Major stock market indexes lost trillions of dollars in value last month. Uncertainty and volatility are still major concerns for investors as we move into February. It's a challenging environment, and investors should consider a few key factors as they manage their portfolios through this ongoing correction.
1. The correction isn't over yet
January was a wild ride. The S&P 500 dropped 7%, while the NASDAQ and Russell 2000 were down around 10%. That's a fairly painful correction, and there were signs of life in the last trading days of the month. Major indexes clawed back some of the previous losses, economic data was better than expected, and earnings season has been positive so far.
Unfortunately, it doesn't look like we're in the clear yet. Interest rates are still rising, putting pressure on stocks.
The Shiller PE Ratio is a popular metric that provides a general assessment of stock prices relative to corporate earnings. According to this ratio, stocks are around 30% more expensive than they were prior to the pandemic. Some of this can be explained by the expanded representation of high-growth tech giants in the S&P 500. Still, it's compelling evidence that the January swoon didn't completely reset valuations.
This observation is also backed up by the price-to-sales ratios of mega-cap tech stocks. Alphabet, Microsoft, and Apple are all well above pre-pandemic valuations based on this metric. These businesses are all strong operators delivering good economic results, but their long-term growth outlooks haven't changed to that degree. Even the laggards are just now dipping below pre-pandemic price-to-sales levels.
Some of the most aggressively priced stocks have come back down to earth, and valuations are much more rational that they were previously. However, there's more room for the market to drop if investor risk appetite continues to wane. Rate hikes from the Fed typically push investors toward lower-risk asset classes. It's not time to get too bullish with your portfolio.
2. Corporate earnings will be a temporary lifeline
Short-term stock market returns are generally dictated by momentum and global capital market trends. Long-term returns are generally driven by the cash flows produced by businesses. Everything is moving in the wrong direction when it comes to momentum and capital markets, so it's going to be tough to fight that tide for now.
However, February doesn't have to be all doom and gloom for investors. It's corporate earnings season, and early indications are mostly positive. With one-third of S&P 500 companies having published their fourth-quarter results, approximately 75% of them are exceeding analyst estimates. That should create some opportunities for more stocks to outperform their peers as they report quarterly earnings in February.
Earnings reports are important data points that shape investor expectations for future cash flows. Companies can impress Wall Street by publishing better-than-expected results and providing a favorable outlook for the rest of this year. Microsoft is one notable example of exactly this process in motion.
Communications and tech stocks have been among the best performers relative to expectations. That could slow the bleeding for a sector that's struggling with unsustainable valuations. Rising oil prices are also driving huge revenue growth and strong performance for energy stocks, which are staging a comeback after a few rough years.
As more companies report Q4 earnings, pay attention to their commentary about supply chain disruptions, labor shortages, and cost inflation. Businesses that manage these challenges have great opportunities for fundamental growth. That should offset some of the market forces weighing on stocks right now.
3. Value will outperform growth
Value stocks held up sneakily well in January. The Vanguard Value ETF dropped 2% last month, but that was better than growth stocks and the market in general. Investors are looking at rising interest rates and a Federal Reserve committed to fighting inflation. Economic data is positive overall, but it seems that growth is slowing to a modest pace.
These conditions aren't favorable for the stock market, and they're especially bad for growth stocks with high valuations. Investors are moving away from expensive stocks that had extremely high growth rates assumed in their price. Value stocks, which were left in the dust over the past two years, suddenly look much better for investors who are looking for safe places. Dividend yields are more valuable now that volatility is dominating short-term returns.
All of the forces that supported value stocks in January are still in play right now. Growth-stock valuations aren't so extreme anymore, but the market is still relatively expensive overall. Value stocks might be dragged down as the market sinks in general, but they still offer more opportunity with less risk for the time being.