By: Wayne Yi, CFA
The pace of sell-off in equity markets accelerated today (Monday, January 24th), down almost 4% around lunchtime, on top of the 7.7% sell-off experienced in the first three weeks of this year. This move put equities formally in a stock market correction for the S&P, which follows the earlier sell-off in small caps and growth indices. We would note that the major indices rallied back to end the day in positive territory, however, we expect volatility to persist this week. A lot of this selling pressure is driven by investors taking gains from the tremendous equity run over the past few years where the Fed had taken a largely dovish stance despite inflation concerns. The Fed has changed their focus away from employment and job participation towards tamping down the currently high inflation rate. This means a quick end to bond-buying and a steady path of rate hikes.
This shifts Fed policy from what was a tailwind to stocks to a headwind. The immediate effect is multiple compression, where the S&P 500, for example, was trading an approximate 20x forward P/E multiple, above its 10-year average of about 17. Growth and small caps were trading at greater multiples and are more sensitive to this new rate policy.
While valuations are coming down, earnings growth and quality of corporate balance sheets still remain resilient, despite the challenges we’ve seen from supply chain disruptions and wage pressures. Fourth-quarter earnings are expected to grow 20% year-over-year with upside surprises to revenues. 2022 is expected to continue to see solid earnings growth at around 10% with high single-digit top-line growth as well. Corporate forward-looking guidance can always change, but we are comforted by strong earnings growth in the back half of last year when some of the macro factors were most acute.
We aren’t calling the bottom to this sell-off, but the velocity of the move in a very short order seems overdone, likely exacerbated by passives selling and algorithmic trading strategies signaling the shift in momentum and de-leveraging as well.
We would note that market corrections of 10-20% occur every 1-2 years. We would also highlight that some of the best equity market returns follow right after these periods. Corrections tend to only last a few months and a Schwab study found that the S&P500 rallied an average of 8% a month after the correction bottom and more than 24% a year later. While unenjoyable, it is healthy for the market to undergo a resetting. We could go so far as to say that a notable decline in equities can also dampen inflationary pressure, resulting in a slower than anticipated hiking cycle.
Annual Returns & Intra-Year Declines
Source: JP Morgan
If you had $10,000 to invest beginning in 2001 through 2021…
Source: Simon Quick Research, Bloomberg - Assumes an investor invested $10,000 on 01/02/01 into the S&P 500 Total Return Index
Market corrections are uncomfortable, particularly when they occur in short periods. However, these periods are not new and should be considered opportunities to add to positioning as being invested in the market maximizes wealth creation potential over the long term.
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