Published on July 19, 2022

Equity markets have struggled so far in 2022, but in our view the declines are largely due to “The Great Normalization” – the unwinding of the Covid economy that was defined by excess liquidity, unusually high demand, and extremely low interest rates.

The Great Normalization

The S&P 500 struggled again in the second quarter, falling by more than 16% and leaving the index down nearly 20% for the year – its worst first half since 1962. While there are several reasons for the market’s poor performance, including rising inflation, Fed tightening, and fears of a recession, we think the overarching explanation is the unwinding of the Covid economy, a process that we call “The Great Normalization.” The pandemic created several distinct but related economic distortions, including excess liquidity, abnormally strong demand, and unusually low interest rates, and each one is in the process of finding a new equilibrium in real time.

For equities, the Great Normalization has triggered a sea-change in market valuations. Specifically, multiples for the S&P 500 have compressed from about 22x earnings at the beginning of the year to about 16x at the time of this writing. The most common reason offered for the unwillingness to pay a higher multiple on earnings is the rise of inflation and interest rates. On this point we agree. The laws of finance dictate that higher discount rates result in lower valuation multiples. While we do not see an end to the tightening cycle this year, with the market trading in-line with its 30-year average P/E, we suspect most of the damage from multiple compression has been done.

However, we do not think valuations are contracting solely due to rising rates, as some sectors have held up remarkably well, particularly consumer staples and utilities. In our view, rising risk premiums have also contributed (though not uniformly), likely due to concerns over both the direction of the economy and persistent geopolitical issues. Recall that as risk premiums rise, valuations fall, and vice-versa. With so much economic uncertainty hanging over the market, investors have understandably become more cautious and are only willing to accept higher multiples for less risky (i.e., less cyclical) stocks, which are generally perceived as safer in volatile markets.

As we approach the upcoming earnings season, the impact of risk premiums will become even more significant. Investors are rightly concerned about the combination of slowing demand and rising input costs. The economy clearly benefitted from the $3+ trillion of fiscal stimulus pumped into consumers’ pockets in 2021. The result was a forward pull of demand and an inelasticity to rising prices. In the wake of the depletion of stimulus checks and the increasing cost to fill a tank of gas, consumers are suddenly more sensitive to high prices and are pivoting away from discretionary items into staples.

We saw a preview of these factors during the earnings cycle in May when several big box retailers lowered their outlook due to rapid changes in customer preferences, excess inventory, and rising supply chain costs. Consumers were suddenly no longer interested in flat screen TVs, and in some cases were even trading down from full to half gallons of milk. Should these issues become evident more broadly across the economy, the earnings outlook for the remainder of the year is most certainly lower. Whether that happens, the degree to which it might happen, and whether much of that risk has already been discounted in the market all remain to be seen.

Looking out a bit further, we remain vigilant to signs of further slowing in the economy. It is generally viewed that Fed tightening cycles have a 12-18 month lag before affecting the economy. Given the more aggressive nature of this tightening, which is happening concurrently with an already slowing economy, we would not be surprised to see the impact of this cycle appear more quickly than in the past. Early signals bear this out. For example, we are already seeing a significant decline in mortgage applications caused by a near doubling of mortgage rates over the past six months.

Whichever direction the economy eventually takes, we remain committed to the idea that globalization is waning. Bloomberg recently reported that the number of reshoring/onshoring/ nearshoring mentions by companies more than doubled from a year ago, and the construction of new manufacturing facilities has increased 116%. This is an example of why we remain optimistic that a downturn will be shallow, but it also points to why the U.S. likely faces structurally higher inflation and interest rates compared to what we have become accustomed to since the Great Financial Crisis. This will likely provide a market-driven restraint to the valuation excesses we are recovering from currently.

All of this leads us to remain cautiously positioned, but we also see a rapidly expanding opportunity set. Because prospective returns are more favorable when the starting point is a lower valuation, we cannot help but notice the disparity between a company like Alphabet, a stock that trades at 16x next year’s earnings, where earnings are expected to grow by 66% through 2025, and Proctor & Gamble, a stock that that trades at 23x next year’s estimates and is expected to grow earnings by 30% through 2025. While we recognize that Alphabet’s earnings may be at more cyclical risk than P&G, it would appear that the market has already discounted much of this in current stock prices. Should there be no recession, or a mild one, then much of this discounting of equities would appear to be overdone.

The net of it all is despite the near-term challenges and market volatility, we are excited about what the future holds. We are seeing an increasing number of industry leaders with attractive valuations, and we are sharpening our pencils. The trick, as always, is “when,” and we will look at how stocks respond to the coming earnings season and economic reports for clues.

Please reach out if you have any questions. We genuinely appreciate the trust you have placed in us, and we look forward to serving you for many years to come.

John Osterweis

Founder, Chairman & Co-Chief Investment Officer – Core Equity

Larry Cordisco

Co-Chief Investment Officer – Core Equity & Portfolio Manager

Written by

John Osterweis

Founder, Chairman & Co-Chief Investment Officer – Core Equity

John Osterweis

John Osterweis

Founder, Chairman & Co-Chief Investment Officer – Core Equity

After graduating from business school, John Osterweis served as a Senior Analyst concentrating on the forest products and paper industry for several regional brokerage firms and later for E.F. Hutton & Company, Inc. In addition to his activities as an analyst, Mr. Osterweis served as Director of Research for two firms and managed equity portfolios for over ten years.

In late 1982, Mr. Osterweis decided to devote himself full time to his portfolio management activities, and in April of 1983 launched Osterweis Capital Management. Mr. Osterweis has served as Director of the Lucas Museum of Narrative Art, Director on the Stanford Alumni Association Executive Board, Trustee of Bowdoin College, Director and Vice Chairman of Mt. Zion Hospital and Medical Center, and President of the Board of Directors for Summer Search Foundation. He currently serves as a Trustee of the San Francisco Ballet Association, Director of the San Francisco Free Clinic, and President Emeritus of the San Francisco Ballet Endowment Foundation, as well as Trustee Emeritus of Summer Search Foundation and of Bowdoin College.

Mr. Osterweis is a member of the firm’s Management Committee, a principal of the firm, and a co-lead Portfolio Manager for the core equity, growth & income, and flexible balanced strategies.

Mr. Osterweis graduated from Bowdoin College (B.A. in Philosophy, cum laude), and Stanford Graduate School of Business (M.B.A. with top honors in Finance).

Larry Cordisco

Co-Chief Investment Officer – Core Equity & Portfolio Manager

Larry Cordisco

Co-Chief Investment Officer – Core Equity & Portfolio Manager

Before joining Osterweis in 2019, Larry Cordisco was a Co-Portfolio Manager of the Meridian Contrarian Fund at ArrowMark Partners/Meridian Funds. Prior to co-managing the Contrarian Fund, Mr. Cordisco was an equity analyst for 11 years, most recently as Vice President of Investment Research for the Meridian Contrarian Fund. Before that he was an analyst within the technology group at Bank of America Securities. He was also a business and technology consultant for Accenture in San Francisco and began his professional career in the public sector as local staff for a member of Congress.

Mr. Cordisco is a principal of the firm and a co-lead Portfolio Manager for the core equity, growth & income, and flexible balanced strategies.

Mr. Cordisco graduated from the University of California, Santa Barbara (B.A. in Political Science), Georgetown University (M.P.P.), and Columbia Business School (M.B.A.).

Related Insight

Invest With Us

For more information about this strategy, please send us an email or call us at (800) 700-3316.

The Osterweis Funds are available by prospectus only. The Funds’ investment objectives, risks, charges and expenses must be considered carefully before investing. The summary and statutory prospectuses contain this and other important information about the Funds. You may obtain a summary or statutory prospectus by calling toll free at (866) 236-0050, or by visiting www.osterweis.com/statpro. Please read the prospectus carefully before investing to ensure the Fund is appropriate for your goals and risk tolerance.

Mutual fund investing involves risk. Principal loss is possible.

Past performance is no guarantee of future results. This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.

As of June 30, 2022, the Osterweis Fund held 7.1% and 0.0% of Alphabet and Proctor & Gamble, respectively.

The Osterweis Fund may invest in medium and smaller sized companies, which involve additional risks such as limited liquidity and greater volatility. The Fund may invest in foreign and emerging market securities, which involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets. The Fund may invest in Master Limited Partnerships, which involve risk related to energy prices, demand and changes in tax code. The Fund may invest in debt securities that are un-rated or rated below investment grade. Lower-rated securities may present an increased possibility of default, price volatility or illiquidity compared to higher-rated securities. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities.

Holdings and sector allocations may change at any time due to ongoing portfolio management. References to specific investments should not be construed as a recommendation to buy or sell the securities by the Osterweis Fund or Osterweis Capital Management.

The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance. One cannot invest directly in an index.

Price-to-Earnings (P/E) ratio is the ratio of the stock price to twelve months’ earnings per share.

The Nasdaq is an index that consists of the equities listed on the Nasdaq stock exchange. One cannot invest directly in an index.

Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [OSTE-20220715-0558]