- Stocks have given up much of their year-to-date gains after a furious rebound rally to start 2023.
- But Denise Chisholm, a top quantitative strategist at Fidelity, thinks plenty of pain is already priced in, priming stocks for further gains ahead.
- Here are five contrarian investments to make if stocks rally despite a recession.
US stocks are heading in the wrong direction after a surprisingly strong start to the year.
Investors are increasingly focused on rising bond yields, persistent inflation, and bearish market calls from some of Wall Street’s top analysts. To complicate matters, resilience in earnings and the labor market are seen as reasons that the Federal Reserve will keep raising interest rates.
When pessimism abounds and predictions of 26% stock market crashes are commonplace, investors can react in one of three ways: reduce risk, stay the course, or go against the crowd.
Denise Chisholm, the director of quantitative market strategy at Fidelity Investments, has chosen the latter. In fact, she views downbeat sentiment from consumers and CEOs, declining economic indexes, and below-trend manufacturing reports as contrarian buy indicators.
“All of these things that actually flash recession to people flash a buy signal to me in my work,” Chisholm said in an interview with Insider.
The bull case for stocks, despite economic uncertainty
Chisholm’s research has led her to a surprising conclusion: US stocks historically hold up well when the labor market weakens.
Since 1926, the S&P 500 has been flat during 12-month periods in which payrolls declined, Chisholm wrote in a February report. She found that when the index fell in the year before job losses began, it typically rose once the cuts actually took place since investors had anticipated the weakness. And the more the S&P 500 slid before those layoffs, the more it rebounded.
In other words, the S&P 500’s 19% loss in 2022 may have already accounted for future job losses. If that’s the case, Chisholm thinks stocks could enjoy a bear-defying relief rally this year.
“The market is forward-looking,” Chisholm wrote in the note. “Stocks may have already discounted a recession, potentially enabling them to advance through any job losses.”
Other reasons to be optimistic about stocks include moderate stock valuations, the possibility of multiple expansion, and disinflation that will boost inflation-adjusted incomes, Chisholm said.
Bears may argue that the market’s declines in the past year didn’t price in weakness for jobs, the economy, or earnings, and instead reflect a falling earnings multiple that has more downside.
Valuations clearly contracted as interest rates rose, though the extent to which that hurt stocks can be debated. As for the market’s current multiples, Chisholm said she isn’t concerned since they’re near their long-term averages at about 18.5x forward earnings and 20x trailing earnings.
“When I look at the overall valuation level of the S&P, it’s ‘meh,'” Chisholm said. “I don’t find it cheap; I don’t find it expensive. I find it at a historical median.”
In fact, Chisholm said that valuations can expand in 2023 if interest rates stop rising — even if earnings drop slightly. That’s the same call that Brian Belski, the chief investment strategist at BMO Capital Markets, made heading into 2023.
“What you usually have happen is what we’re likely to see: that earnings actually do modestly contract in 2023, but you actually get multiples to offset the blow,” Chisholm said. “So I think stocks are even a risk-reward in that setup because we’ve already seen multiple contractions.”
Lastly, inflation has peaked and is expected to slide throughout the year, which Chisholm said will give much-needed relief to consumers — especially when considering that they’ve gotten raises in the past year to adjust for the higher prices. If price growth declines while wages stay elevated, consumers will have the purchasing power to keep spending, even if inflation is high.
“We have stimulus to the US consumer in the sense of a real income growth acceleration, which has been deeply negative over the last 18 months,” Chisholm said.
5 ways to invest with recession risk elevated
Unsurprisingly, Chisholm’s counter-consensus market view is coupled with an outside-the-box take on investing. To her, cyclical stocks look most attractive, even though recession risk is high.
“Cyclical factors — or I call them mostly economically sensitive sectors — I find very cheap relative to the market versus their history,” Chisholm said.
While defensive sectors like consumer staples and utilities historically outperformed during recessions, Chisholm said that investors have gotten ahead of the move so far that valuations for those groups are no longer attractive.
“Defense has almost absorbed all of the rotation that you typically see during the entire recession before — we haven’t even started one,” Chisholm said.
The strategist added: “The margin of safety is higher to the opposite, which is cyclicality.”
Four of the five sectors that Chisholm has an overweight rating on are economically sensitive: consumer discretionary, financials, industrials, and materials.
Companies with discretionary products normally see demand fade in a recession, but Chisholm wrote in a note that the group has “increasingly constructive contrarian indicators” and enticing median valuations. Industrials and materials have also attractive valuations while financials have a positive outlook because of their improving fundamentals.
Healthcare is the lone defensive sector on Chisholm’s buy list since it has a solid combination of promising fundamentals and palatable valuations, unlike many of its recession-proof peers.
Investors looking to get exposure to Chisholm’s preferred sectors can consider the following exchange-traded funds (ETFs): the Consumer Discretionary Select Sector SPDR Fund (XLY), the Financial Select Sector SPDR Fund (XLF), the Industrial Select Sector SPDR Fund (XLI), the Materials Select Sector SPDR Fund (XLB), and the Health Care Select Sector SPDR Fund (XLV).