Cheaper Valuations May Boost Stocks

Sebastien Callebaut -

After A Stellar Year, Stocks Appear To Have Room To Run

In 2021, the S&P 500 gained 27%, capping a third year of double-digit gains. Yet, stocks are cheaper than a year ago: the S&P 500 is currently selling at 21 times analysts' estimated earnings for the next 12 months, down from 22.8 times at the end of 2020.

  • Lower valuations, combined with a rising economy and low interest rates, explain why most Wall Street forecasts expect the S&P 500 to continue to rise in 2022
  • Even as the Federal Reserve prepares to raise interest rates for the first time since the start of the pandemic

Slower Profit Growth

Of course, the future year will be different. For the first time in a generation, inflation is on the rise, threatening to eat into profits. Fed rate hikes will make investors to rethink their earnings forecasts, and the Covid-19 pandemic will almost certainly take further twists and turns.

  • As a result of all of this, profit growth will most likely return to more typical levels. S&P profit growth is expected to drop to 9% from 16% in 2021, according to Wall Street estimates
  • Meanwhile, multiples remain above their long-run average, but many analysts and fund managers attribute this to the low level of interest rates

Go Into Value Stocks?

In the first half of 2021, the MSCI World Value Index outperformed its growth counterpart as the vaccination deployment accelerated, reassuring investors that the economic upswing would continue. However, the spread of the delta variant sabotaged the first "value rally", while growth stocks recovered from their lows amid supportive central bank policies.

  • Many of the elements for value's recovery were present in 2021, including a growing economy, a regulatory crackdown on high-priced tech businesses, and rising inflation, but it nevertheless fell to a new low versus growth in November
  • In many regions of the world, the expansion of the omicron variant is already leading to a record number of coronavirus infections and new lockdowns, the same situation that fuelled significant gains for growth companies throughout much of the pandemic

Despite this, investors are hopeful that the sixth year will be the charm following five years of underperformance for value. According to Morgan Stanley strategists lead by Graham Secker, industries that benefit from specific catalysts and improved earnings projections should fare the best inside value. They listed the auto industry, as well as bank and energy company stocks, as examples of industries with increased profit growth prospects.

Or Go Into High Flying Growth Stocks?

Cathie Wood has toned down her forecasts after receiving backlash for an overly optimistic return estimates at Ark Invest.

  • After posting a market commentary piece in late December, the star fund manager was chastised for claiming that her "more concentrated flagship strategy today could deliver a 40% compound annual rate of return during the next five years"
  • The Ark Innovation ETF, Ark Invest's flagship fund, was down roughly 24% in 2021

Since then, Ark has released an update that removes that specific phrase and clarifies in a footnote that "this statement applies to Ark’s disruptive innovation strategies broadly and does not refer to any particular product or fund".

Ark Invest has nine funds in all, six of which are actively managed and three of which track indices. Only two of their investment solutions, the 3D Printing ETF and the Autonomous Tech. & Robotics ETF were (very slightly) in the green for 2021.

BENCHMARK'S TAKE

  • High flying growth stocks may have a hard time to justify their valuation going forward as the so-called "pandemic boost" was more of a mirage for most technology stocks as only a few of them managed to stick to their lockdown-driven gains
  • The pandemic isn't over yet and the appearance of new variants may trouble markets again. We therefore prefer to stay cautious with energy stocks and some pandemic losers which are now trading a cheap valuations
  • The market in late 2021 was pushed by big tech names such as Apple and Microsoft which are now trading at a significant premium versus their historical valuation
  • We would thus not be surprised to see markets correct in the short term as a fall in Big Tech would drag the market with it
  • For now, we have handpicked 10 stocks cautious investors could be willing to consider going into 2022

Disclaimer

Please note that this article does not constitute investment advice in any form. This article is not a research report and is not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security or financial product does not guarantee future returns. Investors have to conduct their own research before conducting any transaction. There is always the risk of losing parts or all of your money when you invest in securities or other financial products.

Credits

Photo by Artturi Jalli on Unsplash.