We have been surprised by how quickly and deeply the stock market has adopted the assumption of a sharp and imminent recession.  The S&P 500 has fallen nearly 20% from its all-time high on January 3^rd but this understates the decline.  The NASDAQ is down 29% and the Russell 2000 is down 23%.  Consumer Discretionary and Retail sectors are down 33% and 34%, respectively.  Many stocks are down more than 50% with declines in some of the pandemic favorites reaching 70-80%.

The concern for investors is that the outlook for growth in earnings and cash flows is rapidly deteriorating.  The current quarterly earnings season is providing support for this view even though overall results have been pretty good.  The usual number of stocks have met or exceeded estimates, although upward revisions to future earnings estimates have slowed from their usual pace.  Since the all-time high on January 3^rd, the P-E multiple on the S&P 500 has fallen from 21X to 17X.  The clear message is that 2022 and 2023 earnings estimates are materially too high.

Entering this year, Northlake had a moderately cautious view, expecting below average but positive returns for the S&P 500 with tail risk to the downside.  The primary reason for our caution was the shift in Federal Reserve policy from dovish to hawkish.  Wall Street likes simple explanations, most of which are unreliable, but “don’t fight the Fed” is one that usually works.

Relative to expectations at the start of 2022, the Fed has gotten much more hawkish in response to higher and more persistent inflation.  Inflation is biting lower income U.S. consumers hard while government COVID stimulus has expired.  Higher income consumers are also feeling pressure from the wealth effect of the falling stock market.

Last week, the market decline was focused on consumer stocks due to disappointing earnings reports from Walmart and Target.  This week a preannouncement of weak earnings from Snap attributed solely to macroeconomic concerns broadened the sell off to technology, internet, and other economically sensitive sectors.

For the retailers, most of the problem is related to profit margins pressured by inflation in costs like labor and supply chain.  Both reports also contained nuggets indicating consumer demand might be weakening.  Other companies also suggested consumer spending is slowing.  For example, Home Depot noted store traffic fell by 8%.  Snap slashed its outlook as advertisers appear to have abruptly cut back spending, reflecting weakening consumer spending.

The market is focused on the fact that consumer spending makes up nearly 70% of U.S. GDP.  Investors are assuming the unsavory brew of high inflation, stock market declines, weaker economic data, and disappointing earnings reports are signaling a recession immediately ahead.

Northlake believes that the market is assuming a worse outcome for the economy and corporate earnings than is likely to occur.  We expect the stock market to be meaningfully higher than current levels later this year.  However, to get a sustainable rally going requires better news flow.  The most important place this could occur is in upcoming inflation reports.  Easing year-over-year comps should lead to a slowdown in inflation.  The figures are likely to remain elevated, but signs of an inflation peak should allow investors to look past the Fed tightening cycle and realize that current assumptions about GDP growth and corporate earnings are too dire.  Any signal from the Fed that its goal of tightening financial conditions to reduce demand-driven inflation is ahead of schedule would also be a positive.

For now, however, the narrative remains bearish.  Nonetheless, we believe it is best to stay the course rather than sell into the current bear market.  The time to sell was earlier this year.  We saw the risk but did not raise cash.  With hindsight, we made a mistake.  We believe it would be another mistake to sell now.

 

SPB 5/25/2022

Northlake Capital Management, LLC