Staying on the Sidelines

It’s alluring for investors looking to buy stocks who have been stung by the recent bear market to stay on the sidelines, until it’s apparent that the economy will escape recession, or recover from one.

Many analysts foresee another turbulent year for equities, at least in the first part of 2023. Concerns persist that the economy may enter a recession, reducing corporate earnings and pushing the market lower.

Denise Chisholm, Head of the Quantitative Market Strategy at Fidelity Investments, says the debate over a recession is secondary. Instead, she believes that investors should concentrate on values, which are a more essential factor in determining how different parts of the market will do in the future.

It’s difficult to hunker down,” Chisholm says.

I understand that there has been and continues to be a lot of terrible news out there,” Chisholm acknowledges. However, at this point in the market cycle, “the problem is that bad news is frequently a contrarian indicator.

Pricing in the Bad News

This may be observed by looking at the performance of the broad stock market during periods of recession, she claims. Looking ahead two years from the market’s recessionary lows, she claims that 75% of the market’s gains will have been made by the time the recession is done.

You’ve missed it if you wait for good news,” she says.

According to Chisholm, this is because “the market is a discounting mechanism.” In other words, prices will begin to shift in anticipation of an event even before it occurs.

In the statistics, I look at it, what it says is that a lot has already been valued,” Chisholm adds.

That indicates there are opportunities for stock investors to capitalize on. She is concentrating her efforts on the following areas:

Small-cap stocks
Metals and mining stocks, in particular,
Stocks in the financial sector
cyclical consumer stocks
She warns that there are several sectors to avoid due of their less appealing prices, most notably technology.

Is a Recession Already Priced In

There are recessions produced by unexpected shocks, such as the epidemic, and those that have been predicted for a long time.

A recession in 2023, if it occurs, appears to be the latter at this point. According to Chisholm, this is a crucial element for investors to consider.

The more evident the recession, the more probable it was dismissed in advance,” Chrisholm says.

According to Chisholm, the market has likely already priced in an economic downturn, as indicated by the magnitude of stock declines that have already happened despite the absence of a recession.

Stocks fell roughly 25% between the market’s most recent top in January 2022 and its low in mid-October. According to her, some market experts will argue that the broad market has never reached a bottom before a recession begins.

However, “as much as equities have never bottomed before a recession, I would argue that stocks have never gone down 25% before a recession,” she says.

Considering Predictive Evidence

There are numerous methods for slicing and dicing before buying stocks based on market value figures, most of which is frequently conflicting.

When there is contradictory evidence, look at what is predictive,” adds Chisholm. “The starting point of values has been quite predictive.

Chisolm’s favorite strategy is to start with basic price/earnings or price/book ratios, rank them historically, and evaluate how future performance plays out across different valuation deciles or quartiles. She then analyzes current valuations and uses past trends to evaluate the probability of future outperformance.

Another indicator is “valuation spreads,” in which she looks at the gap between the 25th and 75th percentiles of valuation measures such as price/earnings and price/book across the market. When there is more anxiety in the market, valuation spreads widen, but this also indicates a higher possibility of future outperformance.

The S&P 500 valuation spreads were historically broad towards the end of 2022, falling in the top percentile of historical readings. Looking back to 1990, those valuation spreads were followed by stronger 12-month average returns than any other quintile.

This isn’t about determining a bottom,” she explains. This year, stocks could record fresh bear market lows and experience continuing volatility. However, for long-term investors, the valuation landscape might assist in identifying greater chances for entries to buy stocks.

Mid-Cap Companies

Chisholm recommends mid-cap companies rather than large-cap or small-cap stocks for the best chances of outperformance.

Small-cap stocks do appear inexpensive on some criteria, she admits, but the tale isn’t as compelling. “Small caps in the United States are a pure recovery play,” she explains. “The United States midcap does not have to be a recovery play, and there is solid valuation support.

According to Chisholm’s measurements, the relative price/book and price/earnings ratios of mid-cap stocks vs large-cap stocks are in the bottom decile and at their lowest levels since the early 2000s.

Mid-caps have a lot of apprehensions,” she explains.

However, this implies a higher likelihood of outperformance. “Valuations support the assumption that mid-caps can outperform large caps by double digits,” she says.

Basic Materials

Materials companies, according to Chisholm, are the “most exciting to me right now” and make me want to buy stocks.

Because of their significant vulnerability to economic cycles, basic minerals are typically regarded as a sector to avoid during a recession. But, once again, the starting point for an appraisal is an issue. She adds they’re currently appearing inexpensive, which isn’t surprising considering the decline in manufacturing activities.

However, this means that investors can ignore the possibility of a recession and instead prepare themselves for an eventual rebound.

This is especially true for metals and mining companies, which are Chisholm’s favored approach to play the materials sector at this time.

Metals and mining equities have bottom relative prices based on price/earnings, price/book, and price/free cash flow, which she believes suggests the “odds of outperformance are significant.” That’s true even if margins and earnings fall, as they usually do during a recession, she says.

According to Chisholm, metals and mining valuations were in the bottom decile for price/earnings by the end of 2022.

Using data dating back to 1976, the sector outperformed the market by over 15% in the next 12 months 10% of the time when metals and mining were this cheap.

Buying Stocks in the Financial Sector

Another industry that is particularly prone to recessions and increased unemployment is finance. “If we think we’re going into a recession,” Chisholm asks, “does the recession matter, or does the starting point on relative valuations matter?

According to Chisholm’s modeling, bank equities outperformed the broader market by an average of 5% over a 12-month period when their relative future P/E fell into the bottom quartile of their historical range.

Financials’ advantage with such a low value should last as long as unemployment does not increase above 7.5%, which is more than double its most recent level, she argues.

Meanwhile, financials are in the bottom 10% of their historical valuation range for relative price/book and relative price/earnings.

Financials are “much cheaper… than during the big financial crisis,” according to Chisholm, when the sector was at the epicenter of market and economic harm.

Even if I don’t know what’s going to happen with the economy,” Chisholm adds, “that value support has been a strong historical guide in terms of performance” for financials.

Cyclical Consumer Stocks

Buying stocks of consumer cyclicals, also known as consumer discretionary stocks, are companies that provide non-essential goods or services that customers may avoid purchasing during an economic downturn.

It’s the archetypal economically sensitive area,” Chisholm says.

According to Chisholm, “the fundamentals for consumer cyclical stocks are not going to be fantastic and probably aren’t going to get better anytime soon” in the coming months.

Meanwhile, she claims that these stocks tend to move much ahead of the end of a recession.

According to Chisholm, consumer discretionary equities bottom six to nine months before profits trough.

If you wait for the news to improve, you will most likely miss the stock market’s rise,” she warns. “You must rely on contrarian indicators.

Chisholm does not compute valuations in the consumer cyclical sector on the normal market-cap-weighted approach used in market indexes for her data. This is due to the fact that Amazon and Tesla have such a large presence in the sector—roughly 34% of the S&P 500′s consumer cyclical sector. Instead, she equal-weighted the group, giving those two stocks a total weighting of less than 4%.

According to Chisholm, consumer cyclical equities have the lowest relative price/book and price/earnings ratios since the 1970s.

With values in the bottom decile, she believes the industry has a 65% to 75% probability of beating the market in the coming year.

While there is “a lot of concern” in the business, there is also “a lot of valuation support,” according to Chisholm.

What Valuations Mean for Energy and Technology Before Buying Stocks

With a 62.5% increase in the Morningstar US Energy Index in 2022, energy stocks blew the roof off.

Energy has had the strongest two-year performance of any stock sector in the last 60 years, according to Chisholm, between last year’s gains and those predicted in 2021.

According to Chisholm, valuations remain acceptable, and energy appears to have a strong chance of outperforming this year.

However, she believes that the amount of outperformance observed in the last two years is exceedingly unlikely to continue.

It’s fair that many investors are still looking back at the sector’s stellar performance previous to 2022 when it comes to technology equities. However, based on current relative prices, the prognosis does not appear to be as promising.

The prognosis appears to be different from the prior decade, when technology was the overwhelming leader,” she says.

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