2022 has been a difficult year for global equity markets and Wall Street hasn’t escaped the slump. The broad-based S&P 500 index is down 17.3% since the start of the year despite gains over the past month. The tech-heavy Nasdaq has suffered the most significant fall, down around 30% for the year to date.
For UK-based investors, losses suffered from dollar-denominated equities or funds have been partly offset by the over 13% strengthening of the USD against pound sterling. In a reversal of the past decade and longer, London-listed equities have outperformed Wall Street this year.
The FTSE 100 is down just 1.6% since the beginning of the year thanks to its lack of growth stocks, something usually seen as a problem, and a heavy presence of energy, commodities and financial sector companies. High inflation, rising interest rates and slowing growth have hit the growth stocks that have powered Wall Street’s impressive gains since the last stock market slump in 2008 harder than any other category.
The USA is not expected to escape the recession the UK and Europe have already entered and is expected to follow in early 2023. British investors have pulled £875 million out of American funds this year in response to nosediving valuations, though that is only around 4% of the overall £22.2 billion withdrawn from funds this year.
Despite the storm clouds still holding stubbornly in place above the global economy, the USA is expected to recover more quickly than most. Some experts think it might already be time for investors to start dialling investment exposure to Wall Street back up. Others are far less certain and urge caution.
What are the two sides to the argument?
The year after the midterm elections has seen stock market gains 19 times out of 19
One factor being pointed to as supporting a positive 2023 for Wall Street is the fact that it will be a post-midterms year. Since the Second World War, there have been 19 sets of midterm elections. The year after midterms, which usually result in a hung government that lacks majority control of both the Senate and House, has seen the US stock market record games 19 times out of 19.
That’s a remarkable record and the average gain is also not in the slightest negligible at 15%. If U.S. equities don’t finish 2023 with gains, it will represent the first time in modern history that has happened the year following midterms.
Of course, that doesn’t mean it can’t happen but as a historical pattern, it is a significant omen. Another thing in favour of the traditional post-midterms rally not bucking the trend in 2023 is the fact that the U.S. government is nicely hung.
The Republicans were far less successful than had been expected, with midterms traditionally punishing the incumbent party regardless of which it is. In the end, the Republicans did just enough to achieve a very slim majority in the House of Representatives but the Democrats held onto the Senate.
Wall Street usually does well during years there is a divided government in the U.S., enjoying a lack of interference while neither party is in a position to push through any major changes. That will now be the case for the next two years.
Inflation and interest rates
Another factor many see as favouring a Wall Street recovery taking hold more quickly than in other developed markets, particularly those of the UK and Europe, is inflation and interest rates. That is not to say the USA is not also struggling with inflation and rising rates squeezing disposable income and putting borrowers under pressure but it is to a significantly lesser degree than in the UK and Europe.
U.S. inflation has been dropping since a peak of 9.1% in June and was down to 7.7% in October, year-on-year. In the UK, inflation dipped slightly from 10.1% in July to 9.9% in August but was back at 10.1% in September and leapt to 11.1% in October. Inflation has been rising steadily in the Euro Area month-on-month and reached 10.6% in October.
Compared to other developed economies, U.S. inflation has been less severe and has now fallen for 4 months in a row. It’s not impossible that U.S. inflation ticks back up again but it will almost certainly continue to be less severe than in this part of the world thanks to the USA’s energy self-sufficiency.
Inflation and interest rate rises are also hurting U.S. households less than on this side of the Atlantic. 90% of U.S. homeowners are on long-term fixed-rate mortgages. That means that what is usually the largest single monthly expense has remained consistent for most households, making it less painful for them to absorb inflation. Disposable income is still being squeezed but to a far lesser extent.
Big tech looks cheap again
Growth companies that don’t yet generate significant profits, or any at all, were hit hardest by the 2022 stock market sell-off but the biggest tech companies have suffered too. The likes of Alphabet, Apple, Amazon, Meta and Microsoft generate huge profits and are also sitting on huge piles of cash which means they are well protected from an economic slowdown.
But the market had also assigned them huge valuations based on future earnings potential, which was then priced down in the new context of soaring inflation, interest rates and tighter household and company budgets.
Facebook owner Meta has lost 67% of its value this year, Netflix 52% and Amazon 45%. Even Google-owner Alphabet is down 33% on the assumption businesses will have less to spend on ads. Microsoft is down 28% and even Apple’s valuation has shed 18% despite both companies producing relatively strong numbers over the first three quarters of the year even against a rocky economic backdrop.
The question for investors now is have the biggest technology companies seen their valuations fall by enough that they now represent a bargain?
Value investors typically look at two key ratios when trying to determine if a stock is trading for less than its true value: the ratio of share price to earnings, which compares the market value of a firm with its profits; and price to book value, which compares a share price to the value of a company’s assets, such as property, equipment and inventories.
The Economist notes that U.S. tech stocks, especially the biggest companies, have looked hugely expensive when assessed by those ratios for most of the last decade. At the beginning of 2022, The Faang stocks of Facebook (Meta), Apple, Amazon, Netflix and Google (Alphabet) traded at average ratios of 38 times earnings and 12 times book value.
Across the broad-based Russell 1000 index, average valuations represented 24 times earnings and just 4 times book value. That’s partly because tech companies tend to own fewer physical assets than the average company compared to revenues and profits generated. They were also growing so fast that there were more than enough growth investors to ignore the ratios that would put value investors off.
Do tech stocks now represent good value based on traditional value ratios? It’s a mixed back. Alphabet now looks cheap, trading at a price-to-earnings ratio of just 17, as does Meta, which is trading at just nine times earnings and two times book value.
Investors are being put off the latter due to doubts about the long-term future of Meta’s core revenue-earning assets, especially Facebook. And the billions co-founder Mark Zuckerberg is pouring into trying to establish the company as a leader in the metaverse while it is still unclear what the somewhat nebulous concept actually is. As a result of that doubt, Meta may not be the bargain it currently looks.
Alphabet, however, remains in a very strong position. Google’s search market dominance doesn’t look like it is under any serious threat for now and its other main revenue-generating assets like YouTube also look strong, as does its growing Cloud computing platform and Android mobile operating system. It could be a genuine bargain at its current share price, especially if the stock market squeeze encourages less largesse when it comes to investment in future bets.
Amazon and Netflix, however, still look expensive though the former’s valuation could soar if it ever moves to spin out its fast-growing Cloud-computing division AWS. Last year AWS accounted for 74% of group profit despite only bringing in 14% of revenue.
There are also a number of smaller, but still huge, U.S. tech stocks that now look cheap when assessed using value metrics, with two notable examples the video conferencing software company Zoom and PayPal, the online payments platform.
There are a significant number of stock market analysts that question the logic of using traditional value-investing metrics to assess the biggest tech companies but it is still an interesting exercise.
Why it might be too early to move back into Wall Street investment exposure
There are also plenty of economists and financial markets analysts worried about “head fake” tempting investors back into the market early. The term is applied to batches of positive-looking economic data that suggest inflation is dropping only for price pressure to subsequently return.
On November 10 and 11, the Nasdaq added 10%, its biggest two-day gain in over a decade. Early November also saw the USA’s consumer price index for October rise by just 0.4% when 0.6% had been expected.
This led to a surge in confidence inflation may indeed be sustainably receding and on track to drop back towards 5% next year. Still high but if it did prove to be the case would be low enough to be expected to lead to the Fed easing off on interest rate rises. That in turn could see a much less severe recession than expected.
However, a significant stock market rally would not be welcomed by the Fed as it would see it as counter-productive to its aim of taking the steam out of the economy and reducing corporate debt levels. Some analysts are convinced the Fed is very wary of lessons learned in the 1970s when the retrospective consensus is it loosened policy too quickly, which resulted in inflation remaining a problem for longer.
On November 2, Fed chairman Jerome Powell told a press conference four times it still has some “ways to go” before it eases back on tightening measures. Even if inflation does now drop ahead of recent expections, the Fed is likely to wait before concluding the reversal is entrenched and even then only slowly change course.
Hedging your bets
Until after the event, it is impossible to know if the positive, negative or middle-of-the-road outlooks for the U.S. economy will prove correct. Investors with a long term outlook may consider a drip-feeding return to the U.S. equities market as a compromise.
Drip-feeding investment means spreading out the injection of capital over a period of time by making monthly (or some other consistent periodical time frame) investments instead of a single lump sum. Drip feeding increases the chance of a reasonable sum of capital being invested near the bottom of the market. The rest should still eventually benefit from the subsequent recovery, on the presumption valuations will eventually recover to surpass where they are at the time of investment.
Based on historical stock market patterns, it is expected that major U.S. stock markets will recover to surpass current levels and eventually rise to new record highs. However, that doesn’t mean every company will come out of this downturn healthily. Major stock market corrections and recessions also historically mean some degree of a changing of the guard will occur among the USA’s largest companies.
Some will likely continue as profitable enterprises but no longer figure among the very biggest and become vulnerable to aggressive takeover approaches or gradually lose relevance over the years. Some might reinvent themselves and bounce back. Apple is a good example of this. It made its comeback with the iPad 21 years ago, having been on the verge of bankruptcy in 1997, and then became the biggest company in the world thanks to the success of the iPhone.
New companies will almost certainly rise to the upper echelons of Wall Street valuations, like Big Tech and the many smaller but still huge tech companies did over the last decade or so.
Investors considering a return to Wall Street exposure should keep that in mind when taking bets on individual companies that have lost value and now look cheap. There will be value traps. But there will also almost certainly be stocks that bounce back and go on to do better than ever.
Diversifying risk broadly across many companies, such as investing in indices through cheap tracker funds or if you want to pick individual stocks diversifying well, is comparable to drip-feeding investment capital instead of allocating it as a lump sum. You won’t have to hit the nail on the head to benefit from the future stock market recovery, whenever it might eventually take place.
