The S&P 500 fell 20% through the first six months of 2022, officially entering a bear market and marking its worst first-half performance since 1962.
But Wall Street isn’t expecting the pain to end just yet.
Most investment banks are convinced that stocks have further to fall, as four-decade high inflation and recession fears persist, while expectations for falling corporate earnings mount.
Bank of America Research strategists, led by Savita Subramanian, argued in a Tuesday note that equities will continue to experience volatile trading over the coming months as the toxic combination of stagnating economic growth and high inflation—also known as stagflation—rattles markets.
The BofA team noted that, historically, a negative first half of the year for the S&P 500 has led to negative returns for the index over the following six months some 44% of the time. On the other hand, when the S&P 500 sees positive returns through June, it has only turned negative 19% of the time in the second half of the year.
The strategists recommended investors stick with a “stagflation playbook” if they want to buck this trend and outperform the broader market moving forward, even as economic growth stalls.
The ‘stagflation playbook’: Sector positioning
Throughout the first half of 2022, Bank of America recommended investors focus on stock market sectors that typically benefit from inflation like energy as well as defensive sectors in recession-proof industries like health care.
So far, this “stagflation playbook” was a good call. The only sector that managed positive returns in the first half of 2022 was energy, which returned 28% to investors through the end of June, according to BofA data.
Oil and gas companies raked in profits as commodity prices soared to start the year, and BofA argues it’s worth remaining invested in these firms even as oil prices come back to earth.
The investment bank also recommended defensive sectors like utilities, consumer staples, and health care, which haven’t performed quite as well as energy so far this year, but certainly have held up better than the broader market.
As far as what investors should avoid if inflation remains a problem, BofA said tech stocks are likely to continue underperforming. The team noted that growth stocks in the tech sector have “consistently been the worst-performing” during previous periods of stagflation.
The ‘stagflation playbook’: A quality approach
Bank of America’s strategists also recommended investors focus on firms that offer dividends, present value in relation to their peers, and are ranked a “B+ or better” in S&P Global’s quality ratings in this trying economic environment.
This focus on quality, value, and dividends should enable investors to protect their hard-earned capital if a recession does rear its head, or to outperform the broader market in a stagflationary environment, the strategists argued.
As far as quality goes, companies that have consistent earnings and low debt-to-income ratios, which should allow them to weather economic storms, are typically ranked higher in S&P Global’s “quality” ranking system.
These firms have been solid investments historically. From Dec. 31, 1999, through Feb. 27, 2015, for example, the S&P 500 returned 91% to investors, but S&P Global’s High Quality Rankings Index gained 229% over the same period.
And it’s been more of the same so far this year, with high-quality stocks outperforming low-quality stocks by 12 percentage points year to date, according to Bank of America.
With the Federal Reserve raising interest rates to combat inflation, thereby increasing the cost of borrowing for businesses, companies that don’t have to aggressively invest in their growth are likely to have an advantage moving forward as well.
That means value stocks should outperform growth names, even after the recent selloff in many growth stocks, Bank of America argued.
“Despite the de-rating in Growth stocks, they still trade one standard deviation above the historical average vs. Value,” the BofA team noted.
If a recession does hit, investors will likely look to dividend stocks that offer cash payouts to help keep them afloat as well, which could help these companies outperform. And again, historically, buying dividend players has been a winning strategy.
From the end of 1999 through February of 2015, the S&P 500’s Dividend Aristocrats, a group of firms that have raised their dividends in each of the past 25 years, posted a 342% cumulative total return compared with 91% for the overall index.
“As cash grows more valuable amid Fed hiking, we expect dividend yield and bird-in-the-hand strategies to continue to outperform in 2H,” the strategists wrote.
