- Expect mid-to-late cycle dynamics to play out once the inflation scare recedes, meaning financial, energy and materials companies will do best. Then indexes will rebound.
- Stocks to keep an eye on include Shell, Eli Lilly and Ulta Beauty.
- The investing environment is not nearly as bad as it seems. Good days are ahead.
Today's investment landscape appears bleak, seemingly plagued by a host of factors, including mounting inflation, rising interest rates, an economic contraction during the first quarter and a war in Ukraine that has exasperated already lingering supply-chain issues.
Add it all together, and it's been a horrible year for stocks. The tech-heavy Nasdaq shed 13% in April, its worst month since the Financial Crisis, and has lost more than a quarter of its value this year.
Yet it's important to keep in mind that what spurred the market's descent was not a confluence of the issues mentioned above — it was the Federal Reserve. As 2021 drew to a close, fundamentals were reasonably solid. Corporate earnings growth remained strong; the labor market, though tight, was healthy and adding jobs; and consumer balance sheets were in good shape.
However, at the beginning of January, policymakers began to signal that they would start to raise rates and rein in their bond-buying program. From that point, the S&P 500 began to tumble, shedding nearly 16% over the next four weeks.
In retrospect, the drawdown should not have surprised anyone. Markets declined by similar amounts the previous four times the Fed began to remove policy accommodation, in 1983, 1994, 2004 and 2015. Notably, however, in each instance, stocks rebounded quickly and reached new highs within 12 months of hitting bottom.
Granted, this is hardly a significant statistical sample. But it's the sample we have, and for a few reasons, history is likely to repeat itself this time around.
For one, bearish sentiment recently hit a record low, according to a survey compiled by the American Association of Individual Investors. Over the years, when the market outlook is this one-sided, it's a good contrarian indicator that the opposite will happen.
Similarly, when institutions — hedge funds, pensions, etc. — go light, it's also a signal to pounce. Such investors are currently underinvested in equities, meaning the market will soon run out of sellers.
The biggest issue, though, is inflation — it's simply not as bad as most fear.
When the Fed began to talk about raising rates earlier this year, the bond market reacted reasonably, with yields climbing slowly. Then, Russia invaded Ukraine, increasing the chances that fuel and food costs would rise, and nerves began to fray. Investors responded by bidding up Treasury Inflation-Protected Securities, or TIPS, causing inflation-breakeven yields to skyrocket.
Even so, inflation has likely peaked. Indeed, the upcoming data will have a hard time matching May 2021 comps. At the time, vaccines had just become widely available, which caused spending at retail stores and restaurants to spike as more and more people ventured out.
Therefore, what we are seeing now is a panic, one that could quickly recede once we get more data.
So, what does all this mean?
For starters, expect mid-to-late cycle dynamics to play out once the inflation scare recedes, meaning financial, energy and materials companies will do best. After that, look for indexes to recover and then reach new highs sometime near the end of this year led by cyclical/value stocks.
Specifically, Shell is a name to watch the rest of 2022. As alluded to above, many energy companies are well-positioned in today's environment, but Shell has perhaps the most upside. The reason, in large part, comes down to liquefied natural gas.
The easier-to-transport form of natural gas is perhaps the key to making Europe less reliant on Russian oil exports. The company dominates this market segment, delivering more than 65 million tons last year.
More broadly, Shell's integrated gas business represents around 40% of its net asset value, and the company's scale allows it to generate big margins in dislocated markets. This year, the stock could gain another 30% and pay out a 3.5% dividend.
Segments of the health-industry should also perform better than most. Eli Lilly has the most potent existing pharmaceutical lineup within this sector, and its pipeline is promising.
Though the company's long-term prospects could hinge on the efficacy of Donanemab, an Alzheimer's drug in testing that could be a game-changer, shorter-term, the concern is a weight-loss drug aimed at combatting obesity.
It showed promising results in a recently concluded clinical trial. If approved, the drug represents a huge, multi-billion-dollar opportunity.
Meanwhile, despite a recent public relations snafu, Ulta Beauty controls a significant percentage of the high-end beauty and cosmetics market. Admittedly, it lost some ground during the Covid shutdowns, but it is adding more inventory to its remaining physical locations in an effort to capture even more share of this segment.
More and more white-collar professionals returning to the office spells good things for its business, while the cost savings it has created in recent years (it has closed roughly 2,000 stores since 2019) also help.
Fear is a powerful emotion. But that's where many investors are right now — gripped by fear. And while no one should discount the challenges of the current landscape, the environment is not nearly as bad as it seems. Good days are ahead.