Financial markets do relatively well when it comes to predicting the future. Collective wisdom is ultimately translated into share prices. Index investors benefit from this collective wisdom and are effectively free riders to the hard work of many. Yet in the stock market, it is not easy to distinguish between what is possible and what is real.
The reality of the material world versus the reality as it springs from the imagination of the human brain. After all, if enough people believe in this fantasy, such a narrative can even create a new reality. It is quickly labelled a vision, but only if it comes true.
In this song of appearance and being, it is always the question to what extent good or bad news has already been discounted in the share prices. There are plenty of companies where all the good news has already been factored into the price, and then there is little chance of a good share.
Room for a bear market rally
In the past six weeks, the stock market has fallen every week. That has not happened since 2008. If the decline had continued last Friday, there would be a bear market in the S&P 500 index. A bear market is a decline of 20 percent or more. At the beginning of this year, the consensus view was that the S&P 500 could hit the 5,000-point mark by the end of the year.
After the fall of the last few weeks and a possible recession on the way, that same consensus now reckons with an S&P 500 index position between 3200 and 3400 at the end of this year. It can happen. Nevertheless, the fact that the consensus now assumes that the market will fall further is a positive development. After all, a rising market climbs a wall of fear and if everyone thinks the stock market can only go down, the end result is usually a rising market. Take, for example, the shares of the Nasdaq.
On average, those stocks are now 40 percent below top. The Big Tech names are also lagging this year. The reason for this decline is mainly the rising interest rates. This has brought down the valuation of this group of companies. It is not that the results of these companies (as a group) are disappointing, it is a correction to the earlier sharp rise in valuation.
High valuation turns good into bad
A good company becomes a bad stock because of this higher valuation. Consequently, the deteriorating sentiment now offers opportunities to buy good companies at attractive prices. Some large investors are now on the buy side. According to these investors, between 80 and 90 percent of interest rate rises have now been factored into share prices, which would mean that the correction in valuations should be more or less over.
A continuation of this correction should come mainly from lower earnings valuations, to which IT companies are probably less sensitive this cycle. Earnings valuations are under pressure from higher interest costs, energy costs and higher wages. However, IT companies are relatively immune. They are often debt-free, use little energy and have relatively few employees in relation to turnover.
No end to the bear market
So there is room for price recovery. Yet the question is whether this is the end of the bear market. After the figures for the first quarter, the profit estimates for the second quarter were adjusted downwards, but the estimates for the whole year remained unchanged. This means that analysts expect the second half of the year to be relatively good profit-wise, which is precisely the time of year when there will be a slowdown in growth, at least if various leading indicators are to be believed.
The big question is when shares will react to these earnings setbacks. This is not the time to warn that profits will disappoint. That time is more likely to be just before the end of the quarter or in the weeks leading up to Q2 reporting.
Inflation remains a problem
A second problem for long-term price recovery is the still high inflation. Central banks and many investors believe in the illusion that inflation will fall back to 2% in the not too distant future. This is a remarkable form of wishful thinking. Does the Fed really believe that it can contain the current high inflation by leaving the policy rate below the inflation level?
Structural factors such as the retirement of the baby-boom generation, deglobalisation or rather regionalisation, the monopolies of disruptively innovative IT companies and the pendulum of capital-labour which, under pressure from social media and a tight labour market, is swinging in the direction of the labour factor, are causing stubborn inflation. On top of that, central bankers themselves would prefer high inflation because it solves the debt problem, but not so high that it undermines their own credibility. Central bankers also now believe in the Keynesian social engineering with a greater role for government with its investment programmes financed by the central bank.
Perfect storm
The central bank must know that this high inflation is mainly caused by its own exuberant policy in the past. As far as inflation is concerned, there is a perfect storm with a war (which is inflationary by definition) combined with an oil shock and sharply rising food inflation because 1 in 8 calories in the world comes from Russia or the Ukraine and the climate crisis is now visibly affecting the weather and thus food production. Eventually, interest rates will have to rise further, with the aim of hurting the economy more.
Disappointing corporate profits, stubborn inflation in combination with ebbing liquidity suggest that the end of the price decline is not yet behind us. Only the gloominess of investors seems to be standing in the way of further price declines in the short term. But even in this song of make-believe, the market cannot escape reality in the end.
Han Dieperink is chief investment strategist at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. His contributions on Investment Officer Luxembourg appear on Thursdays.
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