The stock market climbed the proverbial wall of worry in the first quarter. The S&P 500 index rose 7% despite a “banking crisis”, the Fed continuing to increase interest rates, geopolitical concerns about China and Russia, inflation rolling over but remaining well above the Fed’s target, massive increases in government debt, lay-offs increasing within a still strong labor market, and earnings estimates being lowered. It was a bifurcated market, however, as three sectors – technology, communication services and consumer discretionary - registered double-digit gains for the quarter while four had gains of less than 4% and four others had negative returns.
The total return for any stock market or any individual stock is the sum of earnings per share growth + the change in the price/earnings ratio + dividends. Fundamentally, price/earnings ratios (P/E) decline when interest rates and inflation are high, and P/Es rise when interest rates and inflation are low.
The interest-rate increases that drove a stake through the heart of stocks in 2022 aren’t finished, though the end may be near if the Federal Reserve chooses to pause after another quarter-point hike. The current P/E for the S&P 500 has come down from its very lofty levels at the start of 2022, but it is still above its longer-term average. Corporate profit margins are declining from all-time high levels as reshoring leads to higher labor costs, cost of debt has increased, and corporate tax rates are likely to move higher. The dividend yield on the S&P 500 is below its long-term average.
While the broad stock market looks overvalued in light of these fundamentals, many individual stocks remain attractive. Some companies will thrive in this environment. Companies with rock solid balance sheets, low debt and strong free cash flow are not directly negatively impacted by rising interest rates. Companies with competitive advantages and pricing flexibility are able to maintain their profit margins in the face of rising costs. Certain companies are guiding earnings estimates higher. Many of these companies are selling for valuations below that of the overall market while having higher dividend yields and a history of consistent dividend increases. Dividend growth is one of the best protections against inflationary pressures.
Short-term US Treasuries have also become far more attractive than a year ago when yields were close to 0%. T-bills and 1-year Treasury Notes all yield well above 4% with no credit risk and great liquidity.
As is almost always the case, there is a litany of concerns for the stock market. Investing will be challenging as the stock market and the economy repay for the excesses of the past. We are grateful for your confidence in having us guide you through these times.
The LVM Team