No Man’s Land – How Far Could Stocks Fall?

By David Nelson, CFA CMT
 
There are no easy answers as to why markets fell apart last week. All the usual suspects had a hand in the carnage. A Fed increasingly behind the curve, inflation expectations rising, a news cycle that gets more frightening by the day and the growing realization that there is payback for some of the outsized returns as many stocks morphed from Growth at the Right Price to Growth at Any Price.
 
Talking heads will point to Friday’s options expiration which added insult to injury and others will point to the rough start to earnings that had everything from banks to streaming giants like Netflix trading in the red post their reports. In the end the reasons why matters less than the fact that it happened. What investors will remember is the Nasdaq put in its worst week since March 2020.
 
The deeply oversold conditions could be a setup to push stocks higher but given the machine selling we have seen over the last several days along with risk proxy assets like Bitcoin falling further, we have to at least acknowledge the potential for more downside. Even if futures go green Monday, broken support becomes resistance with a lot of sellers above.
 
No Man’s Land

Data by FactSet

The breach of the 200-day and broken support at 4495 sets up a No Man’s Land like battlefield for investors to navigate. For those of you not up on your World War I history it wasn’t pretty. While there’s no barbed wire on the perimeter it will take a lot for stocks to break above 4500 and more importantly start living there.
 
The VIX

Data by FactSet

The CBOE Market Volatility Index is of course a proxy for fear. Peaks in the (VIX) often point to investor capitulation. With the VIX spiking above 28 we are at least approaching previous stopping points over the last year. Let me give a shout out to friend and investment sage Lawrence McDonald @convertbond for this chart. Larry gave me the idea over the weekend when he posted a similar chart showing that being long Bitcoin is actually a SHORT on US Equity Market Volatility.

For yours truly running money is a combination of quantitative and fundamental research but it’s also about information, who has it and who doesn’t. I devour the news cycle every week both printed and on air. Karen Finerman @karenfinerman the popular Hedge Fund manager and contributor to CNBC’s Fast Money said something Friday that struck a chord. “The pendulum swings both ways and it doesn’t stop at fair value.”

I think most reasonable investors would agree that the pendulum pushed too far last year. What would be the worst-case scenario if in fact as Karen implies the pendulum swings to the other extreme?
 
S&P Valuation Dot.Com – Today

Data by FactSet

The valuation charts above give us a good representation of what investors were willing to pay for stocks over the last 22 years. The S&P 500 currently is trading just under 20x next twelve month’s earnings. Cheaper than the dot.com bubble but certainly well above the average for the last couple of decades. The argument we have all made is that stocks don’t live in a vacuum and relative to other investments and a risk-free rate at zero, stocks were the better asset class. With the FOMC gearing up to change that dynamic, we should at least put the numbers to the test.

What is Fair Value?

Data by FactSet

Let’s start with the mid-point between the high and low and go with 18x forward earnings as fair value. 18 x $222 the current consensus for calendar year 2022 takes you to just under 4000 in the S&P about another 10% lower than Friday’s close.

If we use 16x as the overshoot the picture gets a little more uncomfortable.

Make sure there is an E in the PE

You could of course go to cash but what will be the catalyst to get back in. A better position is to add stocks to the portfolio with defensible business models and even more important defensible valuations. Make sure there is an E in the PE. Sales growth with no earnings isn’t going to cut it. The price of stock divided by Zero is still Zero. Finally turn to stocks with pricing power. Every company is getting hit with wage inflation and increased cost of goods sold. If you can’t pass those prices on to the consumer, you’re going to have to eat it. 

To be fair, I have done this analysis in the past and it didn’t turn out as expected. Similar work done by yours truly where I concluded in early 2009 the S&P would bottom at about 550. Of course as we all know the bottom was 666 some 20% higher.

The variable of course is that the analysis is based on current conditions continuing or deteriorating further. Economies and markets have a tremendous capacity to repair and adjust. If the economy starts to slow, commodity prices will come in taking some of the inflation pressures off the Fed.

Energy touches every line item of the income statement

The administration has made a significant error with regard to energy policy. In less than a year we’ve moved from energy independent to turning to the not so friendly faces of OPEC. Again, even here the capacity exists for change. They see the polls just like you and I do and will likely make adjustments to policy in the coming months, especially with a mid-term election on the horizon.

The Generals

We have a monster week of earnings to get through this week and its important market cap leaders like Microsoft (MSFT) and Apple (AAPL) deliver not just on the headline print but guidance as well. If the market is going to attempt to make a stand this week it can’t do it without the Generals. The same is true for the troops like Boeing (BA), McDonalds (MCD) and of course Tesla (TSLA). Any of these stocks could turn sentiment. Let us hope the balance of the earning’s season is a lot better than the trailer.

Also on deck is the Fed with an FOMC rate decision Wednesday. Right now, more than 90% of economists are looking for the first hike in March with most looking for at least three more to follow this year. There is a rising chorus of Fed watchers looking for a bold move announcing a 50-basis point hike coming out of the gate. At this point nothing would surprise me even the possibility of something happening as early as Wednesday.

The challenge for Chair Powell is that the opportunity to raise rates in an accelerating economy and healthy market has likely come and gone.

I will be back later in the week with some follow up as the reports hit the tape.

*At the time of this article some funds managed by David were long MSFT, AAPL and TSLA