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Wishing all our readers a prosperous and healthy Lunar New Year!

There’s no telling when the market is going to bottom.

But we’ve recently gained enough confidence to start averaging in. The article below explains why.

Note: I’m deploying cash when I buy stocks. Despite an optimistic medium-term view, I’d still caution against taking leverage at this point, just given where valuations are at vs historicals (corp credit spreads are tight and P/E multiples slightly elevated in absolute terms).

Disclaimer: Unless otherwise indicated, all the data is as of last Friday’s close.

Disclaimer: We’ve recently bought several of the stocks listed below. My only regret is that I didn’t publish this article before Netflix’s 12% pop last night!! Note that all the prices are as of last Friday.

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Why We’ve Started Buying

1) NASDAQ Drawdown 4th Largest In Decade

2) Market already expects up to 9 rates hikes in the next 2 years, leaving less room for further unexpected rate hikes

3) It’s not about Rate Hikes per se, but Unexpected Rate Hikes

4) Growth stock valuations are back to pre-pandemic levels

5) Corporate share buyback blackout window is ending

What’s Cheap?

1) High Quality Growth Stocks

2) Japanese Retailers

3) Asian High Yield Bonds

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Why We’ve Started Buying

What Caused the Recent Market Rout

The market is worried about contractionary monetary policy. In short, one of the Federal Reserve’s mandates is to keep inflation at roughly 2% (“stable prices” for the economy). Inflation has been greater than that in the past few quarters.

The Fed has indicated it’ll combat inflation and it’s likely to do so in two ways: rising interest rates and shrinkage of the Fed’s balance sheet.

That’s bad news for growth stocks. To see why, see the impact that QE had on the combined market caps of Apple, Amazon, Facebook, Google, Microsoft, and Netflix.

In particular, growth stocks with zero profit are especially badly hit. For instance, Zoom is down 65% from its 52-week high while EV manufacturer Lucid Group is down 47% from its high in November ’21.

In recent past, the Fed had been active in supporting the market during downturns (now referred to as the “Fed Put”). It means that after any equity market sell-off, it was only a matter of time before the US Federal Reserve came to the rescue by easing financial conditions.

Things have changed. With persistent inflation and already high employment rates, the market can no longer assume that the Fed will ease monetary policy whenever the market sells off.

Why We’ve Started Buying

NASDAQ Drawdown is 4th Largest in Past Decade

NASDAQ’s current peak-to-trough drawdown from the all-time highs is 16%, the 4th largest drawdown in the past decade (see chart below for severity of past drawdowns). Do note that the market has recovered somewhat in the past two trading days.

Will this market rout be as bad as the March 2020 sell-off, when the markets were starting to take note of a paradigm-changing pandemic? Personally I think not, though it’s up for discussion.

Assuming that the market rout bottoms somewhere between this -16% and -30% mark, I’m comfortable to start averaging into select sectors (detailed in the second half of the article).

Market already expects up to 9 Rates Hikes in the next 2 years

This means that a lot of the Fed’s hawkishness has been priced in, leaving less room for any incremental rate shocks.

It’s not about Rate Hikes per se, but Unexpected Rate Hikes

Markets don’t continue crashing every time there is a rate hike. Market volatility comes when rate hikes come sooner than expected OR when the pace of rate hikes is faster-than-expected.

Here’s what history says about the market P/E around the first Fed hikes. The trends prior to the first rate hike don’t seem to indicate any particular pattern. The most discernable is a ~5% P/E dip in the 3 months after the first rate hike and a recovery subsequently.

Meanwhile, this is what history says about market performance throughout the period of rate hikes. S&P 500 performance has generally been positive, aside from two periods of very sharp rate hikes.

These results makes sense. If the Fed is pursuing such an aggressive contractionary monetary policy, economic growth must be fairly robust. (Remember that the Fed has a dual mandate: maximum employment and stable inflation.)

And robust economic growth should generally translate to a growth in corporate earnings and a healthy market performance. So given our medium term horizon (1 to 2 years), we’re happy to start averaging into the market through the upcoming rate hike period.

Growth Stock Valuations are back to Pre-Pandemic Levels

Given that growth stocks have come off quite a fair bit during this market rout, we wanted to check what the valuations are at the moment.

Valuations are back to pre-pandemic levels, which gives us confidence to start buying at current prices. High Growth & High Margin Growth Stocks are at 8x EV/Sales while High Growth & Low Margin Stocks are at 6x EV/Sales (crashing from 15x since early-2021).

Corporate Share Buyback Blackout window is ending

Generally, companies are restricted from conducting share buybacks for two weeks before the results season till 48 hours after. With several mega-caps yet to announce their results, it’s plausible for there to be incremental support from corporate share buybacks as 4Q earnings season progresses.

Corporate share buybacks can be very significant. US share buybacks authorizations amounted to US$1.2 trillion through 31 Dec 2021, and Goldman Sachs expects it to be the largest source of US equity demand this year.

There have been prior studies showing a negligible relationship between share buyback blackout periods and market performance. In our minds, this would make the commencement of corporate share buybacks a non-event at worst, a positive event otherwise.

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High Quality Growth Stocks (Netflix, Salesforce, Amazon)

In a rising interest rate environment, growth stocks with especially high valuation multiples can collapse. Doubly so for stocks with zero earnings.

But given the market rout, it might be worthwhile to start picking up some “high quality” growth stocks. By this, we’re referring to those with solid earnings track records and strong competitive moats.

Here are a list of stocks from the NASDAQ 100 Index with a P/S multiple of less than 10x and a 3Y average EPS growth rate of at least 10%. Stocks with negative EPS are excluded from the list.

In this regard, Salesforce, Amazon and Netflix stand out to us. All three have very high competitive moats and have experienced outsized declines from recent peaks. We view them as “laggards”, having not rallied much in 2021 but having taken a beating in Jan 2022.

Moderna stands out too, but we have many more qualifications on that front so we’re discussing it in a different article.

Disclaimer: Data shown is as of last Friday. Unfortunately, Netflix has already popped 12% last night.

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Japanese Retailers (“Donki” & “Muji” over “Uniqlo”)

Japan currently has one of the strictest social distancing policies in response to Omicron. Last week, Prime Minister Fumio Kishida recently expanded the Covid-19 quasi-state of emergency to 18 additional prefectures, to a total of 34 out of 47 prefectures.

The measures are effective till 20 Feb. They include shortened business hours for restaurants and other establishments, restrictions on the sale of alcohol in restaurants and bars, and/or limits on the number of customers in enclosed spaces.

Given that Omicron spreads particularly fast and appears to induce milder symptoms in the vaccinated, we’re thinking ahead and trying to identify some of the potential beneficiaries from a loosening of the Covid-19 measures after the Omicron wave has peaked.

We’re not yet ready to look at local hospitality plays (i.e. hotels) given that the Japanese government doesn’t seem at all eager to open borders…

On the other hand, some of Japan’s domestic retailers are looking interesting after correcting 41% to 44% from their peak in Mar 2021. In particular, “Donki’s” and “Muji’s” valuations look attractive to us at current levels and we see them as potential “reopening” plays. Check out the charts below.

• “Donki” or Pan Pacific International Holdings (7532 JP)
• “Muji” or Ryohin Keikaku (7453 JP)
• “Uniqlo” or Fast Retailing (9983 JP)

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Asian High Yield Bonds (ETFs and Mutual Funds)

Regarding Chinese stocks, we’ve received several questions but I’ve little conviction/clarity on that front. A friend of mine who is a portfolio manager for Chinese equities recently mentioned that she expects the Chinese market to be range-bound, given that it’s a political year.

When it comes to China High Yield Bonds, I’m a little more optimistic. Given that Asian High Yield Bonds ETFs and mutual funds will naturally have a high exposure to China High Yield, I’m choosing those as the main instruments of choice. I’m not looking at single line bonds.

Importantly, while brokers continue to expect elevated China Property High Yield defaults rates in 2022, much of this is already reflected in the ETFs/mutual funds, since the bonds which are likely to default are already trading significantly below par.

According to a Goldman Sachs report (7 Jan 2022), investors can potentially still breakeven as long as the default rate for China High Yield Property developers bonds remain below 40%. Goldman’s base case is for default rates to be 19% in 2022 (after the 28% default rate in 2021).

Given the context, our view is that Asian High Yield Bonds provides an attractive risk-reward at current levels. I have recently bought into iShares USD Asia High Yield Bond Index ETF (AHYG SG), and already hold the PIMCO Asia High Yield Bond Fund.