Why investors have become hesitant to buy beaten-up equities. Plus, 17 dividend growth stocks that will help you combat inflation

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Whipsawing bond yields, surging oil prices and a Federal Reserve bent on squashing the worst inflation in four decades are hampering investors’ ability to assess U.S. stock valuations, even as the market’s tumble creates potential bargains.

Without a doubt, stocks are far cheaper than at the start of the year, following a 23% year-to-date decline in the S&P 500 that confirmed a bear market for the index last week.

Whether they are cheap enough, however, is less certain. Market volatility and a rapidly changing macroeconomic landscape have clouded metrics that investors typically use to value stocks, such as corporate earnings and Treasury yields, keeping some potential buyers on the sideline.

“Until we see some better visibility on the rates outlook and some better visibility on the earnings outlook, the fair value for equities is a little bit elusive,” said Sameer Samana, senior global market strategist at Wells Fargo Investment Institute. The institute recently started recommending clients reduce equity risk and move funds into fixed income.

Stocks came under more pressure last week, with the S&P 500 falling to its lowest since late 2020, in the wake of the Fed enacting its largest rate-hike in nearly three decades.

This year’s decline lowered the index’s forward price-to-earnings ratio, which compares its price with its expected profits, to 17.3, from 21.7 at the start of 2022 – closer to the market’s historic average of 15.5, according to Refinitiv Datastream.

But while S&P 500 earnings are expected to rise nearly 10% in 2022, according to Refinitiv IBES, some market participants doubt those estimates will hold up in the face of surging inflation and tightening financial conditions.

Wells Fargo institute strategists forecast positive but slowing earnings growth this year and a contraction in 2023, as they expect a recession in late 2022 and early 2023.

“We are advocating to investors to consider an economy and an earnings backdrop that may be more challenging … so just don’t be fooled by where valuations are based off of today’s expectations,” said Chad Morganlander, portfolio manager at Washington Crossing Advisors, who is recommending clients continue to underweight equities.

Morgan Stanley analysts expect earnings to come in between 3-5% below consensus views, leading them to forecast that the S&P 500 is likely to see a “more reliable level of support” at 3,400, some 8% below Friday’s level, they wrote earlier this week.

U.S. Treasury yields also play an important role in standard valuation models. Since U.S. debt is seen as a relatively risk-free investment, rising yields tend to dull the allure of stocks, as they weaken the value of future cash flows in standard models.

Yet shifting expectations for how hawkish the Fed will need to be to fight inflation have made yields exceptionally volatile in recent weeks, making that calculus harder for investors.

The benchmark 10-year Treasury yield has traded in a nearly 35 basis point range last week alone, while the ICE BoFAML MOVE Index, which measures Treasury market volatility, stands at its highest level since March 2020.

Broadly speaking, “the risk-free rate rising like it has is a headwind for equity indexes as well as individual equities,” Morganlander said.

Some investors believe stocks have fallen low enough to start dipping in.

Peter Essele, head of portfolio management for Commonwealth Financial Network, is advising clients to gradually begin buying stocks, projecting that an oversupply of home-furnishing and other consumer goods along with changing demand preferences will end up moderating prices.

“I just think that equities have inflation wrong,” Essele said.

Others remain hesitant.

Robert Pavlik, senior portfolio manager at Dakota Wealth, believes an inflation fix may not be imminent. He has lower-than-typical equity exposure in portfolios he manages and is more heavily weighted to defensive stocks and those linked to inflation such as energy.

“I want to be convinced that inflation is showing signs of slowing down,” Pavlik said. “Until then, I am waiting on the sidelines with extra cash.”

— Lewis Krauskopf, Reuters

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The Rundown

Central bankers are just as flustered by inflation as the rest of us

Last week, central bankers looked flustered and stock markets looked panicky. But, hey, it wasn’t all bad news. On the plus side, markets continued to function smoothly. In contrast to the financial crisis of 2008, there was no hint that unsuspected weaknesses are lurking deep within the crevices of the financial system. Instead, investors are grappling with a problem that lies in plain sight – inflation. The question that hangs over everything is just how high interest rates must rise to tame the biggest inflationary outburst in decades. Unfortunately, policy makers appear just as baffled by this head scratcher as everyone else is. Ian McGugan explains.

What investors need to do to cope with the bear market

The TSX is in correction territory and U.S. stocks are in a bear market. But there’s some reason for optimism: several factors suggest this bear market may be shorter than many in the past. Gordon Pape explains why, and has some suggestions on how to cope with the latest downturn in markets.

A 17-pack of dividend-growth stocks for investors who want to flip the script on inflation

Here’s an investing strategy to combat surging inflation: focus on dividend-paying stocks because their quarterly cash payouts will help you offset rising living costs. And within the dividend-paying universe, emphasize companies where we can anticipate a higher cash payout in the next 12 months. Financial solidity is important, so put a premium on companies with manageable debt loads and strong profitability. All of these factors were built into a screen of stocks listed on the S&P/TSX Composite Index by Morningstar CPMS. The result is a list of 17 dividend-paying companies in sectors that include energy, utilities, consumer goods, telecom and others where inflation is an issue for consumers.

What a $400-million fund manager has been buying and selling

A year ago, money manager Bryden Teich’s portfolios were almost fully invested, holding about 1 per cent cash. Today, it’s 15 per cent cash – the highest level in a decade. The cash pile is part of a broader diversification strategy that Mr. Teich and his colleagues at Avenue Investment Management believe is necessary to protect investors from a confluence of market challenges, including surging inflation and rising interest rates further fuelled by the economic fallout from the war in Ukraine. Brenda Bouw talked to him to find out more about his latest portfolio moves and strategy.

Looking for bargains amid the selloff? Consider bonds

Bonds haven’t been getting as much attention from investors as stumbling technology stocks and bitcoin during this year’s bout of financial market volatility, but some observers are now pondering opportunities in this beaten-up asset class. A key reason: Bond yields have soared to levels where they are now challenging dividend-paying stocks, offering investors a level of income that hasn’t existed in years, at a time when economic clouds are moving in. David Berman tells us more.

Also see: Nerve-racking week leaves bond investors calling for fast rate hikes

The coin that could wreck crypto

Cryptocurrency prices are plummeting. A so-called stablecoin lost all its value in a matter of days. A newfangled crypto bank halted withdrawals. And investors have been plunged into financial ruin. Now, as The New York Times reports, the crypto industry is grappling with an even grimmer prospect: The worst may be yet to come. Concern is mounting over another potential vulnerability in the crypto market: Tether, a company whose namesake currency is a linchpin of crypto trading worldwide. Long one of the most scrutinized companies in the industry, Tether is facing heightened pressure from regulators, investors, economists and growing legions of skeptics, who argue it could be another domino to fall in an even bigger crash.

Others (for subscribers)

The most oversold and overbought stocks on the TSX

Monday’s analyst upgrades and downgrades

Monday’s Insider Report: Large shareholder invests over $5-million in this oversold REIT yielding 8.8%

My First Stock: An investor regrets selling his TD Bank shares

Globe Advisor

Stock picks for investors as inflation hits beer, wine and spirits makers

Are you a financial advisor? Register for Globe Advisor (www.globeadvisor.com) for free daily and weekly newsletters, in-depth industry coverage and analysis, and access to ProStation – a powerful tool to help you manage your clients’’ portfolios.

Ask Globe Investor

Question: I have more than $15,000 of cash that I want to invest in a guaranteed investment certificate to wait out the market turmoil. What do you think of this approach?

Answer: It’s natural to want to seek safety when markets are tanking. But before you lock up your money in a GIC, consider using the market’s weakness to your advantage. You could, for example, invest a portion of your cash in dividend-paying stocks or exchange-traded funds, which are trading at more attractive valuations and offering higher yields now that the S&P/TSX Composite Index has dropped about 15 per cent from its April high.

It’s counterintuitive, but scary periods like this are often the best times to invest.

On the other hand, if you don’t want to take on any market risk at all, then GICs are certainly a worthy choice. And, for the first time in a long time, they are paying more than peanuts.

With bond yields up sharply and central banks hiking interest rates, many five-year GICs now yield as much as 4.5 per cent. Tying up your money until 2027 has its own risks, however. If you need the cash before then, you’ll be out of luck. What’s more, if interest rates continue to rise – as many economists expect – you’ll be stuck collecting the same yield for the next five years.

The good news is that, because the GIC “yield curve” is relatively flat right now, you can shorten the term of your GIC without giving up a lot of yield. Many financial institutions are offering one-year GIC yields of 3.75 per cent and two- and three-year yields of about 4.3 per cent.

Rather than invest all of your cash in one GIC, consider “laddering” your GICs across terms of, say, one, two and three years. When the one-year GIC matures, reinvest the cash in a new three-year GIC. A year later, do the same with the proceeds of the maturing two-year GIC. And so on. The beauty of laddering is that it gives you access to a portion of your money every year, and by rolling that portion into a new three-year GIC, it lets you benefit from rising interest rates. Laddering also exposes you to falling interest rates, but that doesn’t seem to be in the cards right now.

As enticing as GIC rates appear, keep in mind that what matters is the real return after inflation, and it’s not nearly as attractive. In April, the consumer price index jumped 6.8 per cent on a year-over-year basis. If inflation continues at its current pace, even the highest-yielding GICs will lose money on a real basis.

Bottom line: If you’ll be needing your money to make a major purchase in the next few years, or if you can’t tolerate any market volatility, then by all means consider GICs for the certainty they provide. But if you’re investing for the long run, you may be better off looking at stocks or ETFs, which have a long track record of beating inflation, albeit with more volatility along the way.

–John Heinzl

What’s up in the days ahead

Jennifer Dowty chats with CIBC deputy chief economist Benjamin Tal to find out what his latest views are on the economy, stocks and the Canadian housing market.

Click here to see the Globe Investor earnings and economic news calendar.

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Compiled by Globe Investor Staff