As we enter the fifth month of declining markets, investors may be tempted to ask whether it is over yet.
Certainly, there is still plenty to worry about, but markets have often turned a corner when the world still looked bleak. Are there any signs that markets may be turning a corner and reversing their recent tough run?
The first point to note is that markets have not technically moved into ‘bear market’ territory yet. Bear markets are defined as 20% off the most recent high and currently the S&P 500 is just over 18% off its highs in December 2021.
The FTSE 100, with its high weighting in energy stocks, has had a very different profile, peaking in mid-February and currently only around 2.9% off those highs. The Eurostoxx 50 is around 16% off its November peak.
In the scheme of other market declines, this one still looks relatively mild.
Research from US group Hartford Funds found that stocks lose an average of 36% during a bear market. They are relatively common – 26 for the S&P 500 index since 1928 – and last an average of 289 days.
The longest bear market in recent memory was in the wake of the dotcom bubble, lasting 2.1 years. In other words, we could have much further to go.
Also, it is worth noting how anomalous the past two years have been.
At 3,901, the S&P 500 is only just back to where it was in March 2021. It is still around 500 points higher than it was prior to the pandemic.
The pandemic ushered in an extraordinary period, which saw the valuations of certain stocks hit extraordinary levels.
For example, Amazon peaked at a P/E of 108x in June 2020. Today, it is a more realistic 51.9x.
Investors extrapolated a vast shift to online shopping, which has not materialised. The same could be said for streaming services, online advertising or a raft of other areas where the pandemic conferred a short-term boost for earnings.
More pain to come on the economy and earnings
Undoubtedly, greater realism was needed on pricing and the current falls have brought valuations to more appropriate levels.
However, it is not clear whether share prices reflect the weaker economic environment or whether they simply reflect a change in the interest rate climate and the froth coming off valuations. This will be important, because there is undoubtedly more pain to come on the economy and, potentially, on earnings.
On the economy, central banks are tightrope-walking between managing inflation and crashing the economy with high interest rates.
Peter Spiller, manager of the Capital Gearing trust, says that the Federal Reserve is unlikely to be able to engineer a soft landing.
Debt levels for companies and governments are too high to raise rates in the same way as was done in the 1970s to curb inflationary pressures. As such, rather than crash the economy, it is likely to let inflation remain at inflated levels. His view is that the world economy remains “very brittle”.
Earnings have been relatively robust. Bill Dinning, chief investment officer at Waverton Investment Management, says that the most recent earnings season did not change aggregate earnings expectations in spite of rising input costs.
In most cases, companies have been successful in passing on these rises to customers. Whether this can last in an environment of 10% inflation is open to debate, but earnings growth is predicted to be 5% in 2022, rising to 7.9% in 2023.
Superficially, this seems to be good news. Companies are not issuing apocalyptic guidance, suggesting they are steering a successful path through the current crisis. However, it also suggests that there could be problems ahead if companies are forced to revise earnings lower.
Investors will still be looking for places to park money to avoid cash
Valuations provide some wiggle-room. Neil Birrell (pictured), chief investment officer at Premier Miton Investors, says: “We’re a bit more optimistic today than we have been recently. Valuations have come back and markets are now trading below median forward price to earnings ratios. While there are many headwinds and we’re still positioned as defensively as we’ve ever been, we are getting ready for the opportunity to make money.”
Valuations often over-shoot before recovering and it may not be enough that they are simply below average. Dinning points out that, to date, the declines have happened on normal trading volumes.
That suggests that there is no ‘capitulation’, where investors panic-sell. This means there may be some residual selling pressure if the economic situation or corporate earnings worsens.
Birrell believes that interest rates rises may take a pause, having moved a long way very quickly, but this is not necessarily the catalyst for a change in market direction: “I can’t think of a specific data point that would prompt a bigger change in our view. It will be an accumulation of factors.”
However, given that cash has become more expensive than ever before because of the drag of inflation, there will be money looking for a home. This may support markets even if the environment continues to look weak.
The turning point still looks some way off. The market still has a lot of bad news to digest over the next few months. Households have not yet felt the full force of inflation, nor have businesses.
Market valuations have come down a long way, but may not yet be cheap enough to lure investors back in.
The key support equities have in their favour is the cost of holding cash. In a high inflation world, it looks like the riskiest choice of all.
