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June 2022

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US Equities

During May, the US stock market sent a signal that a US recession is likely. On May 20, the S&P 500 Index briefly fell into bear market territory, the benchmark having declined 20% from its all-time high in Jan. In the past, a bear market has been reliable indicator of an impending economic recession. Over the past 50 years, there has been only one case, Black Monday 1987, when a bear market was not followed by a recession. Bear markets are most commonly defined as when the closing price drops at least 20% from its most recent high. Since the S&P 500 recovered on May 20 to finish unchanged, the S&P 500 is not technically in a bear market. That technicality does not change our view of the current downturn in US equities. We are expecting corporate earnings to disappoint, and economic data to deteriorate this year. However, as US stocks decline, they are pricing in future bad news. When negative headlines hit, they may not hurt the market too much because the bad news is already priced in. We continue to recommend clients cautiously add to their portfolios. If US shares retreat back into bear market territory, investors should add more aggressively.

If the S&P 500 retreats back to its May low, US stocks still will not be at bargain-basement prices. The S&P 500 will be trading at around 16.1x forward earnings, which represents an average valuation for the index. According to Factset, it is below the five-year average of 18.6x, and below the 10-year average of 16.9, while it is still above the next three most recent historical averages: 15-year (15.5x), 20-year (15.5x), and 25-year (16.5x).

Stocks do not need to be dirt cheap to be attractive relative to current US interest rates, which are historically low. Although US Treasury yields have risen sharply this year, the US 10-year yield is still only just above 3%. The long-term average yield of the 10-year Treasury is about 4.3%.

There is a risk that Treasury yields move sharply higher. However, we do not view that as likely. It seems as if the US fixed income market has reached a state of relative equilibrium. After a lot of volatility at the beginning of the year, Fed Fund futures have stabilized. For the past two months, they have been indicating that the Federal Reserve will increase short-term interest rates to 3.25% over the next one and a half years. The market seems convinced that will be sufficient to get inflation under control. Policymakers at the Fed will give significant time for the impact of the first-rate hikes to work their way through the economy before they decide that they need more rate hikes are necessary. Until much later in the year, US monetary policy is on autopilot, and we are not expecting big moves from the US Treasury market.

For most of this year, equity prices have dropped when Treasury yields have risen. Tactically, we would like the Treasury yield to move up modestly. If Treasury yields tick up, it could create an opportunity to pick up shares at lower prices.

Currently, the S&P 500 sectors that are most beaten up and most attractively priced are the technology and communication services sectors. However, as we pointed out in our May Wealth Monthly, the timing to buy these sectors is far from perfect. Technology and communication services stocks usually do not outperform during an economic slowdown.

Last month, we reiterated our buy recommendation on Disney (DIS US, -34.1% ytd). Disney is seeing a massive rebound of its theme parks and tourism business, which includes Disney experiences and consumer products. Revenue for 2QFY22 more than doubled yoy to US$6.6b.