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In April, the S&P 500 continued to edge toward a bear market, defined as a 20% drop from recent market highs; through May 11th the S&P had dropped 18% from its January 3, 2022 high. The NASDAQ, on the other hand, is well into bear territory having peaked on November 19, 2021 and dropped 29% since then.
Looking at past bear markets suggests bracing for further declines. For the S&P 500, there have been 14 post-war corrections of 20% or more. Each bear market featured an average peak-to-trough decline of roughly 32% and an average duration of just under a year. In other words, if history is any guide, the downturn we have experienced over the first four months of 2022 is likely to mark the early innings of a larger repricing.
We have been writing since late 2021 about the litany of risks facing markets in 2022, including: the need for the Fed to raise rates to combat rising inflation; the extension of 2021 supply chain difficulties; the roll-off of pandemic lockdown/reopening tailwinds in many sectors; and the difficulty of achieving earnings growth in the current environment. Add to that list an ongoing war in the Ukraine along with a Chinese economy grappling with a new wave of Covid, and the outlook for most companies has become downright bearish.
The one bright light may be that, following its recent drop, the S&P 500 is less expensive relative to earnings. Based on current tallies, analysts project S&P 500 earnings of $236 in 2023, which produces a forward multiple of 16.7x.
However, earnings estimates are a weak link. Reaching $236 in 2023 requires earnings growth of 6.5% in 2022, followed by growth of 19.2% in 2023. It is safe to say that any 2023 rebound is unlikely to happen if inflation remains high and global growth continues to slow. For context, earnings grew at a compounded annual rate of 6.4% in the five years prior to the pandemic, when inflation averaged 1.8%.
The challenge is that most low growth scenarios imply weak or negative forward returns for the S&P. Consider that if:
- Index earnings grow by 5% in 2022 to $208;
- The 10-year U.S. Treasury climbs to 3.50% by year-end; and
- The earnings yield premium falls to 2% based on trailing earnings.
… then the implied S&P 500 target through early 2023 is just 3,782 ($208 divided by 5.5%) down about 2% from current levels. In other words, with rising rates and investor jitters, earnings growth is the only thing preventing a potential bear grazing from turning into a bear mauling. Which is why we see the pendulum now shifting away from growth-at-any-price, towards profitable growth and quality of earnings.
Even though analysts have been slow to revise their estimates, the market is catching on to the risks posed by companies with low to negative earnings, many of which are seeing growth slow this year. The priciest of these companies have been crashing.
Given the current backdrop, we remain defensively positioned and are sticking to investments in companies with strong balance sheets, sustainable cash flows, transparent accounting disclosures, and forthright management teams. In our Absolute Return Fund, we are capitalizing on weak and volatile conditions to add to our short book and earn additional premiums from option writing.
As always, we benefit from the in-depth accounting and due diligence work being done by the team at Veritas Investment Research, who continue to produce some of the best equity research on the street.
Year-to-date through April 30, 2022, the NASDAQ was down 21.1%, the S&P 500 was down 12.9% and the S&P/TSX was down 1.3%. Over the same period, our Canadian Equity Fund rose 1.3% and our Absolute Return Fund was up 0.4%. (Performance based on F series).