U.S. stocks entered bear market territory in the Second Quarter of 2022, as global economic uncertainty arose from inflationary pressures. PE multiples in the recent quarter contracted to adjust to the reality of higher interest rates and slower earnings growth. The S&P 500 Index posted a loss of 16.10% in the second quarter, resulting in the worst first half of a year since 1970. While the recent turbulence in financial markets has been unsettling, market leadership seemed to favor fundamental investing and reward individual stock selection. However, by the end of the quarter, there were few places to hide as energy, industrials, semiconductors, and financial stocks experienced an abrupt and broad sell-off in the last few weeks of the quarter.
Today, we face an entirely different market environment than six months ago. Based on more than a hundred discussions our investment team has had with public company management teams over the past month, we expect corporate earnings to hold up well through the June quarter, with visibility in the second half of the year being constructive but less certain. However, what investors are willing to pay for future earnings in response to higher interest rates have contracted PE multiples. As a result, growth stocks whose earnings are the furthest out into the future have been among the stocks hardest hit during the recent correction. In addition, economically cyclical stocks sensitive to higher borrowing costs and consumer discretionary stocks have also seen a significant contraction in PE multiples. According to the most recent data published by FactSet, the S&P 500 is trading at approximately 15.8X forward earnings estimates compared to 21.2X at the beginning of the year and the five-year average of 18.6X. Although PE multiples have contracted, the inverse of the S&P 500 quarter-end PE multiple is earnings yield of 6.33%, which was still well above the 10-year Treasury yield of 2.98% at quarter-end. In this environment, we believe active portfolio management becomes essential to navigate quickly changing business conditions across many sectors.
Furthermore, prevailing inflation, a slowdown in the economy, and higher interest rates favored stocks with solid balance sheets and whose underlying assets can produce stable cash flow and earnings. Although the market is pricing in a more challenging macro environment for earnings in the balance of the year, we still see a favorable risk/reward in stocks that have the staying power to deal with volatile commodity prices and curtailed discretionary spending. Challenging macro conditions and the recent sell-off in stock prices will likely result in new sector leadership in the months ahead. With this in mind, the Hodges Capital Management investment team has positioned our portfolios to benefit from shifting economic trends and secular and structural changes across different industries.
The Federal Reserve has signaled plans to further reduce liquidity through fewer asset purchases and additional increases in the Fed funds rate. Capital markets have started to price in this reality, resulting in lower multiples for stocks and lower bond prices. As previously mentioned, we spend little time predicting interest rates, foreign currency fluctuations, or future commodity prices. However, we pay close attention to stock prices and, more importantly, the pricing power that our portfolio companies exhibit within the goods and services they produce. For many businesses, inflation and a slowdown in demand could adversely impact profit margins and revenues in the months ahead. Companies that exhibit pricing power and a low threat from substitute products can often pass on higher costs and see profit margins benefit from an inflationary environment. As a result, we are overweighting our portfolios with growth and value stocks that we believe can create shareholder value under these conditions.
As we enter the second half of the year, we are reminded of one of Don Hodges' sayings, “You make your best investments in bear markets. You just don’t realize it at the time.” As we attempt to capitalize on the recent sell-off, what we know for sure is what we do not know. We do not know the day that the bear market will bottom, the peak level of interest rates, or the severity of an economic slowdown. We do know that investor sentiment is now far less bullish, and most stocks are trading at lower valuations than six months ago. Specific sectors of U.S. stocks such as housing, transportation, retail, semiconductors, and other cyclicals have priced in a meaningful slowdown in the months ahead. The lack of capital flows into equities, and overall cash levels indicate that investors are defensively positioning portfolios, which is part of the bottoming process for any bear market. The big question in the coming months is: What will investors be willing to pay for future earnings in a rising interest rate environment, and what earnings expectations are priced into individual stock prices? We believe the PE multiple for the broader market has no room to expand if interest rates continue their ascent. However, this is not true for every stock, as we see the potential to unlock value for many under-the-radar companies in our portfolios.
During this dramatic sell-off, the investment team at Hodges Capital is rigorously looking for bargains in businesses that we believe are well run and control their destiny by relying on ingenuity and well-calculated business decisions rather than day-to-day momentum in the stock market. Our clients can be assured that we are not changing our core investment discipline, which is to seek out quality companies, running great businesses with excellent management teams, and trading at reasonable prices. Furthermore, we see this as an ideal environment for active portfolio managers to carefully select individual stocks that we believe can generate long-term value for shareholders.
Everyone has the brain power to make money in stocks. Not everyone has the stomach.” -Peter Lynch
Sincerely,
Eric Marshall, CFA
Co-Chief Investment Officer, Portfolio Manager,
& Director of Research
Hodges Private Client is a program offered through Hodges Capital Management, Inc. (“HCM”). HCM is an Investment Advisory Firm registered with the Securities and Exchange Commission (“SEC”), is a wholly owned subsidiary of Hodges Capital Holdings and serves as investment advisor to the Hodges Funds. HCM is affiliated with First Dallas Securities, Inc, a broker-dealer and investment advisor registered with the SEC.
This discussion is not intended to be a forecast of future events and should not be considered a recommendation to buy or sell any security. Past performance is not indicative of future results. Investing involves risk. Principal loss is possible. Investing in smaller companies involves additional risks such as limited liquidity and greater volatility. No current or prospective client should assume that information referenced in this communication is a recommendation to buy or sell any security or is a substitute for personalized investment advice from your individual advisor. HCM does not provide tax or legal advice. Consult your tax or legal advisor for any related questions.
All information referenced herein is from sources believed to be reliable and is provided as general market commentary and does not constitute investment advice. This material was created for informational purposes only and the opinions expressed are solely those of HCM. HCM shall not in any way be liable for claims and makes no expressed or implied representations or warranties as to the accuracy or completeness of the data and other information. The data and information are provided as of the date referenced and are subject to change without notice.