Stocks fell for a sixth week in a row as investors continued to worry about a possible recession in the US, high inflation, lockdowns in China and the war in Ukraine.
We turned more constructive on the market last week because:
1. Markets rarely fall more than 20% outside recessions. We do not expect a recession in 2022.
2. We believe the US central bank will act patiently this year as it assesses the effect of higher interest rates on the economy. Long-term interest rates could thus consolidate around current levels for the rest of the year.
3. Value stocks ($VTV) have not moved up as much as the move in interest rates implies, so they should have additional upside relative to Growth stocks ($VUG) if interest rates stay at current levels.
This more positive near-term outlook does not change our strategic view, which is that 2022 and 2023 are going to be weak years for the markets. However, we think that the market could trade sideways for much of the rest of the year, perhaps with a slight downward bias, before declining more in 2023 as interest rates resume their march higher and a recession becomes an inevitability.
Given our more constructive near-term outlook, the risk level of the portfolio has been increased by buying Financials ($XLF). The Financials sector usually benefits from higher interest rates. This year has been an exception as worries about an upcoming recession have outweighed any benefit the sector derives from rates.
If we are correct that there will be no recession this year, we think the sector could rally 10-15%. Valuations of many stocks in the sector are at record lows. An example is $SAN.MC (Banco Santander SA), which trades at a 5x forward PE (price-to-earnings). Similar valuations were last seen in the 2008 Global Financial Crisis and the 2011-12 European debt crisis. There is no crisis right now, so the valuation seems out of place. Analysts following the stock believe it has 40-50% upside.
There are risks with these Financials positions – notably, if interest rates increase rapidly, the solvency of Italy and many other highly indebted borrowers (public and private) will be questioned, causing financial instability. Our general approach is to accept higher risks for higher returns, so we accept this risk and manage it by diversifying into banks in different geographies (US, EU, UK, S Korea), not putting all of our eggs in one basket.
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$NVS (Novartis ADR), $MRK (Merck & Co.), $ROG.ZU (Roche Holding Ltd), $AT1.DE (Aroundtown SA) and $CAPC.L (Capital & Counties Properties PLC) were replaced by $EQR (Equity Residential), $BAC (Bank of America Corp), $EQH (Equitable Holdings Inc.), $AMUN.PA (Amundi SA) and $LLOY.L (Lloyd’s Banking Group PLC) .