A cathartic flush?

US equity markets have gotten off to a rough start this year. The S&P 500 is now down 6.5% from its all-time high on the first trading day of 2022. It was hard to identify a catalyst for the big swing on Thursday that saw the S&P 500 close 2.6% lower than its intra-day high. However, the big story so far in 2022 has been the rapid move higher in interest rates, which is prompting investors to re-assess valuations for some of the most expensive segments of the market and rotate into value stocks. When these market rotations are very rapid, sometimes broader market volatility escalates. We would make a few points:

• We are picking up some good contrarian buy signals.?For example, investor sentiment is reaching very cautious readings. The latest weekly survey from the American Association of Individual Investors showed that only 21% of respondents expect stocks to rise over the next six months. This is lower than 97% of all readings since 1987. Extremely cautious readings like this tend to be good buying opportunities. The signal is even more powerful when business activity measures such as the ISM Manufacturing index are strong. When the ISM is higher than 55—the latest reading was 58.7—and less than 25% of respondents in the AAII survey are bullish, stocks tended to rise 19% over the following one year, and the worst 12-month return was a loss of only 3%.
• This sell-off may feel uncomfortable?because investors have enjoyed a period of very limited drawdowns over the past 15 months. The market usually experiences two sell-offs of more than 5% in any calendar year. This is now the worst drawdown since September of 2020.
• 4Q earnings results season is still in the early innings, but so far the numbers have been decent.?Seventy-five percent of companies have beaten sales and earnings estimates, and earnings have come in 5% higher than estimates. So, despite some disappointing results and/or guidance from some high-profile companies, results have generally been good. And on average, analysts are maintaining their estimates for 1Q for the companies that have reported. Importantly, bank management teams have made it clear that their customers are in very good financial shape and loan growth is starting to pick up. This should propel further economic growth in the coming year, especially amid signs that the latest COVID-19 wave is peaking. We’ll get a broader read on results next week when 90 companies representing 22% of the S&P 500 market cap report. We see no reason to change our S&P 500 EPS growth estimate of 12% for 2022.
• Over the past three months, real interest rates have risen by about 0.4%.?Periods of rapidly rising rates in the past decade or so should offer comfort.?Since 2010, there have been six episodes when real interest rates have risen by more than 0.4% in three months. During these events, the S&P 500 experienced a drawdown of 4.3% on average. The most famous of these periods, and perhaps most similar to what is happening today was the so-called taper tantrum in 2013 when the Federal Reserve indicated it would start withdrawing post-financial crisis stimulus. During that period, stocks experienced a drawdown of 5.8%. So history suggests that further equity market downside may be limited.
• Lastly, investors may be getting too cautious about the impact of Fed tightening.?Since 1983, stocks have risen by an average of 5% in the three months before the Fed’s first rate hike. And, while volatility can pick up just after the Fed starts to hike, stocks tend to rise by another 5% in the six months after the Fed starts to raise interest rates. Also, bear in mind that economic momentum is strong right now, and interest rates are at zero. It will take quite a bit of Fed tightening before there is a noticeable impact on economic growth.

While it’s always hard to predict the bottom of any market sell-off, we believe the risk-reward for US stocks is getting attractive. We maintain our end-2022 S&P 500 price target of 5,100. Within the equity market, we continue to favor value equities over growth stocks, especially as the Fed embarks on normalizing monetary policy. At a sector level in the US, we like consumer discretionary, energy, financials, and healthcare. We also prefer mid-caps.

Authored by David Lefkowitz, Head of Equities Americas, Nadia Lovell, Senior Equity Strategist Americas, and Matt Tormey, Associate Equity Strategist Americas

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