The Removal Of Uncertainty May Present Opportunity

By Richard S. Nackenson

A more attractive equity valuation environment, combined with the removal of uncertainty, may present opportunity for stock-specific alpha as the focus shifts to company fundamentals.

Following three years of gains, U.S. equity markets have experienced a number of challenges thus far in 2022. Elevated inflation, higher interest rates, the conflict in Ukraine, and supply chain constraints have created uncertainty in the markets.

Equity earnings multiples have compressed as investors weigh the prospects of decelerating economic growth and recessionary headwinds and the corresponding impact on earnings. We believe this is creating opportunity.

Equity valuations have become more attractive since the start of the year. As of July 31st, 2022, the S&P 500 forward earnings yield is approximately 5.7%. The spread between the S&P 500 forward earnings yield and the 10-year Treasury yield is approximately 310 basis points.

This represents the “equity risk premium” and is well above the 30-year average. The S&P 500 Index is currently trading at approximately 18x forward earnings. This is below where the market was trading in April 2020 when the economic outlook was significantly more uncertain.

This suggests that equity valuations are in a reasonable range. This does not necessarily mean that equity markets will go up or that valuations will expand. There are still challenges ahead that individual companies need to address.

We believe companies will need to continue to prove that they have the ability to address these challenges. Hence, this may present opportunity for stock-specific alpha as the focus shifts to company fundamentals.

The potential impacts of the aforementioned challenges are likely to have a differential impact across sectors and individual companies. In a dynamic environment, companies that effectively respond to these challenges by utilizing pricing power, deploying free cash flow, proactively managing their supply chains, and implementing cost actions, have the potential to enhance their underlying earnings outlook through company-specific solutions.

This differentiation was evident throughout the 2nd quarter earnings season. We witnessed select companies reduce earnings guidance and provide cautionary outlooks, while others demonstrated effective operational execution, gained market share and strengthened their underlying fundamentals. This highlights the potential benefits of investing in companies with sound business models that are geared to respond to current challenges.

As we progress through 2022, there is the potential for the reduction of macro uncertainty. We expect more clarity on the trajectory of interest rates, rate of inflation, trends in the U.S. labor market, and outcome of the mid-term elections. A more attractive equity valuation environment, combined with the removal of uncertainty, may present opportunity.

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