Published November 23rd 2022

Daily Brief - Are stocks worth the risk?

Growth stocks have gotten crushed this year. Meta at 2 times book might even be a value stock. Inflation looks to have peaked and the economy is finally showing signs it’s slowing down. So why isn’t everyone buying yet?

A couple of reasons. The first is an old maxim: don’t fight the Fed.

It may be that Powell and Co. are relieved to see core, trimmed and headline inflation ticking down. Are they relieved enough to pause, or even just take down the pace of hikes to 50 bps? It’s possible.

What they are definitely not ready to do is declare “Job done” and stop hiking. This tightening cycle isn’t over yet and the next few months offer the perfect opportunity to finish it: midterm election is over, presidential elections are far in the future, and a strong job market ensures little political pushback.

The chart below shows the danger of betting on a bull run too soon before the Fed actually starts to ease financial conditions. To be fair, the stock market is ACTUALLY a part - a small part - of monetary policy conditions so the reasoning here is ever so slightly circular. For the most part, monetary conditions are driven by Fed policy and interest rate yields.

monetary policy conditions index
Source: Real investment advice

The second reason it may be too soon to plunge in is the risk reward. The risk premium stock buyers receive - the Equity Risk Premium - is actually at the lows. In other words, although it may feel like a miserable time to buy stocks, markets aren’t even compensating you for it.

How can that be?

Rising yields. The way to calculate the added premium stock buyers get as a reward for holding a riskier stock over a risk free Treasury is to subtract that yield from the earnings the business makes per each share. It’s an imperfect measure to be sure but, economically, those earnings do belong to the shareholder even if they’re actually never paid out (and instead invested in further growth of the business … or exorbitant CEO salaries to reward their unmatched talent.)

equity risk premium

To wit: the Equity risk premium is almost zero right now. Part of it is slower earnings growth but the biggest issue for stock buyers is a viable alternative - for the first time in a long time fixed income is actually yielding a decent amount.

There are three ways the ERP can rise: earnings can grow faster (a tough task in a slowing economic environment), yields can decline (probably not while inflation is above 5 %) or - you guessed it - stocks have to get even cheaper …

For now, that may be the path of least resistance.

Idea Spotlight: Home Depot

TOGGLE analyzed 4 similar occasions in the past where analyst expectation indicators for HD:NYSE were low and historically, this led to a median increase in price. This insight received 5 out of 8 stars in our quality assessment.

The National Association of Home Builders is forecasting that the remodeling sector will fare the best among the residential construction submarkets during this current housing contraction.

home depot price history

Daily Brief - Are stocks worth the risk?

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