Rising the wrong way
Rising the wrong way
Stock markets have started the new week relatively calmly after last week's rally.
In this post, I will briefly discuss how investors are confused by the stock market's strong green colors after a long period of time. Such fast-paced moments can tell the story of stock market bottoms - or a bear market rally.
Let's then see how stocks have behaved since the central banks reached their interest rate peaks. The reaction should be good, at least initially.
Rising the wrong way
In a recent post headlined Safety cushion under stocks, I reflected on how the turbulent price reactions indicate the flush phase of the bear market and the approach of the end. Maybe.
Over the past week, there seems to have been enough hands under falling share prices. Often at turning points, price reactions are turbulent.
Nasdaq Helsinki is close to its bottoms below 9,000 points, or what was the bottom so far on the stock exchange on 10/23/2023 in what has been affectionately dubbed a "scam market" on Inderes Forum.
The reactions to even lukewarm results have started to become positive. Nokian Tyres, mentioned in a previous post, is close to the level before the earnings announcement and Revenio Group is above it. Technology company Qt Group has risen 42% from the panic levels of the results day, after someone sold shares for as low as €40 a share on below-expectations earnings, until CEO Juha Varelius' comments revived the stock.
I’m trying to smell out such signs of a turnaround, because equities tend to bottom out before everything else. Then we should later start to see signs of a turnaround in rapid economic indicators such as PMIs, and soon in earnings.
Elsewhere in the world, indices were already bottoming out a year ago. And now it looks like that, e.g., the earnings for the S&P 500 companies will turn upwards in the current quarter, one year after the stock market turned around. Just as scripted. This graph shows the S&P 500 index and the earnings per index side by side. The stock market tends to bottom out long before the results.
As inflation falls, interest rates will become more stable, as they are unlikely to rise further. Thus, instead of making guesses about the gravity of stocks, the focus shifts to another factor affecting value, namely the performance of the Helsinki stock exchange. And there is "anxiety" about a recession in terms of results. Actually, it’s already materializing, as results are already in recession, so it’s anybody's guess how much further the global economy will weaken. And whether that is already sufficiently priced into equities.
This is a purely anecdotal observation, but investors seem to have been confused by the green color on the stock exchanges after a long bear market. It seems to me that a sharp rise at the turnaround is often condemned as “rising the wrong way” because the world looks so bleak. Time will tell whether a turnaround is now at hand or whether this will turn out to be another bear market rally. However, even now is unlikely to prove the worst buying opportunity if you look at the years ahead.
That's it for the rate hikes, and then what?
A few follow-up thoughts on last week's Fed rate decision not to raise the policy rate further and how stocks usually react to interest rate peaks. What should one think about the interest rate level in the future?
Of course, after Fed Governor Powell skipped the opportunity to further tighten the interest rate vise, investors immediately start speculating on interest rate cuts. The policy rate affects the price of money and the price of money in turn affects the valuation of equities, so the heavy focus on the Fed is understandable.
Powell, and other central banks such as the ECB, have commented that it is too early to talk about or even think about interest rate cuts. But as you know, central banks don't have a crystal ball either. From summer 2020, Powell famously went full broken record for days on end how the Fed is not even thinking about raising interest rates. And finally, the coat turned when Powell started after the runaway inflation train in a handcar in the spring of 2022. This embarrassing blunder has clearly brought more humility to central bank communication, which has been vague in recent times.
Central banks, of course, monitor economic data when making interest rate decisions. In Europe, the situation is clearer for the ECB, since the economic statistics point to a recession, as I have pointed out in several recent posts. In contrast, the US economy is strong, but even there one can list weaknesses such as the recent weak ISM PMI figures, which the market considers to be good indicators of the economy. Or the completely frozen housing market, which should unwind in some direction because at some point people will have to move. Maybe less than what real estate agents would like, but still.
Not to mention the weak lending data or the so-called normalizing loan losses that I talked about in a previous post. Or just look at the Russell2000 small cap index, which has taken a real hit from the difficult economic environment. The gorilla index S&P 500 may have a life of its own, but small companies are swaying like a seesaw with the general economy.
The labor market data released last Friday also missed forecasts. There were 150,000 new jobs in October, instead of the 180,000 expected, and the figures for previous months were also revised downwards. The unemployment rate rose to 3.9%, while wage growth eased to an annual rate of 4%. A strong labor market has been the mainstay of a strong economy and inflation and is also showing signs of wobbling.
Inflation is far from going to zero, as it was in the days before the pandemic. Market expectations for average inflation over the longer term remain elevated. In other words, even if interest rates are eventually cut once the acute inflationary crisis subsides, inflation is likely to remain more present than before and we are not returning to a period of zero interest rates. Inflation is driven by factors such as labor shortages and strong wage growth, aging demographics, de-globalization, the need to invest in the green transition and the re-industrialization of the West, the war and other conflicts in Ukraine and - to top it all - climate change, which is increasingly disrupting supply chains.
At present, the market's expectation for interest rate cuts is for the ECB next spring and for the Fed in the summer. In a couple of years, policy rates would still be above 3%. In any case, the so-called "higher for longer" interest rate narrative has also started to erode.
The stock markets also seem to have positioned themselves for this. The valuation of the average company has been reset to a lower level if you look at, e.g., the valuation multiples of the balanced version of the S&P 500. Equities around the world and euro equities, including Nasdaq Helsinki, have been hammered down in this poor environment.
How will equities fare now that interest rate peaks are behind us?
On average, initially well in terms of the S&P 500 index. But if interest rates eventually fall because of the recession, rough times are ahead for equities. After all, the central bank raises interest rates when the economy is too strong and lowers them when it wants to support the economy.
After the 2018 peak in interest rates, equities rose 43% until they crashed into the COVID pandemic. Similarly, after the 2006 peak in interest rates, stocks rose another 27% until they crashed into the financial crisis. The peak in interest rates in the 2000s coincided with the peak of the dot-com bubble and over the next 3 years the stock market halved. But after the peak in interest rates in 1995, the stock market tripled, returning 25% per annum for the next five years.
I think the strongest message of this graph is that interest rate cycles come and go, but in the long run the stock market is a good place to sit on the ride.
In addition to historical examples, we need to consider the uniqueness of the current situation. If stocks took a beating from the sudden jump in inflation and the subsequent whiplash from interest rates, shouldn't they in principle rise when inflation falls as expected and interest rates start to fall? Yes, and that's what we've seen in the last few days. As long as the economy stays together.
Finally, a healthy reminder that at one time zero interest rates surprised most investors by their depth and duration or even their existence, although I think there is nothing strange about them in a stagnant economy. Then inflation caught investors by surprise in 2021. Going back further in history, I would argue that no one in the 1970s predicted that interest rates would trend down between 1980 and 2020, which was the biggest force shaping the financial world at that time.
It’s therefore safe to assume that inflation and interest rates will continue to surprise investors. Furthermore, it’s thus worth building your own long-term investment strategy so that it can withstand a wide range of environments.
Thank you for reading the post! Read analysis and make good stock picks!