Near-term volatility, long-term opportunity

Russ Koesterich, Managing Director and Portfolio Manager, suggests the recent sell-off could continue but still offers an opportunity for long-term investors.

The recent equity sell-off has resulted in the largest stock market correction since the beginning of the pandemic. During the last week of February, the S&P 500 Index traded 14% below its recent high, while the Nasdaq and Russell 2000 technically entered bear markets, if only intra-day, down more than 20% each.

While markets partially recovered by week’s end, stocks remain significantly below their recent highs. The relentless selling has also left stocks significantly cheaper. Valuation is a poor market timing indicator and new lows are very possible should the situation in the Ukraine continue to deteriorate. That said, longer-term investors should benefit from a much better entry point for global equities

Looking like 2018

In contrast to the painful but remarkably brief bear market in early 2020, today’s correction has not been driven by a collapse in earnings. Growth is almost certain to slow, but nominal growth (NGDP) should remain at or above the post-GFC norm; this will in turn help support earnings. As a result, expected earnings for U.S. large cap stocks have crept higher since the start of the year.

Rather than lower earnings, the correction has been driven by lower valuations. Stocks are suffering through the worst multiple compression since 2018. This is not a coincidence. While the events in the Ukraine clearly add another significant risk factor and are a drag on multiples, the pattern was set even before it became obvious that Russia was going to invade. As was the case four years ago, stocks have been repricing on the back of tighter monetary policy and less benign financial conditions. Since the start of the year equity multiples in the United States and Europe have detracted more than 10% from total returns (see Chart 1).

Equity sources of total return - year to date

And while U.S. stocks are still trading somewhat above their 10-year average valuation, on a global basis stocks are more reasonably priced than was the case in late 2021. Many developed and emerging markets are now trading at less than 15 times earnings, with several also at valuations below their 10-year average. The latter list includes Germany, China, Japan, Australia, and Taiwan.

2018 was followed by 2019

Even with the recent sell-off valuations are not so low as to provide an immediate floor for equities. In addition, stocks will remain vulnerable to higher rates, persistent inflation, and the news flow from Ukraine. But while lower valuations will not protect near-term, they do suggest better long-term returns. As was the case in 2018, when multiple compression set global stocks on their way to a three-year 75% gain, less aggressive valuations suggest better long-term returns. True, monetary and financial conditions will not be as supportive, but that would have been the case anyway. At least today valuations are starting to turn from a headwind to a tailwind.