We are at War!

David Nelson, CFA CMT
Fears of a coming Fed hike and rising cost of capital hardly seem a worry when Russian troops are firing on a nuclear plant and geopolitical tensions rival those of the Cuban Missile Crisis.
Like it or not we are at war. The broad-based sanctions including the denial of Russia to access its foreign currency reserves will plunge the country into depression. It doesn’t matter whether we define it as war in the conventional sense. It only matters how the enemy sees it.
Putin has said Western sanctions are akin to war. I can’t imagine anything more dangerous than a sociopath backed into a corner who believes the world would like to kill him. Especially when it’s true.
The Fog of War
The fog of war obscures all news good and bad. However, I’m going to try and put the obvious aside and focus a moment on data that could be good news if and when this crisis ends.

Data by FactSet

Sometimes good news doesn’t get the press it deserves especially when the news cycle is focused elsewhere. Friday’s employment report was just that. February payrolls came in at +678,000 well above the +400,000 expected. Add a +92,000 revision and a steady 3.8% unemployment rate it becomes clear that Omicron and some of the other drags on the economy are starting to slip into the rear-view mirror.

Average hourly earnings holding flat was good news for employers and gives a green light to Powell and the FOMC to proceed as planned.

The good news on labor of course doesn’t change the fact that U.S. markets even before the current crisis were undergoing a full valuation reset. When the cost of capital goes up multiples go down. In that backdrop some of the most expensive stocks have come in 50-60%.

Data by FactSet

Cathie Woods’ Ark Innovation Fund (ARKK) has become the poster child of that excess.
Value stocks and other strategies focused on free cash flow have outperformed for most of the last several months

The Magnet

Data by FactSet

In my article earlier this year No Man’s Land I discussed a potential range of outcomes and why I think 18x forward earnings is fair value. I also put forth that in valuation resets markets don’t always stop at fair value and often overshoot to the downside. I like to call this range of outcomes the magnet an area where I think markets will settle as the Fed tightens monetary conditions. However, it is important to note this is not a technical level of support or price points where investors are likely to step in and buy. Since it is based on fundamentals in part the estimate revisions of analysts covering these companies daily, it’s a moving target.

Moving Target

Data by FactSet

Six months from now if economic conditions hold investors and portfolio managers won’t be looking at 2022 earnings to base current valuations. They will be rolling forward to 2023. Now that magnet moves a bit higher. The good news is that even in the specter of war, earning’s estimates for the S&P 500 pushed a little higher last week, up a dollar to $223 for this year and $247 for 2023.

Look, I know it’s naïve to think that pure fundamentals on their own can improve investor sentiment. As I wrote in The Cost of Freedom, unless you’ve got a pipeline to the White House or a cousin working in the Kremlin it’s impossible to have a clear picture of exactly what is taking place on the ground. I do know we have been here before and likely we’ll be again.

Each of those times investors were challenged to walk away from their plan, and I suspect those who did, never got back in.