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Market Update: Correcting extremely high stock price valuations

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Key takeaways

  • Global stocks have declined more than 8% to start the year.
  • Primary cause: Price correction to stocks that were trading at extreme valuations.
  • Our view: This is not the beginning of a sustained bear market.

After an exceptional 2021, returning over 20% in Canadian dollar terms, global stocks have dropped more than 8% to start the year. The decline has been led by a correction in U.S. stock prices – the NASDAQ Composite Index in particular, was down more than 18% intraday from its highs at one point.

Maybe appropriately, the largest drawdowns occurred in momentum stocks and technology companies with little-to-no profitability that have gained popularity with retail investors. Many crypto-related stocks, recent IPOs1 and SPACs2 suffered losses greater than 20%. Similarly, other companies with rich valuations – EV, renewable energy and other companies with favourable ESG profiles – pulled back significantly.

Notably, broader markets also adjusted lower with most regional markets trading down. Russian-Ukrainian tensions also accelerated, leading European markets lower as well.

The probability of recession is low over the next 12 months

As the bulk of the drawdowns were born from stocks that were trading at historically extreme valuations, we view the recent market activity as a technical correction – further proof that markets are functioning correctly.

It’s worth acknowledging that the sharp rise in real interest rates caused by higher short-term inflation expectations, may have triggered the sell off. Fundamentally, many of these speculative and high long-term growth companies require a lot of capital to realize their potential, and the increase in the cost of capital may have made them less desirable.

It’s our opinion that these stocks were being traded by speculative investors and that the ultra-high valuations were unlikely to be sustained in perpetuity. Simply put, bubbles were forming, and air has been let out.

We do not believe this is the beginning of a sustained bear market3 and here’s why:

  • The foundation of the global economy is sturdy – Economic growth in China has recently stabilized and growth is likely to remain above potential in the U.S. and Europe. We discuss this and more in the latest episode of the MD Market Watch podcast.
  • Recent volatility has been mostly limited to the stock market – Investment grade bond yield spreads remain near historic lows and high yield bond yield spreads have moved only slightly higher.
  • The yield curve remains positively sloped – This indicates that the market does not believe monetary policy is overly restrictive and that the U.S. Federal Reserve and other central banks still have the capacity to tighten further when needed.
  • Not all stocks are down – Companies with more reasonable valuations were insulted from the sell off, energy stocks have benefitted from the rebound in oil prices and financial companies have delivered relatively strong returns in the face of the drawdown.

However, there are risks to this view:

  • Inflation remains stubbornly high – It will take time before pandemic-induced supply chain disruptions are resolved, higher input costs normalize and pent-up consumer demand subsides. We expect these factors to all ease throughout 2022, but inflation will remain historically high, especially compared to pre-pandemic levels.
  • The removal of ultra-supportive government policy – The volatility we are seeing now combined with the gradual reduction in pandemic-level stimulus could create headwinds to the economy and corporate profitability. This will become more prominent as we progress through the year.
  • Valuations are still elevated – Despite the recent correction, prices for many assets remains high. An unruly unwinding of these excesses cannot be ruled out, but we think that secular trends (e-commerce, cloud computing and metaverse development for example) should prevent a material adjustment near term.

We remain overweight equities and maintain a procyclical position

Our view on the economy has not changed and our outlook for stocks remains positive over the next 12 months, albeit with less conviction than earlier in the stock market recovery due to the aforementioned risks. While it is not the best time to be invested in equities, it is by far, not the worst time either. Overall, we remain overweight equities and underweight bonds. We retain a modestly procyclical stance in our regional equity, sector and currency positioning.

The latest drawdown has not been as significant as some prior corrections (so far) and we recognize the potential for further volatility in the near term before stock markets ultimately move higher should our outlook materialize. It’s interesting to note that the average correction, once markets decline more than 10%, takes approximately 4 months to reach its low point and an additional 4 months to recover. However, more recent corrections, like those experienced throughout 2018, have peaked and recovered significantly quicker.

The risk of correction due to the extremely high valuations in pockets of the market has been a key concern we have been monitoring and analyzing. This risk is lower today which may provide opportunities to supplement some of our positions that we reduced over the last 12 months. However, it’s important to recognize that this risk has not been eliminated.

For more information, please do not hesitate to contact your MD Advisor*.

 

1 IPO (Initial Public Offering): The first time a company sells shares to the public to generate financing.

2 SPAC (Special Purpose Acquisition Company): A shell company with no operations set up for the purpose of acquiring a private company.

3 Bear market: When the market is down 20% from its peak for an extended period of time.

* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).

The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.

 

About the Author

Ian Taylor, CFA, is an Assistant Vice President with the Multi-Asset Management team. He oversees strategic and tactical asset allocation mandates, alternative investment mutual funds and is a member of MD’s Tactical and Risk Allocation Committee.

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