Page 12 - ISQ July 2022

INVESTMENT STRATEGY QUARTERLY

tinue to tilt portfolios in favour of value for now, we recommend using
the downdrafts as an opportunity to accumulate growth – increasing “ We see plenty of companies trading
our conviction once momentum builds and/or the economic picture
improves. near or below pre-COVID prices,
while earnings are significantly above
We believe small-cap equities are another area likely to provide
opportunity in a recovery. Small caps are now trading at 12.2x P/E early 2020 levels – resulting in
”
– the lowest of the past 20 years outside of the credit crisis and attractive valuations.
COVID shutdown which hit ~10x. The current 35% P/E discount to
the S&P 500 was only lower at the COVID shutdown bottom (~40%
discount). While this is intriguing, our view that the current bear
market may have more to go (in price or time) creates a pause for months, and that equities will be higher than current levels over
the higher beta, more volatile small caps. For example, if the the next year. But this progress is unlikely to occur quickly, and
economy moves into recession, and the market moves to new stocks may ultimately need to move lower before all is said and
lows, small caps are likely to underperform. However, small caps done. The trajectory of inflation will remain a large influence on
are likely to outperform on the other side of this bear market as Fed policy and the economy, in turn being a key impact on equity
well. For now, we lean toward large-cap equities but look to accu- market trends moving forward. With that said (and given the S&P
mulate small caps when opportunity presents itself. 500 is already down 24% from its highs), we believe investors
should manage the current environment with an eye on opportu-
Within sectors, there are clear winners and laggards in the current nity for the other side of this bear market. Large caps, value,
environment. Energy is the clear leader right now – buoyed by Energy, and more defensive areas are likely to outperform as long
high oil prices and capital discipline, resulting in strong funda- as the market downtrend persists. But small caps, growth, and
mentals. The more defensive areas such as Utilities have also held areas more levered to inflation improvement and lower bond
up relatively well through the market’s volatility. While these yields (i.e., the Consumer Discretionary and Technology sectors)
groups may continue to outperform the longer market weakness are likely to see the sharpest rallies once the dust settles. We rec-
persists, they are unlikely to outperform when the economic ommend long-term investors use the market downdrafts as
backdrop improves. On the flip side, the Consumer Discretionary opportunities to accumulate favoured areas – increasing convic-
sector has come under intense pressure with high energy prices tion as inflation and/or technical momentum improves.
and input costs weighing on margins. Additionally, sharply higher
interest rates have weighed on Technology’s high valuations,
though fundamental trends remain solid. Finding the right port- KEY TAKEAWAYS:
folio balance is important for managing the current environment.
We would continue to err on the defensive side for now, but use • Unless the narrative changes in regard to Russia
the downdrafts as opportunity to accumulate those stocks more backing off or China ending COVID lockdowns, it will
levered to an improvement in inflation. be difficult for equities to sustainably move to the
upside without better inflation data.
At the stock level, valuation has become more compelling across • While overall we believe that the market may remain
sectors. We see plenty of companies trading near or below pre- challenged with additional weakness in the coming
COVID prices, while earnings are significantly above early 2020 weeks and months, we also believe equities will be
levels – resulting in attractive valuations, particularly for compa- higher over the next 12 months given our belief that
nies with stable or improving fundamental outlooks. Valuation inflation moderates as the year progresses.
can be a poor timing indicator, but it matters for potential returns
over the long term, presenting a more favourable setup once the • Diversification is paramount in weak trends, as is
dust settles on this bear market. And while these stocks can get finding the right balance of ‘defence’ for the current
cheaper before the downside pressure abates, earnings often win trend and opportunity for the eventual recovery.
out over the long term. • We recommend long-term investors use the market
downdrafts as opportunities to accumulate favoured
THE TIDE WILL TURN areas – increasing our conviction as inflation and/or
In sum, we believe it will be difficult for the market to move sus- technical momentum improves.
tainably higher without an improvement in inflation. We do
believe that inflation will moderate over the next six to twelve

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