BofA Securities’ widely-followed U.S. quantitative strategist Savita Subramanian has updated her S&P 500 forecast for 2022 and for investors the news is … not great. The 4600 target is less than 2 per cent higher than current levels.
The main limiting factor for equity gains is not the economy – BofA is bullish on U.S. growth - it’s the Federal Reserve. Ms. Subramanian estimates that the central bank’s post-financial crisis monetary expansion is responsible for more than 50 per cent of S&P 500 gains since 2010, and the expected tapering of monetary support next year will result in market weakness.
The dominance of growth stocks in the benchmark has made U.S. stocks highly sensitive to changes in interest rates, and this will require some explaining.
The most commonly accepted definition of an equity’s correct price is the use of discounted cash flow analysis to calculate the present value of future cash flows or, more simply, the current value of future earnings.
Investors do not need to do this math themselves, but they do need to know that high growth stocks respond extremely negatively to increases in interest rates. And the S&P 500, with the five biggest growth-oriented technology stocks making up between 20 and 25 per cent of its market capitalization, will take a hit if the Federal Reserve’s monetary tightening results in higher rates.
Ms. Subramanian estimates that the S&P 500 will fall four per cent for each one-tenth of a percentage point increase in the 10-year Treasury bond yield. This will be offset by other positive factors like earnings growth, but it does highlight the danger of higher bond yields to equity returns.
The strategist warned B of A clients about upcoming volatility in blunt terms rarely seen in research reports. “This [rally] may not end now. But when it ends, it could end badly,” she wrote. “If taper means no upside to the S&P 500, tightening [raising interest rates] would be worse”.
Ms. Subramanian recommends investors add portfolio positions in dividend growth stocks in sectors like energy, financials and materials that have historically outperformed during periods of inflation.
-- Scott Barlow, Globe and Mail market strategist
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Ask Globe Investor
Question: Many foresee another “wave” in this pandemic with the Delta virus and the fear of even more serious variants developing. What is that going to do this time to regular blue-chip stocks? – Jennifer W.
Answer: Stocks (blue-chip and others) have done very well throughout the pandemic, after the market plunged in March 2020 when the seriousness of the coronavirus became apparent. It turned out to be the shortest bear market in history as all North American indexes rallied back to record highs.
There are four major reasons why this happened.
First, central banks slashed interest rates to near zero and reintroduced quantitative easing programs to stimulate the economy.
Second, massive government spending programs provided support for laid-off employees, small businesses, renters, and others affected by the pandemic.
Third, stock markets always look to the future, not the past. Markets rose in anticipation of a recovery that would produce higher corporate profits, which has happened.
Finally, low interest rates have reduced real yields on bonds (after accounting for inflation and taxes) to negative territory, leaving stocks as the only profitable option.
As you note, we are now in the fourth wave of the pandemic. How bad will it be and what will be the impact on stocks? Even if it’s as bad as previous waves, which is doubtful because more people are now vaccinated, I doubt we will see the kind of reaction as we did in March 2020. The safety mechanisms I mentioned are still in place and the recovery mentality continues to drive prices higher. Even record new infections in places like Florida and Texas aren’t slowing down the markets.
However, given the strong run the markets have enjoyed, we are likely to experience a slowdown going forward. Prices are high and the components aren’t in place to sustain the recent momentum we’ve enjoyed.
The bottom line is the growth pattern of your blue-chip stocks is likely to slow, no matter what happens. That said, I’d continue to hold them for the long term.
What’s up in the days ahead
Rob Carrick will tell us why the move by three big banks to ban sales of third-party mutual funds by their financial planners is bad for customers.
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Compiled by Globe Investor Staff