Markets start the year off under pressure

Pretoria East March Newsletter 2022

In fact, market pullbacks like these are not uncommon at all. Below is a graph by Morningstar, which clearly indicates that we have experienced five similar pullbacks since early 2020 and many more over the long term.

In this case, the declines may simply represent an overdue reset of overvalued markets digesting the impact of higher interest rates going forward. The economy is still expected to grow at a healthy pace this year and, taking the historical perspective, interest rates are still expected to remain well below long-term averages.
High-flying technology stocks have been hit hardest, mostly due to lofty valuations that are unlikely to be justified, given future growth expectations. In times of rising interest rates leading to higher discount rates on company valuations, the price paid today becomes increasingly important. This dynamic has led to the most highly valued technology shares being hit the hardest.

The table below highlights price drawdowns for several indices and stocks in comparison with their peak valuations during the last three years. The valuation metric used in this instance is a price/sales multiple. Although less common than the price/earnings multiple, several of these technology stocks do not yet generate profits, thus rendering the price/earnings multiple unsuitable. Price sensitivity to high valuations is clear, especially in times of market distress and in a rising interest rate environment.

To sum up, markets have been under pressure for the year to date, but the outlook is not as dire as headlines may portray it to be. Even with growth rates slowing, the US economy is still projected to grow at a healthy rate during 2022 and 2023. As interest rates are set to increase, one must remember that they are coming off historical lows and are still expected to stay low for the foreseeable future, based on these historical standards. In times like these, it is important to focus on investing in quality companies with reasonable growth forecasts, without having to pay unreasonably lofty valuations.