Branstad: Hi, everyone. Thank you for joining us here at Thrivent Asset Management. I'm Jeff Branstad, portfolio manager.
Lowe: And I'm Steve Lowe, Chief Investment Strategist.
Branstad: Steve, the equity markets have had a pretty challenging year. Where are we at with that? There's been a little bit of a rally. Are we past the bottom? Do we have a feel on that yet?
Lowe: Yeah, it's been a, as you mentioned, very challenging year. It's been a volatile year; a lot of turmoil within the equity markets. We had a bear market level of down about 20%, 24% in the second quarter. If you look at that, that's close to a non-recessionary bear market, but not quite to where you would typically be in a bear market, which is down in the mid 30’s. Nasdaq and small-caps particularly took a hit. They're both down +30%. And it's just been a lot of volatility and particularly more so underneath the index level. If you're looking at the individual stocks, many of them are down 40%, 50%, 60% on average and median level within the index. So, there is a lot of damage beneath – beneath the surface.
You know – as I mentioned, volatility has been high, but not quite to the levels of the Great Financial Crisis or Covid. It hasn't spiked to the levels we've seen in some of the worst markets. What's driving the equity market has been higher rates. Equities are valued partly off of where rates are. And you've seen the long duration stocks, which are really growth stocks – far into the future. Those have been hit the hardest, which is one of the reasons why you've seen growth trail value so much this year.
But the market has bounced. That's very typical within a bear market. You see rallies of 10, 20, or more pretty frequently. It's come out strongly. And what triggered that was rate expectations rolling over a little bit, that people started to think that the Fed won't be able to raise as much as they want, and you see longer-term rates come off. And because of that, you've seen the higher beta parts of the market rally, particularly early in the third quarter, and growth [has] come back pretty strongly so far. And small caps also have bounced very significantly.
Branstad: We've seen a little bit of a rally so far in the third quarter. What's been driving that? What are the key pieces there?
Lowe: Yeah, we've seen a pretty significant bounce. It's been a risk on bounce. You've seen higher beta names rally, you've seen growth rally, small caps rebound. A lot of it has to do with lower rates and lower inflation expectations, just that longer term rates have gone down. People are expecting the Fed to cut relatively soon, maybe not have to go as far as they thought.
And the other thing is valuations became much more attractive, particularly on a long-term basis. You know, buying into the market when it's down 20% or so generally has paid off over time. And the positioning was really one sided. And you often see bounces within bear markets where markets rally once, [then] people get too bearish because the marginal seller doesn't exist anymore and it's very prone to sharp rallies when position gets too one sided, which it did.
Branstad: So, things are cheap, at least cheaper than they were. And even if they may go a little bit cheaper, in general, this would be a pretty attractive entry point for a lot of people, which is one of the drivers for seeing that bounce.
Lowe: Yeah, certainly. Once you reach the bear market level, over time, particularly over a one-year period, your odds of being down are low. That's somewhere in the order of 20%. So, if you have a longer-term horizon, buying when you reach that level with a long-term view works. You can still go down, you can end up buying 20%, and then it goes up 40%. But within a year, the odds are very high that you can have a positive return.
Branstad: So, how about the recession chances and the Fed's likelihood of a soft landing? How are the equity markets interpreting that?
Lowe: That's one of the reasons the market rallied earlier in the quarter, it's just that it's a little more optimism or a little more window into a soft landing. I mean, there's still a good chance baked into current valuations of a recession that will continue to be [there] until you see positive signs that inflation has rolled over durably and the Fed can ultimately back off.
Branstad: But the equity markets are staying consistent with what we've discussed about a roughly 50% chance of a recession, and it would be a more moderate recession. They're not running for the hills that there's going to be a severe recession or anything.
Lowe: At current levels, if they stayed there, it's priced in line was a moderate recession or a soft landing.
Branstad: Let's dig in under the hood a little bit. Earnings are going to be an important driver of long-term returns. They've had a lot of pressures with inflation and all of the input costs rising. What are we seeing on earnings so far?
Lowe: Yeah, earnings are very important because, over the long run, they drive the equity market. There's a lot of focus on them. I mean, earnings have been decelerating already heading into this year. You know, the peak was in 2020/21, so you've seen growth rates come down more in the 4–5% range. But for the full year, there’s still 10% earnings growth, which seems high with the economy slowing. And you're starting to see more companies revise their earnings guidance downward.
Margins are under pressure, demand is weakening. So, it's our expectation that that will continue. But earnings estimates look high, which is fairly typical. They tend to come down slowly. Analysts don't cut them; they just do so somewhat reluctantly. But the market is forward-looking, and it is anticipating this already.
If you look at valuations, the market is down largely off of multiples like the P/E ratio, because the E part of that has stayed stable. The only way for – it gets reflected in the multiple. But embedded within that, I think, is the expectation that earnings will go down. And you've seen some people talk about the next leg to hit the market will be earnings revisions, and it certainly could [to some degree]. But the point is that a lot of that is baked in, or some of it is at least.
Branstad: With the P/E's, then you've got your prices. That's what's come down so far. The earnings are going to come down next. How, then, do the prices come down with the earnings? Do they, you know –
Lowe: You see multiples or prices come down less than they would have independently. Maybe they're stable-to-up a little bit, but they could still fall. But you won't see the sharp drop that you saw so far this year. We saw valuations go from about 25 P/E, which is rich historically, down closer to 15. Nasdaq tech stocks are up above 30 on the multiple, which is very high. And those have come down to about somewhere around 20.
Branstad: Everybody knows that earnings need to come down from current expectations or current predictions, I guess. But a lot of that’s already been baked in.
Lowe: At least some of it. You know, it's hard to say whether it all is. That depends how far – if we have a recession and earnings come down 25%, 30%, though, that's not all baked in. But there already is the assumption that they will fall, but probably not to a full-blown recession level.
Branstad: When we look at the big picture from equities, what's our outlook on equities going forward? There's a lot of moving pieces here still.
Lowe: Yeah, it's a lot of moving pieces still. We're sort of cautiously optimistic, but somewhat cautious if we had a very significant bear market rally. We are a bit overweight to equity right now. We might use that to trim a bit, but I think it's really important to, when you're in a bear market, to look strategically long-term.
As we mentioned, if you go out over a ten-year period, once you hit a bear market level, you've only lost money about somewhere around 20% of the time in the postwar period. So, you don't want to miss that rally out of it. You need to keep it. You know, the point is, you need to stay active in the market and have a long-term view, because one of the things psychologically is that people pull out of the market and then they miss that rally.
Branstad: Yeah. It can come quick sometimes.
Lowe: Yeah. Keep a steady hand through it at this point; given that we're down, odds are very high that you’re going to be up over a one-year period and periods beyond that much more significantly.
Branstad: So, Steve, what are some of the areas within the equity markets that you're feeling the most confident about?
Lowe: Well, small caps are looking increasingly attractive. You look at the valuations; they're very attractive to their history and they're very attractive toward large caps. We have a model internally that we use, and it is signaling that it's about time to get overweight to small caps in a significant way. And the trigger to that tends to be when things are bottoming. In other words, confidence is low, credit spreads are getting wider, the economy is slowing. Because small caps tend to rally very hard from the bottom; it tends to be very cyclical. So, you want to get in at the bottom so you don't miss that. We're not quite there yet, but we're very, very close to getting very bullish on small caps.
Other areas – with the economy slowing, we would expect growth to fair well; value has outperformed strongly year-to-date. It's a function of inflation of rates. [Value] tends to do better when rates are going up and inflation is high. But when the economy slows, that turns over.
Inflation should moderate, rates should come down, and growth stocks in particular do. And the reason for that is investors turn toward growth stocks because there's a scarcity of growth elsewhere. And when value and cyclicals tend to do well is when the economy is stronger.
Branstad: And everyone's – there's more of a rising tide lifting all boats. But when the economy is slower, you’ve got to find the growth somewhere so you can find it at the growth stocks, the true growers.
Branstad: Thanks again for joining us today. For more information, please visit us at thriventfunds.com. Goodbye, and we'll see you next time.