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May 2022

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US Equities

US equities have been down four out of five months this year. During that time we have remained unenthusiastic about US equities. Although we did not advise clients to radically reduce their exposure to US stocks, we have been removing names from our US stock selection list, while we have not added any new names this year. In our April Wealth Monthly, we wrote that investors should hold off on adding to their US equity positions. We suggested that market volatility may give them the opportunities to add at lower levels.

US stocks have been down every week since we wrote our last Wealth Monthly. The combination of lower share prices and growing earnings has made the average forward P/E of the S&P 500 much lower than it was one year ago. Although shares on Wall Street have been scary volatile, we don’t think investors should let market volatility put them off buying, assuming they are happy with the prices. Bouts of severe volatility do not last very long. We are now modifying our view of US equities, albeit modestly. Investors with a long-term view should begin cautiously adding to their portfolios. We are not ready to make a bold bullish call. We are faced with a conundrum. The shares that appear to be the best value are growth and tech stocks. Historically, we are at the wrong point in the economic cycle to be buying growth and tech.

At one of our recent US financial market webinars, Tony Petrilli of ViewTrade spoke about the relative performance of S&P 500 sectors during different stages in the economic cycle. He presented an analysis by State Street Bank that showed that during the “slowdown” and the “recession” stage in the economic cycle, the consumer staples and healthcare sectors tend to outperform, while consumer discretionary, communication services, and technology are among the underperforming sectors.

Such historical analysis has shortcomings. Although they are correct on average, each rotation through the economic cycle is different. For example, the current economic slowdown comes on the heels of a global pandemic, a rare event. Perhaps that is why the healthcare sector has not been an outperformer, even though it usually outperforms during an economic slowdown.

Utility stocks typically outperform in a recession. That seems unlikely to happen in the current cycle. Central banks are raising interest rates as the global economy slows. Usually, interest rates decline as an economy moves into a recession. Utility stocks tend to do well when interest rates are falling.

Although we are not going to follow State Street’s “Sector Business Cycle Analysis” slavishly, we recognize that it accurately predicted consumer staples’ outperformance this year and the underperformance of consumer discretionary stocks. We also infer from the underperformance of the technology and communication sector that big institutions are positioning themselves for a US recession.

In fact, those two sectors are so beat up, that they look relatively attractive. Technology and communication services look very cheap compared to consumer staples. Consumer staples have been outperforming, and based on history, will continue to outperform until the US economy is actually in a recession – assuming there is a recession.

For example, let’s compare Google-parent Alphabet (GOOGL US, - 20.2% YTD) to Coca-Cola (KO US, +9.2%) and Walmart (WMT US, +3.4%). Alphabet is on our stock selection list. It is a member of the communication services sector because it derives most of its income from advertising. During a recession, advertising spending is likely to drop. It makes sense that investors are not paying up for Alphabet shares. However, the stock is trading at 20.4x 2022E earnings. That is low for a company that is growing earnings at an 18% rate.

We removed Coca-Cola from the US stock selection list in April after the company reported a 1Q2022 earnings beat. Coca-Cola faces the challenges of rising raw material and transportation costs. However, it appears that Coca-Cola will be able to successfully pass on cost increases to its customers. Consumers typically do not cut back on spending on staples even when prices are rising and times are tough.

So why did we recommend taking profit from Coca-Cola? It is trading at 27x forward earnings. A year ago that might not have seemed very expensive. However, relative to where other stocks are trading today, Coca-Cola appears to be overpriced. Its long-term growth prospects are worse than Alphabet. There is growing awareness that sugary carbonated drinks are unhealthy.

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