A comprehensive look at flat markets

Season’s greetings to all my readers! You’re reading the last What’s Up with Stonks of the year.

For many investors, the stock market year has been a reckless, icy slide on a rickety sled. Growth stocks have been crushed, while owners of insurance businesses such as Sampo have barely even noticed the bear market. Dividends have just trickled into the account. Overall, the Helsinki Stock Exchange and its dividends have returned the same amount in euros as the major indices, so a loss of just over 10% this year.

 
In this post, I’ll attempt to capture the big picture of the market and what the drivers there are for equities now. I’ll wrap up the post and the year with some unauthorized speculation on the direction of stock markets in the coming years to offer some food for thought.

I'm constantly trying to improve this concept, so comments and suggestions in our forum are very welcome! Let’s get back to it at the beginning of January.

Central banks chasing the inflation on a handcar

One of the main themes of the past year has been how central banks went after the runaway inflation train. The too long stimulus policy was a mistake, but who wouldn’t have been lulled into expectations of low inflation when for the last 10 years or more the economy has been in a period of almost non-existent inflation. Or, judging from forecasts and market expectations, and with stock prices still high at the beginning of the year, most of us investors were surprised by the persistence of inflation.

Last week, on both sides of the Atlantic, both the Fed and the ECB continued to raise their policy rates. Fed to 4,5% and ECB to 2,5%. The message from both central banks was very, as they say in financial jargon, hawkish. The Fed assured us that the inflation problem is a sticky one and that the mistake of loosening monetary conditions too early won’t be made. This graph shows the Bloomberg Monetary Conditions Index that gauges the tightness of monetary conditions.



Thanks to the recovery in stock prices, monetary conditions in the US have somewhat eased recently. In Europe, monetary conditions are almost as tight as they were during the eurozone crisis, but they have also recovered slightly. And that’s something that really annoys central bankers because loosening monetary conditions make it harder to suppress inflation.

ECB's Lagarde was defiant at the briefing, stating that the market is underestimating the ECB's future rate hikes. She predicted another 0.5% hike in February and more screw-tightening on top of that. This is despite the ECB's own forecasts that the economy will be on the brink of recession next year.

The Fed's Powell, in turn, shouted that tight interest rates will remain the status quo for a long time until inflation is subdued.

Against this background, it's curious that the market is pricing something else. Looking at interest rate swaps in Europe, the market seems to expect the policy rate to be around 3% in a year's time. This expectation has not changed much since September.

Similarly, in the US, investors expect the policy rate to hover around 4.5% next December, i.e., the same level as now. Interest rates would peak at 5% in the spring, so in practice they would be cut in a year's time.

Investors have a well-worn adage: “Don't fight the Fed”. If the Fed wants to tame inflation by plunging the economy into recession and crushing stocks, no one’s forcing you to buy them. But investors have been pushing back against this adage all along, although so far there have been light hits in the boxing ring with Powell. As you can see from these curves, no one knows for sure where inflation and interest rates will be in a year's time.

However, given the fact that the Fed's predictive power is limited or non-existent, the collective wisdom of the stock market is powerful, and a super-efficient global economy is supposedly not very resilient to tight monetary conditions, I would also lean towards the interpretation that central banks are mainly required to call for higher interest rates as a matter of duty. Until the economic slowdown and the realities of the financial market force them to pivot. I'm not talking about a return to zero interest rates, I'm talking about the fact that current interest rates may not go up very much from here until they start to go down. It may also be that the Fed's coat has already turned, as I pointed out in a recent post.

Interest rates on government bonds don't seem to be getting excited either. This graph shows the interest rate on US 2- and 10-year bonds. Both have been on a downward trend since October. The 10-year is swayed by the economic and inflation outlook, while the 2-year is more inclined to follow the policy rate itself. Interpreting these is like reading the tea leaves, but it now seems that bond investors don’t believe that rapid inflation will continue for long.

By looking at the difference between inflation-linked bonds and nominal interest rates, we can fork out what investors' average inflation expectation is for different periods. Here you can see the 5-year inflation breakeven for the US. That too has slipped to just over 2%, which is close to the 2% target that the central banks are pulling out of their hats.

It’s therefore reasonably safe to say that there is an expectation in the market’s cards that inflation will ease and economic growth will slow. The Fed is bluffing if you ask investors.

The market has also learned to wait for the Fed to pivot. For the last quarter of a century, the Fed has always yielded to market pressure and come to the rescue.

Now, if inflation is of a more structural nature, for example because of a tight labor market, hopeful investors may be in for a disappointment. Labor market and wage developments are the exciting cards for investors to watch now.

When writing this post, monetary policy in Japan's disinflationary bastion is shaking. The Bank of Japan announced just a short while ago that control on bond yields will be freed up, allowing interest rates to rise to 0.5% from the previous 0%. Japan's 10-year bond rate immediately shot up to these levels. For the time being, it's too early to say whether the Bank of Japan will join the monetary policy tightening party. The chief of the Bank of Japan clarified at a press conference that it would not be a change in monetary policy but an improvement in the functioning of the financial market. As one of the world's biggest lenders, the homecoming of Japanese money could further tighten monetary conditions elsewhere.

Stock valuations don't leave much room for maneuver

Next, a few words about stock valuations and expectations at the moment. If investors in their collective wisdom are right, they may not have much to gain. If they are wrong, they have a lot to lose.

The valuation of shares has already corrected in these recent months of price rises. It’s difficult to see valuations correcting significantly higher unless we fantasize about a return to zero interest rates, which doesn’t seem likely now.

However, on average, equities have downside potential if inflation doesn’t recede and interest rates continue to run high. Here is Fidelity's graph of the S&P 500's 12-month forward P/E ratio, and where the P/E ratio should theoretically be at this interest rate level. This is derived from cash flow models. The exact figures aren’t that relevant, but surely everyone will agree that even if risk-free interest rates offer a solid return for a long time, it’s not worth paying 17 times their uncertain future performance for stocks. If that model is even somewhat correct, at current rates the P/E of the S&P 500 should be between 14-15. This would mean a fall of just under 15% from current levels to somewhere around 3,300 index points.



This chart from Fidelity provides a history of how stocks have reacted to the Fed's interest rate cycle pivots. Especially in the 80's and 90's, stocks were booming, but I must point out that in those cases the valuation of stocks was lower.

In many cases, the reversal of monetary policy has been due to the economy going into recession. Stocks have collapsed despite improving monetary conditions and falling interest rates. One could put it this way: once inflation comes down, the number one concern for investors will be the risk of a recession and its impact on earnings if it already wasn't.

That's the way things are on average. Of course, there are always opportunities below the surface of the index level. If an investor believes that inflation can moderate without the economy going into recession, the cyclical energy and banking sectors certainly offer satisfactory opportunities. If you believe in a sharp downturn, cash and bonds aren’t a bad option, because then you have liquidity to buy cheapening stocks.

The investment pundits who conjure up magical target prices from who knows what boiled rabbit bones, the equity strategists, expect the S&P 500 to flatline for the next year. The median score at the end of 2023 for the S&P 500 is 4,000. If we look at where the S&P 500 should be a year from now, based on target prices for individual stocks, it should jump to 4,500 points. Analysts, especially American analysts, are notoriously obsessive optimists, but perhaps this data point supports the fact that nothing terrible is expected in the stock market in the future. Still, take these mainly as entertainment, because no one can predict exactly where the stock market will go in a year's time.

That is why I recommend trying to see the growth potential of listed companies several years ahead. It's also worth considering the company's competitive advantages, as these will, in the best case, allow it to grow profitably. And if you manage to identify such stocks and still strike a bargain while others panic, it's even better. In my opinion, there was a moment like this during the gloomy sentiment in the fall, but I'm not so sure about the current situation. Of course, I’m quite picky, so I guess that there’s something interesting for everyone at the moment.

Similarly, here is the playful target price for the Helsinki Stock Exchange's general index, derived from analysts' company-specific target prices. If stock prices were to hit target prices, the overall index would rise from just under 11,000 points today to just under 13,000 points, meaning that there would be a 15% upside. Perhaps a situation where share prices were approaching or even exceeding target prices would indicate overvaluation, and that all the good stuff has now been priced in, as was the case on the Helsinki Stock Exchange in early 2021. And a big gap in target prices may indicate a better buying position, although this comment is largely based on my own gut feeling.

Profits at risk of recession

Let’s talk about risk of recession. Throughout the fall, I have been repeating how analysts' earnings forecasts show no major drama. If we look at the familiar S&P 500 index, which is the largest and most powerful in the world, earnings growth is expected to continue. Next year, earnings per share would grow by 7% to $ 235, although forecasts have been revised downwards since last spring. Usually in recessions, a couple of dozens of percent has been trimmed from the results, so there is no recession in the analysts' papers.

Earnings growth in European equities looks more subdued, but a positive turnaround is equally expected in the coming years.

In contrast, one might well ask whether there is reason to expect a big drop in results for the time being. Nominal earnings growth is supported by inflation. If prices alone go up almost by 10%, it's strange if companies can't get their own profits up even though volume growth may be weaker.

The latest economic data has been mixed recently. Euro area purchasing managers' indices for December, in both services and manufacturing, are still below 50. This indicates a decline in activity compared to the previous month, but a rather mild one at that. The decline was also less pronounced in November.



In contrast, in the US, the purchasing managers' indices compiled by SP Global took a dive. Many investors look to the more "official" ISM survey for their profile, and my understanding is that SP Global's sample is more weighted towards smaller companies. The manufacturing PMI’s dived to 46, but I also included the ISM version in this graph, with the latest data point from November.



In services, the difference between the two yardsticks is even more dramatic. The ISM non-manufacturing sample is dominated by large companies and includes literally all sectors outside manufacturing. The ISM reading was 56 in November, indicating rapid growth. By contrast, SP Global's index, which focuses only on the services sector, was at 44, already showing signs of a recession. SP Global's version did fall harder in the COVID crisis too, but these don't look like good readings.

 
I also reiterate the point I brought up in my latest post that, especially in goods, there is hope for massive pandemic over-supply. The weaker performance of industrial purchasing managers' indices may well reflect this return to normal.

Following recent economic releases, the Atlanta Fed's GDP Now gauge has fallen below 3% for the fourth quarter. This is as good a predictor as any other. So far, the economy seems to be doing reasonably well, but of course the stock market is already trying to anticipate tomorrow, which even this gauge doesn’t tell us anything about.

The next few years for stock markets: flatlining

When you think about all these factors that affect equities - inflation, interest rates, earnings, and the economy in which those earnings are made - it's hard to be super-bullish, but it's also hard not to be ultra-bearish. It's easy to come up with really heinous scenarios in this world situation, from stagflation to mushroom clouds, but even those don't seem likely, at least for now. Moreover, investing is fundamentally about looking at the world through a positive lens. If you have no faith in the future, you shouldn’t save in stocks whose present value is based on cash flows decades away. Then it’s a better idea to go to a local pub to have and sulk.

Inderes has no official macro or market view, but if I had to offer a hypothetical development trajectory for the next few years at the index level, some sort of flat market seems a realistic scenario. Inflation is (hopefully) coming down, but at the same time as the economy cools down, earnings growth is tough to come by. There is limited, if any, upside in the valuation multiples of listed companies.

Flatlining wouldn't even be wild, since the whole world ex USA have been going horizontal for 15 years in a row and the average investor's returns have been based on dividends. In fact, the performance of US stock markets over the past 15 years has been quite an anomaly in the world. This graph shows the performance of the S&P 500 and the global stock market index without the USA in the 2000s. Now that’s what you call flatlining!



I've mentioned a few times the analogy to a similar flat market in the 40s, where stocks went sideways for years before the next bull market. This graph from Fidelity shows the S&P 500 after World War II and the current trend with inflation today and then. In both cases, highly valued stocks plummeted as the economy, then ravaged by war and now by pandemic, experienced a real shock after stimulus-heavy monetary conditions. However, earnings growth continued and eventually the stock markets went sideways for several years while bringing valuation multiples back to healthier levels. Such a scenario, where we experience 20% booms and busts, shaking novice investors out at bottoms, doesn’t seem at all impossible in the light of current knowledge. Again, I stress that this is my gut feeling, and the world is such an unpredictable place that no one knows these things in advance. Still, a stock market enthusiast must assume something about the future.



Finally, it is good to remember the old investing wisdom that “it's about time in the market, not timing the market”. Such a flatlining market or a bear market would be a very positive outcome for young net savers, because they would be able to tank their shares at a lower price for a longer period of time. And if there is a big crash, there will be even more to buy.

At this point, I wish everyone happy and peaceful holidays! Read the analysis and make good stock picks in the flat market.