To start this piece, I’d like to make one thing very clear: I am long-term bullish on the U.S. stock market. That is, over the next three to five-plus years, I believe stocks will power considerably higher.
However, stocks don’t go up in straight lines. They take two steps forward, and one step back. And that brings us to the topic of this piece…
The stock market has taken some huge steps forward over the past few years. Indeed, after rattling off three consecutive years of 15%-plus gains, the S&P 500 is tracking for its best three-year stretch since the late 1990s.
But now, the market is taking a step back, and I’m here to tell you that things will likely get uglier before they get prettier.
The new year is off to a rough start. Year-to-date, the S&P 500 is down nearly 3%, marking one of its worst starts to a calendar year in recent memory.
The culprit, of course, is the Federal Reserve. The so-called “masters of the financial universe” – because they control the key interest rate that determines the supply of money in the U.S. economy – has gone from providing a wall of liquidity for markets in 2021, to promising to pull that liquidity out of the markets in 2022 via rate hikes and balance sheet reductions.
It’s not good news. The stock market has expanded to ultra-rich valuation levels since the pandemic emerged on the idea that the Fed would sustain easy monetary policy. But, now that the Fed has changed its tune, the stock market needs to correct to lower valuation levels.
That’s the story. And the numbers tell us that stocks have lower to go before they’ve been fully “repriced” for higher rates.
The Fed is forecasting for three rate hikes in 2022. The market, however, is increasingly expecting four rate hikes this year. That would put the lower end of the Federal Funds Target Range at 1%. Based on our analysis, a Fed Funds rate that high should produce a 10-year Treasury yield in excess of 2.5%.
Over the past 20 years, the 10-year Treasury yield has often traded north of 2.5%. When it has, the S&P 500 has averaged a trailing earnings multiple of about 19X.
Analysts are forecasting calendar 2022 earnings for the S&P 500 at $225 per share. A 19X multiple on $225 in earnings per share produces a 2022 price target for the index of 4,275 – which is more than 10% below where the market entered the year, and about 7% below where the market currently trades.
In other words, if the Fed does hike rates four times this year, the stock market’s three-year party will end – and stocks will broadly drop.
Scary… but also exciting…
Because, as we like to say around here at InvestorPlace, it isn’t so much a stock market as it is a market of stocks.
The implication is that even if the stock market struggles in 2022, there will be certain stocks and sectors in the market that will still protect your wealth and generate huge returns.
So, the million-dollar question is: What are those stocks?
We have a theory… that is totally counterintuitive, controversial, and contrarian… but which we think is supported by a ton of evidence… about which stocks will outperform in a choppy 2022 for the markets.
That theory is that super rate-sensitive, early-stage growth stocks will win big this year.
I know. It’s opposite everything you’ve heard on CNBC, Bloomberg, Fox Business, and elsewhere. Those stocks are supposed to get crushed in 2022 as rates go higher, right? They’re the ones with most sensitivity to rate hikes!
True. But, because of their ultra-sensitivity to rate hikes, they’ve already been repriced for higher rates. Many of them have already dropped 50% or more. And that sell-off isn’t because of weak earnings or sales trends. For most of these stocks, sales and earnings are still growing at an extremely quick pace, meaning that behind their 50%-plus drops is an even bigger contraction in their valuation multiples.
These washed-out stocks are already priced for low rates!
But, as evidenced by the “back-of-the-napkin” math above, the rest of the market isn’t. So, when rate hikes do roll around in 2022, the stocks already priced for higher rates – the early-stage growth stocks – will work, while the stocks not priced for higher rates – the value stocks – will not work.
Sounds crazy, sure. But it has historical precedent. In fact, this is exactly what happened the last time the Fed entered a rate hike cycle in late 2016.
All year long, investors were worried about what rate hikes would mean for growth stocks. So, in anticipation of the Fed hiking rates, investors sold growth stocks and piled into value stocks throughout 2016.
In that year,
Square, err, Block (NYSE:SQ) suffered two 30%-plus corrections, Shopify (NYSE:SHOP) dropped more than 15% on four separate occasions, Netflix (NASDAQ:NFLX) got washed out by 30%, Amazon (NASDAQ:AMZN) collapsed more than 15% twice, and Salesforce (NYSE:CRM) dropped ~20% or more three times.
Then, in 2019 after the Fed entered its steady rate hike cycle, all five of those stocks rose more than 50%, paced by 150%-plus gains in the two “growthiest” stocks in the group – Shopify and Square.
Get the point? Growth stocks get repriced for rate hikes well ahead of when the rate hikes actually happen because they’re so sensitive to those rate hikes. So, when the Fed does actually hike rates, the proverbial band-aid is ripped off, and those stocks start soaring again.
Same thing is going to happen in 2022. Growth stocks are going be volatile until the Fed actually hikes rates. Then, once they get into a rate-hiking groove – which they will by mid-2022 – those washed-out growth stocks are going to come storming back.
History has a tendency to repeat. That’s what it is doing right now. So, let’s position ourselves on the right side of history by buying growth stocks.
If this contrarian bull thesis sounds compelling to you, click here. You’ll find out how to win in this down market.
On the date of publication, Luke Lango did not have (either directly or indirectly) any positions in the securities mentioned in this article.