Yin/ Yang in the markets, has the pendulum swung too far?

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  • The market run since March 18th, 2020 came to an end last December and 2022 has since seen US 10 year, IG and HY CDS spreads soar back to multi year highs. Fed could be forced to slow down or even reverse course in the event of any credit or funding markets disruptions.
  • 2022 has become largely macro driven traders’ market and valuations have taken a back seat even for well positioned companies. Markets are on sale but credit market disruptions could even trigger fire sales.
  • High valuations were not sufficient reason last year for markets to correct but Russia Ukraine war and Covid lockdowns in China have proved to be the catalyst triggering the correction — To be a bear now, you have to expect double digit inflation for the next 2 years coupled with QT even in wake of credit market disruptions
  • I might sound like a broken record — markets go up or down, just stick with quality compounders

S&P down 15% and Nasdaq down 25% (not to mention the 60–80% correction under the hood) leave no doubt that correction is well underway and whether the pendulum swings further will hinge on the behavior of credit and funding markets this summer as 10 year and CDS spreads hit 5–10 year highs. Any resulting disruptions could potentially force Fed’s hands and (counterintuitively) trigger a vicious bear market rally. Current S&P valuation multiples seem to imply that end of correction might not be far, and while there is still a possibility of further sharp correction, the next leg of correction would likely be short-lived.

S&P 500 has gained ~$60/sh in the last twelve months ($34/sh this quarter yoy) in revenues and $7/sh in operating earnings this quarter despite inflationary pressures. At 17x P/E, S&P valuations are back at 2013 levels as market now predicts at least 10–20% decline in earnings next twelve months with a clear possibility of a recession- 2yr 10 yr spreads are kind of confirming the recession indications as well.

Has the pendulum swung too far? rate impact on multiples

Most of the last few years, cash flows were probably getting discounted at 2% at best and cash flows 5 years ahead would be worth 8–9% less today — $100 in year 5 was worth $91-$92 today. The current rate expectations have bid up that discount rate closer to long term equity risk premium of 6% — $100 in year 5 would be worth $75 today (17–18% correction in multiples). If inflation hits double digits and stays there for next couple of years it would push down the valuation further to more like $62 today (another 17% correction)

Cash will certainly not be the tool to beat the inflation but compounding cash flows can certainly help beat inflation and markets in the next 5 years. For the companies that can double their cash flow in next 5 years, the cash flows will compound at 15% well north of any inflation expectation. It is time to buy stocks with that kind of cash flow profile for the next five year — it will be prudent to pass on companies that do not have the balance sheet to support this growth and would rely on capital markets.

Monetary policy actions take six months to show up in the economy, which coupled with any demand slowdown from tightening does also leave the possibility of inflation peaking this year and easing of tightening conditions. It would likely be a rocky summer of 2022 but the extended sale period will offer some great cash flows to own for next 5 years.