US stock markets: Where are they headed?

Since the pandemic, Indian retail investors have taken to international investing — particularly in US stocks — in a big way. However, much like the Indian markets, volatility and bearishness have overtaken optimism for quite sometime now. From peak levels reached on recent months, the DJIA, S&P 500, NASDAQ have dropped around 11, 15 and 26 per cent respectively. A sizable pocket of the US market consisting of many large-cap to small-cap TMT stocks (technology, media and telecom) has become a sea of red with corrections ranging from 40 to 90 per cent from 52-week highs. Even blue-chip stocks such as Meta Platforms (Facebook), Paypal, Netflix, Salesforce, and Disney have not withstood the onslaught by the bears.  

Jeremy Grantham, in his exclusive interview with BL Portfolio last week, indicated that the ‘golden era’ may be over for the US markets and it may tending towards lower PE (Price to Earnings) ratios and profit margins in the current decade. Is the party over or do corrections provide good accumulation opportunities for long-term investors ?

What lies ahead for US markets and what should Indian investors who have exposure to US stocks do now ? Here’s a lowdown.

Golden run

Over the last decade, a confluence of factors such as innovation, risk taking, and easy money aligned perfectly for US equities to outperform other asset classes. 

A steady state of economic growth (till pandemic disruption) ensured consistent progress and low inflation ensured that liquidity was cheap and ample. This provided for smooth flow of investment and credit to innovative ideas that germinated inside many garages. Quite a few of the largest companies globally by market cap and index heavyweights – Alphabet, Amazon, Meta Platforms, Tesla, Nvidia did not exist three decades ago, showcasing a remarkable journey from start to the top in a relatively-shorter span of time. 

Further low interest rates also meant earnings growth could also be achieved via financial engineering. Companies could borrow at ultra-low rates and buy an asset earning more – their own stock through corporate buybacks. This was also another driver for equity returns. 

With the above factors driving earnings growth, stocks got booster shots from multiple expansion as sustained period of low interest rates, made equities as an asset class more and more attractive on a relative basis as well

As can be seen in the table, while there was decent earnings growth for US companies in the last decade, the index returns outpaced earnings growth. This was driven by multiple expansion as mentioned above (increase in interest rates can have the reverse effect).

Why things are changing

The US (and global markets) now need to contend with the ‘RRR’  brickwalls – Rates, Russia and Recession.

The kind of aggressive rate hike path that the Fed is embarking on now, was only last witnessed in the mid-1990s. Thus, in a way, this is new territory for markets in the current century and probably for a majority of the market participants as well. Investors need to get wary of market conditioning of the last 20 years to receiving support from central banks, while entering this uncharted territory. 

The primary objective of Fed in increasing rates is to apply brakes on the economy and rein back inflation. The Fed also wants to pull the hand brakes via quantitative tightening. How markets respond to this tightening, which began on June 1, will get clearer a month or two down the line. 

Another significant brickwall is the way geopolitics is going to influence global trade. Much like the global move away from dependence on China as sole suppliers, the Russia-Ukraine crisis can have long-lasting impact on global supply chains. Countries and companies could be willing to incur more costs to minimise reliance on a single country and these changes can be inflationary. Diversifying away from the current supply-chain dependencies will involve multi sourcing and near shoring. These will chip away at some of the deflationary benefits of globalisation.   

And finally, the risk of a recession if the Fed is unable to avoid a soft landing as it tries to cool the economy. In fact, many economists believe soft landing is very challenging and unlikely.  Unlike the pandemic-driven recession which markets brushed off with a gush of liquidity, recessions typically end up causing deep negative impact to earnings that will take a couple of years to recover to pre-recession levels. This would mean prior earnings estimates and price targets going for a toss. 

What now for investors

So, with the tide turning, what should investors do now ?

As long as the threat of the RRRs mentioned are not abated and markets do not adequately reflect this (PEs still at long-term averages, implying risk of impact to earnings is not factored), the risk that the market correction will be long drawn remains high. Long-drawn market corrections tend to happen in phases with intermittent pull back rallies. Further, with hands of the Fed tied due to inflation, a backstop may not be forthcoming in the event of recession this time.

While the secular changes underpinning the markets may require investors to temper return expectations at broader market level, being judicious in stock selection can compensate for that and generate superior returns.

The US remains the cradle of innovation globally, and there doesn’t appear to be any other country (whether in the West or East) that can imminently displace it from the number one spot for now. While China is making progress in this space, there are very few countries willing to trust and embrace its technological offerings. Thus till a tough competitor emerges, the best of high-growth tech opportunities will continue to emerge from the US.

In this context, when quality stocks from this space correct and offer sufficient margins of safety for potential downside scenarios, it is always time to start dipping into it. Investors with a high  risk-appetite — an ability to withstand high volatility and drawdowns — can make use of the corrections and invest in stages over the next two years. At BL Portfolio, we have been carefully recommending US stocks which appeared to offer sufficient margins of safety in recent times. From a long-term investing perspective, we have a positive view on Meta Platforms (Facebook), Netflix, Trivago, Coursera, Paypal, Intel and Disney.  

Investors can accumulate/buy these stocks as the correction plays out. We also tell you our outlook on our earlier recommendations, following the corrections (see table).

Published on

June 04, 2022

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