Athos Capital Advisors – Monthly Newsletter – October 2022
Quote of the Month
“A rich understanding of human psychology, a reasonable appreciation of financial theory, a deep awareness of history, and a broad exposure to current events all contribute to development of well-informed portfolio strategies.”
“Emphasizing inefficiently priced asset classes with interesting active management opportunities increases the odds of investment success. Intelligent acceptance of illiquidity and a value orientation constitute a sensible, conservative approach to portfolio management.”
David Swensen, Chief Investment Officer, Yale University Endowment
Market Update & Outlook
Interest Rate Expectation – Fed Funds Futures
Stocks rallied in October on the heels of data suggesting inflation is moderating. The stock and bond markets quickly reacted with yields declining and stocks rising and expectations for future Fed rate hikes coming down slightly. The “terminal rate” (the highest rate in this rate hiking cycle) is now expected to be 4.9% in May 2023, down from 5.3% just a couple of weeks prior. This continues to be one of the most important charts to monitor as just about everything in the financial markets is quickly repricing based on where the world thinks the Fed will take interest rates over the coming months and year.
The Energy sector resumed its out-performance during October with a market leading 25% gain compared to 8.1% for the S&P 500. The chart below shows just how dominant Energy has been – in fact, it is the only sector within the S&P 500 that is up this year. Despite a rise of nearly 70% the opportunity in Energy remains – the sector is still the cheapest in the market, most investors are still significantly underweight the sector, and earnings growth, dividend growth, and significant share buybacks combine to make the sector still the most attractive area of the stock market.
10 Years of Energy Sector Under-performance
Most investors are underweight (or not exposed at all) to Energy because it has been a very poor returning sector for the past 10 years. In fact, one of the best things you could have done over the past 10 years was to avoid Energy all together and focus on technology and other growth stocks. That playbook has completely reversed in 2022 with the Technology sector becoming one of the most important parts of the market to avoid and Energy the most important part to focus on.
Is Energy still an attractive investment?
It’s critically important in investing to avoid performance chasing (chasing the best performing asset class in hopes it continues to be the best performing asset class). In the case of Energy that risk, on the surface, appears very valid. However, looking more closely the two fundamental drivers of investment returns – valuation and earnings growth – remain quite attractive in Energy. By a wide margin, the sector is still by far the cheapest part of the stock market. The sector pays the biggest dividend, yielding 3.9%, and trades at a very modest 8.6x PE Ratio. This is made all the more impressive after the big run up this year but the vast majority of the 70% gain in the sector this year has been led by growth in earnings and that growth is set to continue if commodity prices stay around these levels. Put simply, Energy stocks are still the cheapest part of the market yet also the sector with the most earnings growth.
Energy is still very under-owned by most investors
Most investors still remain very underexposed to Energy equities. The combination of a decade of underperformance, the demonization of fossil fuels, and the dominance of big tech in the large US stock market indices has put Energy as a percent of the S&P 500 at just 5.4%. Apple alone is a bigger weight in the S&P 500 than the entire Energy sector (Apple is 6.3% while Energy is 5.4%).
Mid-Term Elections and Stock Market Performance
Last Tuesday the United States electorate went to the polls to vote in the widely anticipated 2022 Midterm Elections. A lot of clients have asked how the stock market fares after Midterm elections so we went back and crunched the numbers. The historical data is interesting – going back to 1942 the stock market has always produced a positive return twelve months after the Midterm election. Additionally, the final three months of the year have on average been very strong during Midterm years. While the historical data suggests a prolonged stock market rally, we are taking this all with a grain of salt at Athos Capital. This has been a year where longstanding trends and patterns have been shattered and caution remains warranted.