The other headwind for stocks comes from earnings.  After annual growth of over 20% in 2021, the 4th quarter earnings reports and first quarter guidance coming out in the past few weeks have been raising some warning flags due to rising input costs as well as supply and labour shortages.   The big money-centre banks such as JPMorgan and Goldman Sachs were first out of the gates, disappointing with rising employee costs and some shortfalls in trading.   On the industrials side, early news from Sherwin Williams, Boeing and General Electric also showed higher input costs, supply chain issues and revenue shortfalls.   The first FAANG stock to come out was Netflix.   It’s growth outlook was less bullish due to the massive amount of new competition in streaming services (Disney Plus, Amazon Prime, Apple TV, HBO Max, Paramount One) and investors did not take it well, driving the stock down almost 25% on the day following the release!  Earnings had been the ‘magic powder’ that had sustained the bullish outlook.  If that growth is decelerating, then that’s a problem since expectations are so high in the tech group.  Microsoft once again beat earnings and revenue expectations but initially sold off 5% folllowing those results as they weren’t as ‘significant a beat’ as in prior quarters.  Clearly the big tech stocks are ‘priced for perfection’ and any shortfalls relative to those expectations are not taken well.

The meltdown in growth stocks this year has most money managers, ourselves included, advocating the switch from ‘growth to value,’ much as we have for the past year.  The last time this happened was after the ‘tech wreck’ in 2000 and was mostly responsible for the great relative renaissance of value investing in the early 2000s.  while this trade looks good for the next year or two, we don’t think we will have the same kind of extended ‘value cycle’ as we had from 2000-2007.  Also, we shouldn’t lose sight of where we want to be positioned in the longer term.  Over the balance of the decade we would rather own companies involved in electric vehicle production as opposed to ICE (internal combustion engines).  We also prefer renewable energy stocks over fossil fuels and other carbon-based energy sources.  In financials we prefer payments companies over traditional banking.  However, in all of these cases we have to ask ‘at what price?’   When pre-production auto companies such as Rivian and Lucid trade at higher valuations than GM (which produces over seven million vehicles a year) we’ll take the trade on GM!  When renewable energy stocks trade at 18 times cash flow and traditional oil and gas stocks trade at 3-4 times, we’ll take the trade in the energy stocks, and when payments companies such as Visa and Paypal trade at 35-40 times earnings while money centre banks such as Citi and JPMorgan trade at 10 times, we’ll take the traditional banks.  The ‘rubber band’ of valuations just got stretched too far in favour of growth stocks over the past few years.  These valuation differentials should start to ‘normalize’ over the next year or two as interest rates rise.  Moreover, when valuations get so far extended in one direction, they rarely just come back to ‘trend’ or historical levels.  Instead they generally tend to overshoot in the other direction, mostly because those trades had become so ‘crowded.’  We think that big tech faces some of those headwinds in the short term as the average investor unwinds massively overweight positions in many of these growth plays.  We should remember that it took Microsoft almost 15 years to re-achieve the highs it reached during the tech bubble before it collapsed in 2000.   However, it’s not like Microsoft did poorly and didn’t grow in the ensuing 15 years from 2000 to 2015.  Valuations just got too extended and they ended up moving to ‘below market’ valuation levels.  However, following that period, the stock has had a ten-fold increase to its current level.

Bottom line is that stocks are still looking pricey, especially in a rising interest rate environment.  While valuations are a poor timing tool in the short run, they are an excellent forecaster of stock prices in the long run. The Shiller PE Ratio has reliably predicted the 10-year return on equities. Today, the Shiller PE is consistent with total real returns of close to zero over the next decade.  Investors’ allocation to stocks has also predicted the direction of equity prices.  According to the Federal Reserve, U.S. households held a record-high 41% of their financial assets in equities as of the third quarter of 2021.  If history is any guide, this would also correspond to near-zero long-term returns on stocks.  This is just another reason to keep some cash available and stick with low valuation, high dividend paying stocks with some pricing power and exposure to a rebounding economy.

Within our managed accounts we had raised cash levels substantially at year end by reducing positions in the technology sector as well as golds.  We then lightened up further on some energy and financial stocks on their strength early in 2022.   As stocks have sold off we have bought back into some core technology stocks (Microsoft, Qualcomm, PayPal and Meta), autos (GM, Magna) and have also added some defensive stocks such as Alimentation Couche-Tard and Maple Leaf Foods.  One new name we added this month was Pfizer, for both growth and defensive reasons.  We had been light on health care exposure after selling Regeneron late last year as we were concerned about some drug approvals as well as not having as effective vaccines as Pfizer or Moderna.  Pfizer for us is the ‘go to’ name in the sector.  Trading at only about 14 times earnings, it is going to get a boost this year from its mRNA vaccine.  We also see these earnings as sustainable as we don’t think the vaccines are a one or two year thing.  These variants will mutate and we might end up in a spot where people are just getting annual shots the same way as they do for the flu.  Pfizer is leading there as well and also has an established pipeline of other pharmaceuticals, an animal health division and a huge distribution system, which is an absolute necessity in the health care /biotech field.   This is going to be a more volatile year for stocks and we expect some pullbacks along the way to single-digit gains by year end.  That would still be better than the returns on bonds or cash and allow investors to see a return in excess of elevated inflation rates in 2022.   However, as always, we will monitor the earnings commentaries and economic growth trends as well as overall stock valuation levels and investor sentiment and be prepared to make adjustments as market circumstances dictate.

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