- We remain underweight equities in our overall asset allocation framework. Within equities, we favour the S&P 500, which appears near fair value now. Other major indices still appear rich.
- The energy sector offers exceptional value and dividend/cashflow yields. We view the current weakness in oil price as an opportunity to put on longer-term energy positions.
- We move semiconductors from overweight to marketweight. We view this as a tactical move and expect return to overweight as consumer-facing companies work off excess inventories.
Broad Equity Indices Face Downside
In our overall Asset Allocation framework, we continue to underweight equities. We think the combination of rising rates, inflation, a slowing economy and ongoing geopolitical tensions will increasingly weigh on earnings, leading to further declines in equities. Equity valuations will come under pressure too. The S&P 500 (SPX) forward P/E ratio is now 17.5. As rates rise, it will likely fall. Based on current earnings projections, P/E of 16 and 15 imply SPX declines of 7.5% and 13.3% respectively. Lower earnings would mean further declines.
We do not have a downside price target in mind; our point is that risks appear weighted to the downside.
That said, based on current earnings projections and free cashflow generation, SPX is close to fair value. We expect it will trade in a range near 3900 for now, until new (and presumably) more negative news comes out.
Within the equity space, we favour SPX over the NASDAQ 100 (NDX) and Russell 2000 (RTY). Both are overvalued relative to earnings and free cashflow, with the NDX more so.
We are also underweight European equity indices, including the STOXX Europe 600 (SXXP), Euro STOXX 50 (SX5E), and FTSE 100 (UKX) indices. Earnings projections for these indices have not yet begun to price in the likelihood of recession in Europe and the UK.
Energy Sector Offers Significant Value
Oil prices have been falling steadily as consumers adjust to high prices and Russian oil somehow finds its way onto global markets. The benchmark West Texas Intermediate futures has dropped to $82, decisively below $100, and Brent futures are near $87.
Historically, that would have been a yellow flag for the fossil fuel energy sector. But things are different now. In the past, energy companies would have been ramping up production as oil prices soared above $100. But not this time. Instead, as they made clear during the recent earnings season, their priority now is returning cash to investors through dividends and share buybacks.
Markets do not altogether believe them. The forward P/E of the XLE ETF is now only about 40% of the SPX – historically, it has been in the 60-80% range (Chart 1). The dividend yield is about 4% – roughly double its level in the post-financial crisis period when oil prices were also relatively high (Chart 2). And free cashflow yield – the raw material of CAPEX but also dividends and share buybacks – is over 12%.
It is an open question whether and when energy company equity prices will reflect this new reality. But the combination of dividends and share buybacks should ensure that the energy sector provides an attractive total return.
We do not expect oil prices to keep falling to below $60, barring some crisis and economic collapse. But the current softness will likely push energy equities lower. We view this as an exceptionally attractive opportunity to add to energy positions, whether through ETFs or individual companies. Our latest Explainers dive into which energy ETFs look promising, and the difference between commodity ETFs and equity ETFs.
The Good and Bad About Semiconductor Stocks
We have advocated an overweight position on semiconductor stocks since last autumn. This was due to the widespread shortage of semiconductors as economies worldwide started to fully reopen after pandemic lockdowns. We admit this trade has worked poorly (Chart 3). Since inception, it has underperformed the SPX by about 10%.
The primary reason is weakness among companies that make semiconductor chips for consumer goods – especially those in such heavy demand during the pandemic lockdowns. Many of these companies are well-known to the public, including Nvidia (NVDA) and Dell Computer (DELL). These problems mostly appear to be a matter of working off excess inventories rather than an outright collapse of demand.
Meanwhile, companies that focus on semiconductors for industry and corporate IT departments generally report strong earning and outlooks – most recently Broadcom (AVGO), which said its backlog is nearly a year.
A key source of demand for semiconductor chips is the auto sector. Over the past year, monthly auto sales have been around 13 million (annualized rate), versus a normal rate near 17 million (Chart 4). They could surely sell that volume if they could get the chips they need. Instead, that demand has been met by used cars – where prices are some 60% above pre-pandemic levels.
Clearly, the tactical trade would be to underweight consumer-oriented semiconductor companies and overweight industry-facing companies. Current ETFs do not provide that option.
We acknowledge near-term technicals may be challenging for the semiconductor industry until consumer-oriented companies work off inventories. And there is a risk that demand from corporations slows.
On balance, we move to a marketweight position. We view this as a tactical move. Medium term, we are bullish on the semiconductor industry. After all, the world is only becoming more digital.
- We close out our position in AWAY, a reopening theme trade. AWAY holds equities in internet-based travel companies. It has underperformed the SPX by 25% since last November. Many of these companies are loss-making. Apparently, they were unable to capitalize on the massive travel boom as economies reopened. There is little hope they as a group will succeed as travel returns to normal.
- In the energy sector, we close out our position in OIH, an oil and gas services company focused on exploration and production. With little new CAPEX entering this sector, it is likely to underperform relative to more diversified energy companies.
- As noted, we move semiconductors from overweight to marketweight.