Every once in a while, the stock market sends a stern reminder to the investing community that equity valuations don't climb in a straight line -- even if 2021 made you believe they did. This has been one of those years. Since hitting their respective all-time highs between November 2021 and the first week of January, the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite have all entered a bear market, with peak drops ranging from 22% to 38%.
Although there are a lot of factors that have pushed Wall Street into the grips of a bear market, the bulk of the finger-pointing is rightly aimed at the Federal Reserve. In hindsight, the Fed's dovish monetary policy, including its decision to sustain quantitative easing measures (i.e., long-term bond-buying designed to keep lending rates low), was a key component of the runaway inflation rate experienced this year. With the nation's central bank aggressively hiking interest rates to tame inflation, it's removed the cheap capital that had fueled growth stocks for so long.
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But there is an upside to a Fed-induced bear market: the bargains. Long-term investors are being given an opportunity to scoop up high-quality businesses at a discount, thanks to central bank's miscues. What follows are three of the smartest stocks to buy in a Fed-induced bear market.
Bank of America
The first genius buy in a Fed-induced bear market is none other than banking giant Bank of America (BAC 1.70%).
On one hand, bank stocks are cyclical, and therefore exposed to the temporary economic weakness that's likely to be caused by the Fed raising its federal funds target rate by an aggregate of 375 basis points in less than a year. It's not uncommon for banks to contend with higher loan losses during recessions.
On the other hand, this isn't a typical Fed tightening cycle. This is the first time in history the Fed has had no choice but to aggressively raise interest rates into a plunging market. This means certain dynamics change for bank stocks -- in this instance for the better.
Even though Bank of America is liable to see loan delinquencies and/or charge-offs grow in the quarters to come, higher interest rates are helping the company generate more net interest income from its outstanding variable-rate loans. In fact, no money-center bank is more sensitive to interest rate moves than BofA. With the Fed aggressively raising rates, BofA recognized a $2.7 billion year-over-year jump in net interest income to $13.9 billion in the September-ended quarter.
To add to the above, Bank of America estimates that a 100-basis-point parallel shift in the interest rate yield curve would produce $4.2 billion in added net interest income over the next 12 months. The Fed already moved another 75 basis points following the release of BofA's third-quarter results.
Bank of America's digitization initiatives are paying off, too. Digital transactions, such as banking online or via mobile app, are considerably cheaper for banks than in-person interactions. BofA has grown the number of active digital users by 5 million to 43 million over the trailing three-year period. More importantly, 48% of total sales were completed digitally in the third quarter, which is up 19 percentage points from the comparable period in 2019.
Long story short, the benefits of higher interest rates and this digital shift far outweigh any short-term loan loss concerns. That makes BofA an absolute steal at 10 times forward-year earnings.
Palo Alto Networks
The second extremely smart stock to buy in a Fed-induced bear market is cybersecurity stock Palo Alto Networks (PANW 4.19%).
If there's a knock against Palo Alto Networks, it's the company's valuation (43 times forward-year earnings). During bear markets, it's not unusual to see businesses with premium valuations take it on the chin. But valuation is a poor reason to avoid what looks to be a fast-growing and highly profitable player in the cybersecurity arena.
One of the best aspects of cybersecurity as a whole is that it's a very defensive industry. It doesn't matter how well or poorly the U.S. economy is performing, robots and hackers will always be out there trying to steal sensitive data. This makes data protection increasingly important, especially with businesses steadily shifting their operations and data online and into the cloud.
What's helped Palo Alto Networks turn heads is the company's four-year and counting operational transformation. Over this time, the company has de-emphasized physical firewall products in favor of software-as-a-service (SaaS) subscriptions. SaaS solutions are nimbler when responding to and dealing with potential threats, and happen to generate more predictable cash flow and better gross margin than physical firewall products.
Perhaps most interesting is the effect this shift has had on courting large businesses. In just the past two years, the number of customers spending $1 million on a trailing-12-month basis has grown 65% to 1,240, as of the end of fiscal 2022 (Palo Alto's fiscal year ends July 31). This ability to attract bigger clients has actually accelerated its sales growth at a time when most other businesses are seeing weaker growth prospects.
Something else to consider about Palo Alto Networks is the company's extensive history of making bolt-on acquisitions. Although higher interest rates could dissuade some future acquisitions, the company has regularly leaned on smaller buys as a means to expand its product/service ecosystem and cross-sell its solutions.
A bear market primarily caused by the Fed isn't going to have a substantive impact on Palo Alto's scorching-hot growth trajectory.
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Enterprise Products Partners
The third smart stock to buy in a Fed-induced bear market is energy stock Enterprise Products Partners (EPD -0.31%).
To some, the idea of putting your money to work in an oil and gas stock may not be appealing. It was, after all, just 31 months ago when West Texas Intermediate crude oil futures briefly traded at negative $40 per barrel. The volatility inherent in energy stocks since the pandemic began has made this industry an adventure, to say the least.
However, Enterprise Products Partners can easily allay investor's fears -- even in an environment where interest rates are rapidly climbing. That's because it's a midstream oil and gas company. Whereas drillers ebb and flow with energy commodity spot prices, midstream operators sign long-term fixed-fee or volume-based contracts with upstream drillers to transport, store, and possibly process energy commodities. These contracts are specifically designed to remove the effects of inflation and spot price volatility from the equation.
Being able to accurately predict how much operating cash flow it'll generate in a given year, no matter how wild the oil and natural gas market become, is very important for Enterprise Product Partners. Having a solid understanding of its cash flow is what's allowed the company to put $5.5 billion (in aggregate) to work in more than a dozen infrastructure projects. Most of these projects, which are heavily skewed toward natural gas liquids, are expected to be up and running by the end of 2023.
Enterprise Products Partners also looks to be in an ideal position to benefit from global energy supply chain woes. Earlier this year, Russia invaded Ukraine, which has cast doubt on Europe's energy commodity supply in the near term. Likewise, global energy companies reduced their investments during the pandemic. The end result of all of this is an inability to quickly boost oil and gas production anytime soon. This would appear to be a recipe for higher oil and gas prices, and all the more reason for drillers to eventually boost production. More production equates to more long-term midstream contracts for Enterprise.
And definitely don't overlook this company's stellar dividend. Enterprise Products Partners has increased its base annual distribution in each of the past 24 years, and is currently doling out an inflation-fighting 7.6% yield. At no point during the worst of the pandemic was this payout in danger of being reduced.
Valued at less than 10 times Wall Street's forecast earnings for 2023, Enterprise Products Partners appears to be gushing with potential.
