Stocks Could Have a Messy Fall. Time to Embrace the Risks.

Yet, this year’s turmoil also offers opportunity: Stocks are cheaper than they have been in a long time, and shares of companies with competitive business models, healthy balance sheets, and steady cash flows beckon. The fixed-income market offers even more from which to choose, with numerous categories sporting their highest yields in years. It is tempting to focus on macroeconomic forces that have depressed stocks and lifted bond yields in the first eight months of the year, and many Wall Street strategists do. But investors who pick their spots well could benefit from the prevailing negative trends.

Barron’s recently canvassed eight Wall Street strategists to get their read on the investment outlook for the rest of the year. While the average target among the group puts the S&P 500 at 4185 at year end, up 6% from recent levels, individual estimates range from 3600 to 4800. That’s an unusually large span with four months remaining in the year, and reflects widely divergent views on the strength of the economy and corporate earnings, and the Fed’s determination to fight inflation.

Some strategists, like Ed Yardeni, proprietor of Yardeni Research, see more of a muted recession than a full-blown economic contraction. “If we’re going to have a recession, it could be very shallow,” he says. “Or, it could be a rolling recession that hits different sectors at different times, like we arguably saw in the mid-1980s.”

U.S. gross domestic product contracted at an annualized 1.6% in the first quarter and 0.6% in the second, but underlying trends don’t suggest the economy is in a recession. “When I look at the underlying dynamics [of the economy], be it corporates, be it households and consumers, the real economy doesn’t look so bad outside of inflation,” says Sonal Desai, chief investment officer of Franklin Templeton Fixed Income and a member of Barron’s Roundtable.

Desai sees little evidence of a broad slowdown in economic activity—at least not yet—and says the coming year could bring more of a zero-growth, stagnant economy than a meaningfully shrinking one. Strength in the job market and consumer balance sheets have much to do with that, even though inflation is taking a bite out of incomes: Annual inflation of 8.3% is equivalent to lopping off one month of a worker’s annual salary, and savings will last only so long.

For stock market bulls, a potential peak in inflation is enough to get excited about the market’s prospects. Should inflation continue to decline, investors could look ahead to the eventual end of the Fed’s tightening cycle and expect less economic and earnings damage.

J.P. Morgan ’s chief U.S. equity strategist, Dubravko Lakos-Bujas, has a year-end S&P 500 target of 4800, reflecting a 20% gain from here, and a record high. He doesn’t expect a global recession and sees inflation easing as commodity prices decline and other pressures fade. He notes that people are underinvested: As of late August, funds’ relative exposure to the stock market was lower than 90% of historical readings. Alongside corporate share buybacks, he expects to see daily inflows into equities of several billion dollars a day over the next few months, lifting indexes.

Wells Fargo ’s head of equity strategy, Christopher Harvey, sees the economy and earnings holding up in the second half of 2022, before a potentially more challenging 2023. He doesn’t expect the Fed to get more hawkish, and thinks the pressure on stock multiples from rising bond yields is largely played out.

“We’ve seen the top on yields, the Fed is going to decelerate, and the fundamentals aren’t as bad as feared,” says Harvey. “The places where we have begun to see some negative revisions and margin compression have been more so on the growth side. And that’s where we already saw that big derating in the first half of this year. Let’s not forget, this was the worst first half in over 50 years. A lot of the bad news is already priced in, and it wouldn’t be surprising to see a bounce.”

Harvey has maintained his 4715 year-end target for the S&P 500 all year. He recommends a growth-at-a-reasonable-price tilt, emphasizing quality in a potentially rockier economy next year. He’s bullish on the more media- and technology-leaning areas of communication services—as opposed to telecom—and bearish on software and retail stocks. Harvey also recommends creating a so-called barbell portfolio with more-defensive companies, namely in food, beverage, and tobacco. The Invesco Dynamic Food & Beverage exchange-traded fund (ticker: PBJ) is one way to execute this idea.

Among market sectors, energy stocks have a lot of fans for the remainder of this year. Elevated oil and gas prices look likely to stick—not at $120-a-barrel oil but comfortably above the cost of production. Energy companies are harvesting profits, paying down debt, and spending more responsibly than in the past. Shareholders will continue to benefit, strategists say—energy is far and away the best-performing sector in the S&P 500 in 2022, up 41%. The Energy Select Sector SPDR ETF (XLE) provides broad exposure to the sector and yields 4.2% in dividends annually, while the iShares U.S. Oil & Gas Exploration & Production ETF (IEO) is more concentrated in the upstream subsector.

Healthcare is another popular recommendation among investment strategists. The sector is increasingly tech-focused, with enviable secular growth characteristics. But it doesn’t trade for an overly pricey valuation multiple, perhaps due to concerns about government legislation, including a drug-price negotiation program in the just-passed Inflation Reduction Act.

“Healthcare provides some protection against an ailing economy, and you don’t have to overpay,” says Mike Wilson, chief investment officer and chief U.S. equity strategist at Morgan Stanley . “Outside of biotech, it’s underowned, I think, because there’s still concern around the government coming in with a heavy hand on pricing.”

The Health Care Select Sector SPDR ETF (XLV) includes all S&P 500 stocks in the sector. The iShares U.S. Healthcare Providers ETF (IHF) is more focused on insurers and providers, which have a pent-up-demand tailwind postpandemic—rather than pharma companies or medical-device makers.

Wilson has a June 2023 target of 3900 for the S&P 500, down 2% from recent levels. He’s worried about earnings, which reached a record high in the second quarter. “While the Fed is still raising rates, that’s not going to be the main driver of equity prices from here,” Wilson says, “The valuation damage from rates going up, that’s not really the issue. The issue now is that earnings are going to come down a lot.”

Wilson expects Wall Street analysts to reduce their earnings estimates in the coming months, dragging down stock prices. That process began with second-quarter reporting season, and he notes that earnings-revision cycles tend to last for three or four quarters. The fall conference-call season and third-quarter results could be the catalyst for downward revisions, if management teams offer gloomy forecasts or reduce guidance. That’s also an opportunity to separate winners from losers.

“Where the first-half selloff was just a blunt instrument that hurt all stock valuations, it becomes more idiosyncratic from here,” Wilson says. “Stocks can separate themselves depending on which companies can operate better in this environment…but we’re bearish on the index level over the next three to six months.”

Wilson is focused on some of the least flashy but most stable sectors of the market: utilities, real estate, and healthcare. His recommended underweights are consumer-discretionary stocks and cyclical areas of technology, including semiconductors and hardware firms.

Like Wilson, Savita Subramanian, BofA Securities’ head of U.S. equity and quantitative strategy, sees plenty of room for earnings estimates to come down. “Consensus estimates are far too optimistic,” she says. “Consensus is forecasting 8% growth next year, and we think that it’s going to be probably more like minus 8%. This is consistent with our view that there’s going to be a recession.”

Subramanian, who has a target price of 3600 on the S&P 500, advises looking for companies that are inexpensive based on their ratio of enterprise value to free cash flow. That approach emphasizes businesses that can best continue to generate cash despite rising cost pressures and without reliance on too much debt, which is getting more expensive.

“As you move into the later stages of an economic cycle, you’ve got inflation and the Fed tightening,” says Subramanian. “Maybe earnings hold up OK, maybe sales hold up. But free cash flow starts to become scarce because companies are forced to spend on higher costs, capital expenditure, or higher interest on their debt.”

Screening for companies that are cheap based on enterprise value to free cash flow yields mostly energy companies in the S&P 500, including Exxon Mobil (XOM), Chevron (CVX), Marathon Petroleum (MPC), and EOG Resources (EOG). Pharma companies such as Pfizer (PFE) and Moderna (MRNA) are other examples, as are Dow (DOW) and LyondellBasell Industries (LYB), in chemicals. The Pacer US Cash Cows 100 ETF (COWZ) includes a basket of Russell 1000 companies that meet similar criteria.

Subramanian’s sector picks have a value tilt, and include energy, financials, healthcare, and consumer staples. But she says there may be some opportunities in profitable growth companies that have sold off this year; many tech names have lost 50% or more, and could appeal to those with a longer-term investment horizon. PayPal Holdings (PYPL), Adobe (ADBE), and Salesforce (CRM), for instance, have positive free cash flow and are down at least 33% in 2022.

Gargi Chaudhuri, head of iShares investment strategy for the Americas at BlackRock , recommends another way to add a quality tilt to your portfolio: the iShares Core High Dividend
ETF (HDV), which yields about 2.3%. Top holdings include Exxon Mobil, Johnson & Johnson (JNJ), and Verizon Communications (VZ).

For fixed-income investors, it’s a new era: The asset class is generating income after a lengthy drought. The S&P U.S. Treasury Bond index has declined 8.5% this year, U.S. investment-grade corporate bonds have lost 14%, and mortgage-back securities have slid 9%. But that has lifted yields, which move inversely to a bond’s price.

Nuveen’s chief investment officer of global fixed income, Anders Persson, believes that most of the damage in higher-quality areas of the bond market, such as Treasuries and investment-grade corporate bonds, is done, while high-yield bonds and other riskier categories may have more downside. He doesn’t see any screaming bargains and stresses a focus on income generation and diversification.

“It’s not going to be a beta market,” Persson says. “It’s more of an alpha market, where you have to really do your work as an active manager, looking for those industries and names that can hold up best.”

He points to the TIAA-CREF Core Plus Bond fund (TIBFX), which yields 3.4% and includes a variety of fixed-income assets such as U.S. and foreign sovereign debt, investment-grade and high-yield corporate bonds, preferred stock, and asset and mortgage-backed securities.

Persson singles out the Nuveen Preferred Securities and Income fund (NPSRX), with a 5.7% yield. It includes preferred shares from mainly banks and other financial institutions with strong underlying credit quality helped by heightened regulations since the 2008-09 financial crisis. Persson also likes the Nuveen Floating Rate Income fund (NFRIX), lower in credit quality but with a yield of 5.2%. The loan portfolio’s floating rates provide some insulation from a rising-rate environment, although the risk of defaults in an adverse economy is greater.

Desai similarly recommends the Franklin Income fund (FKIQX), which is about half in traditional bonds and the rest in dividend-paying stocks, preferreds, and convertibles. The fund has a yield of 5.2%.

Not much movement is expected in the long end of the Treasury curve for the remainder of this year. Strategists generally see the 10-year yield remaining range-bound and finishing 2022 around 3.00% or slightly higher, versus today’s 3.26%.

Strategists see the Fed raising interest rates by another 100 to 125 basis points (a basis point is one-hundredth of a percentage point) over its remaining three meetings this year. That would take the federal-funds rate target range to 3.50%-3.75% at year end. In 2023, the benchmark rate could rise a bit more. Then the Fed might pause. None of the strategists with whom Barron’s spoke see the Fed cutting rates early next year, as futures markets had been pricing in before Fed Chairman Jerome Powell’s Jackson Hole speech on Aug. 26.

Addressing the central bank’s annual economic policy symposium in Wyoming, Powell emphasized that inflation fighting is the No. 1 priority, and that some economic pain would be required. That means slower or potentially negative real GDP growth and an increase in the unemployment rate, currently 3.7%. Markets will test the Fed’s resolve once job losses begin to pick up, Desai says.

“Historically, people have always said ‘don’t fight the Fed,’ ” she says. “This time around, everyone wants to fight the Fed.”

That will be a recipe for more volatility in stock and bond markets. BlackRock’s Chaudhuri expects the S&P 500 to land at 3800 by year end, after a volatile stretch. She recommends staying invested to take advantage of sharp rallies that might occur.

Chaudhuri cites iShares MSCI USA Min Vol Factor ETF (USMV) as one way to insulate a portfolio from greater volatility. Its top holdings include Eli Lilly (LLY), Microsoft (MSFT), Accenture (ACN), and T-Mobile US (TMUS).

One thing to worry about this fall is quantitative tightening, or QT, by which the Fed shrinks its balance sheet and drains liquidity from the financial system. “People are underestimating the impact of liquidity risk to the market and the real economy [due to QT],” Wilson says. “Just like quantitative easing was like grease to the engine, QT is more like a wrench in the engine.”

Rising rates, more volatility, and engine wrenches don’t sound like a recipe for the large gains investors saw in the past two years. But judicious stock-picking and smart fixed-income investments could go a long way to avoiding the season’s biggest risks.

Write to Nicholas Jasinski at nicholas.jasinski@barrons.com