Opinion: The stock market is in no man’s land. Prepare to cash in when the turnaround comes

For the bigger picture, here’s part of the first-quarter letter I sent to my hedge fund investors in April before stocks had completely tanked:

“The list of stocks that are starting to look like great investment opportunities is growing slowly and I expect to find several stocks amidst the rubble that can go up 10-100 times in coming years. It’s in times like we are heading into that great fortunes are built.”

Now let’s talk about the here and now. When I analyze the market from the top down, looking at the S&P 500
SPX,
-1.02%,
things still look dire. Analysts still believe that the S&P 500 will grow earnings to about $220 a share for 2022. Take 10%-30% off that for the likely earnings cuts for some companies as margins narrow (higher costs) and demand declines, and you have earnings of $180 or so.

The markets have been trading at an 18-20-plus multiple on those earnings for the last couple of decades while inflation was low and, more importantly for multiples, interest rates were extremely low.

As interest rates rise, U.S. Treasury securities and other debt become more competitive, so people are willing to pay lower multiples for stocks. So let’s say we should expect to a 15- to 16-time multiple on those earnings (and that might even be generous if interest rates stay up here or even go higher). In math, take 15 to 16 times 180, which equals 3200 to 3380 points for the S&P 500. It’s currently trading at 3790, which means that the S&P 500 could go lower another 15% and still be considered at about fair value.

Then again …

• When I analyze individual stocks that I like from the bottom up, I like the action. Let’s use two names that I’ve recently started building up, Adobe
  ADBE,
  +0.35%
  and ShockWave Medical
  SWAV,
  -2.11%.
  Shockwave isn’t at all like ADBE, but it’s an interesting comparison. Shockwave has new biotechnology that will penetrate new markets and will be largely paid for by the government’s ridiculously favorable rules for health-care companies that allow them to make 85% gross margins. ADBE has software for its primary business, which has almost no incremental costs when you bring on a new paying customer. This company also runs at 85% gross margins, without having the government set its prices. Anyway, Shockwave will grow 40% or more for the next few years as it penetrates new hospital systems and more doctors likely adopt its technology Adobe will continue to grow in the high single digits or low double digits — call it 10%. Shockwave is set up to become cheap in five years. In the meantime, it’s pretty expensive now. ADBE is cheap now and will get cheaper, but slowly.

• Likewise, when I look at the near-term economy with all its challenges, including higher interest rates, inflation, Silicon Valley depression, Russia/Ukraine war, supply chain crises, real estate and other overvalued assets, the outlook is dire. 

• Then again, long-term investors need to consider the following: Large companies have spent the past couple of years figuring out how to make their supply chains more resilient and redundant by moving at least parts of their manufacturing to additional countries in Asia, Eastern Europe and Central/South America — and of course, re-domesticating much of the supply chain into the U.S.

• And interest rates are already now close to natural levels for the first time in decades — that’s healthy!

• And the rate of inflation has probably already peaked, even if inflation itself probably isn’t going back to 2% this year or next. But it could eventually, as those new and improved supply chains cut away at the global shortages, and inventories go back to healthy levels, as prices are cut to clear the existing excess inventories in many sectors out.

• And many companies like Alphabet
  GOOG,
  +0.02%

  GOOGL,
  -0.01%,
  Meta Platforms
  META,
  +0.06%
  and Adobe are finally rationalizing their employee base and are probably going to see wider operating margins in many sectors of their business as the overhiring phase is over.

• And crypto is finally washing itself out.

• And just as recently as last week when we followed our playbook and bought stocks, fear was everywhere and bears were bragging about how brilliant they’ve been and the bulls were deferring to them.

Our largest positions at the time of this writing include, in alphabetical order: GOOG, Intel
INTC,
-1.66%,
META, Qualcomm
QCOM,
+0.31%,
Rocket Lab USA
RKLB,
+0.22%,
Rockwell Automation
ROK,
-0.68%,
Tesla
TSLA,
-1.11%
and Uber Technologies
UBER,
+1.88%.

For the first time in a long time, I covered almost all of our short positions as the markets collapsed into the end of the quarter, opening up some additional long exposure into the panicky action, as planned.

I will judiciously look to add some more shorts and/or put hedges in coming days and weeks. I expect  individual stocks will stop trading so broadly in line and that stock picking on the long and short side is going to be more important for the next cycle.

Be careful out there. Some stocks have bottomed, and some are very close to bottoms. We will look back at in a few years and be glad we were taking advantage of the broad sell-off. But we’ve already had this huge bounce off those recent lows and we should be prepared for more volatility and perhaps more downward bias as the path of least resistance in the broader markets. Be ready to keep buying on the dips, especially when they get extreme like last week. 

Cody Willard is a columnist for MarketWatch and editor of the Revolution Investing newsletter. Willard or his investment firm may own, or plan to own, securities mentioned in this column.