the industry for three,” he said. They don’t remember 2015. Let them think it’s the end of the world.
We’ll keep doing what we do. We can pivot to strength and dump weakness. A portfolio of nothing but materials stocks, industrials, banks and retailers might do extremely well next year.
If you’re scared, stick to these sectors. Let the children chase long-term unicorns.
And guess what? In late 2015, people were terrified because Amazon was trading at a record 940X earnings multiple, leading many to pontificate about the market being broken.
Back then AMZN was available for under $700 a share. Some investors grabbed it and held on for dear life. Others got shut out as the stock roughly doubled from year to year . . . defying the Fed in the process.
And if the Fed sees that it’s choking the economy, the rate hikes will slow down. They aren’t blind. They’ve shown us that if it’s a question between the job market and fighting inflation, they’ll sacrifice prices to save jobs.
Cannabis Corner: The Bright Spot
At this point, few on Wall Street are willing to speculate, much less invest for the long term. As a result, cannabis stocks remain in the shade, unable to catch a break.
Large or small, it hasn’t mattered. All the cultivators are down YTD and added to their losses over the past week, giving up the strength they showed us on their last bounce.
The only difference is how deep the losses are from company to company. But one stock on my screen remains green for the year. It isn’t a big winner, but even a little profit is a whole lot better than what the cultivators have been able to deliver.
Scotts Miracle-Gro (SMG). Selling hydroponic equipment to industrial growers as well as the entrepreneurs that really form the core of this industry . . . and are making the money.
SMG is profitable. It’s actually cheap compared to the broad market at 17X trailing earnings. Growth in the coming year won’t be great, but the business looks fairly stable.
And SMG pays a dividend. If you love the cannabis theme and aren’t willing to commit to the long haul, this is the single stock that shines.
GreenTech Opportunities: Don’t Believe The Hype
As you know, the cruel irony of green investing revolves around the way oil prices drive adoption of more sustainable alternatives. When fossil fuels are cheap and plentiful, it takes a lot more to get people to convert their homes, cars and appliances.
And with oil down 9% over the past month, it might feel like the fire is going out of green stocks once again. Will we be content to drive gas-burning cars another year?
With that in mind, it’s no wonder that Tesla is down 15% in that same month. But here’s the thing: oil is a commodity and so its price falls when the dollar strengthens.
A more active Fed is a positive for the dollar. Rate hikes raise the value of our currency, especially in a world where some countries are still cutting rates to support their economies.
A stronger dollar is necessarily negative for oil. We’ve seen the reverse scenario play out, with energy costs in a zero-rate world feeding ambient inflation.
The Fed may just be green investors’ best friend. Hang in there!