The S&P 500 Is in a Correction. A Little Good News Would Go a Long Way. — Barrons.com
Nicholas Jasinski
(Dow Jones) — Stocks are dropping for a fourth straight week to start the new year, with the S&P 500 falling into correction territory shortly after Monday’s opening bell. Investors are finally pricing in a higher interest rates in earnest after ignoring the glaring reality for much of late 2021, while weighing uncertainty about fourth-quarter results and geopolitical wild cards.
But there’s reason to believe the overall market will be meaningfully higher by the end of 2022, just with plenty of volatility still in store.
The S&P 500 was down 3.1% in afternoon trading, to about 4,265 points. The index was off about 11% from its Jan. 3 record high close. Other indexes — the tech-heavy Nasdaq Composite and the small-cap Russell 2000, for example — were down even more. All are in their deepest selloffs since the early pandemic-induced crash in February and March 2020.
Investors are pricing in faster and sooner Federal Reserve interest rate hikes — and uncertainty about earnings growth with inflation running hot that could crimp profit margins. There’s also some profit-taking after a big 18 months for market returns.
It’s a healthy shift that brings market pricing and investor expectations more in line with reality and the return to normalcy in monetary policy and the economy. After a brief selloff in September, the market rallied to record highs in the fourth quarter despite a hawkish shift from the Federal Open Market Committee, another Covid-19 wave, and the highest inflation readings in decades.
“The FOMC is likely to use its January meeting…to hint at a March liftoff and to begin formulating a plan for balance sheet reduction,” Jan Hatzius, the chief economist at Goldman Sachs, wrote in a report published Saturday. “We expect the FOMC to raise interest rates four times this year starting in March and to announce the start of balance sheet reduction in July.”
That’s in line with current market pricing, which has the Fed raising its interest rate target by a quarter of a point four times in 2022 beginning in March. It compares with just one hike priced in, in early October. That shift in expectations has been felt most in Treasuries, where yields have risen, and in high-multiple growth and technology shares, which have led the market lower.
And, after a long rally, it doesn’t take as much negativity to spur some selling. Investors sitting on big gains from 2021 might be happy to take some money off the table today and see how things shake out.
There’s a lot of information and data for investors to sift through right now.
— There’s the FOMC meeting, which ends on Wednesday and will be followed by remarks from Chairman Jerome Powell. — We’re in the thick of fourth-quarter earnings season, with some 200 S&P 500 companies on deck to report this week and next. — Geopolitics is front and center, with near-daily headlines suggesting escalating danger of an armed conflict in Ukraine. — There’s the midterm elections this fall and all the uncertainty they bring.
Sentiment is a lot more bearish lately. The percentage of bulls in the AAII’s Investor Sentiment Survey fell to just 21% last week — an 18-month low. The Hulbert Stock Newsletter Sentiment Index, which is a more short-term indicator of the market’s mood, is also more bearish. And traders are more defensive, too, with the S&P 500 put-to-call ratio spiking since the start of the year.
Those are all contrarian indicators, with history suggesting positive market returns going forward when they have reached similar levels. It recalls the Warren Buffett adage about being fearful when others are greedy, and greedy when others are fearful.
“I prefer to look at things in terms of risk and reward,” said Keith Lerner, co-chief investment officer at Truist Advisory Services. “And that has become a lot more favorable over the past few weeks as expectations have been reset. When sentiment is low, a little bit of good news can go a long way.”
For those with a diversified portfolio and a longer time horizon, there’s no good reason to panic right now. Some repricing in stock valuations was due. That’s a different animal than a correction spurred by declining earnings expectations or a deterioration in the economic outlook.
The S&P 500 has averaged just over one 10% decline a year over its history, and has averaged 3.4 pullbacks of at least 5% annually, according to Dow Jones Market Data. The index had one 5% drawdown last year. In other words, what investors are contending with now is closer to normal than the exceptionally low volatility of 2021.
Lerner sees both fundamental and technical reasons that suggest the current selloff could be nearing a close. During the S&P 500’s last extended bout of selling in September, the index bottomed out around 4,275 points. That’s a technical support level.
On the fundamental side, consensus forward earnings estimates for the S&P 500 stand at $225 a share — a record high. Applying a 19 times price-to-earnings ratio to that figure also yields a 4,275 index level. That’s a higher multiple than the S&P 500’s long-term average, but lower than it has been since early 2020.
Of course, the S&P 500 can overshoot that 4,275 level on the downside in the near term, but for investors with a longer view, there’s more to like at current levels. Strategists’ consensus target for the S&P 500 at the end of this year is 5,263. That would be a close to 10% rise from the start of 2022, and about 23% above Monday morning’s level.
A forecast for modest returns that requires investors to sit through periods of double-digit swings isn’t a recipe for sound sleep. It’s a lot of volatility for little reward relative to recent years’ gains.
But markets are in a new chapter in 2022, with monetary policy getting tighter and economic and earnings growth slowing. Volatility is back. There’s no avoiding that.
Write to Nicholas Jasinski at nicholas.jasinski@barrons.com