Save cash for better buying opportunities

The following post contains purely bearish views. For weeks, I have been highlighting mainly positive aspects of the market, so now is a good time to counterbalance this with a reminder of the risks and threats. When investing in equities, it’s not enough just to seek returns, you also must bear in mind the risks that threaten you in the form of a permanent loss of capital.

This post will be gloom on top of gloom, but in the familiar style with a twinkle in the eye. Unfortunately, this will also be the only post this week, as I'm trying to cut back a bit on working hours. However, the topics in this post shouldn’t necessarily become outdated right away.

Let's get to it.

The key to favorable stock development is profitable earnings growth. Currently, the dream scenario would be for inflation to slow and interest rates to remain close to current levels, but for the economy not to fall into a deep recession. If companies can continue to grow earnings, the outlook for the stock market should be quite reasonable. After all, the valuation levels aren’t particularly high, especially in Europe.

But slowing inflation is not just a cause for celebration. In this Nordea’s graph, the change in producer price inflation and the change in the S&P 500 earnings are plotted side by side. The rapid cooling of prices may also indicate a lack of demand. One person’s expenses are another one’s income. Thus, a decelerating inflation can also be a symptom of earnings deteriorating. However, prices are not yet falling, so this analogy doesn’t scream of a fall in earnings for the time being.

The threat of recession has by no means receded, although recent economic data have been stronger than expected. The inversion of yield curves has been a reliable predictor of recession, albeit usually a couple of years in advance. Now virtually every possible interest rate curve has turned into negative territory. This means that you get a higher return on shorter interest rates than on longer ones. One possible reason why this phenomenon is pushing the economy into recession is banks. After all, banks finance themselves with short-term money, such as deposits. At the other end, they lend out long-term loans, such as mortgages. If their funding becomes more expensive than the interest on the loans, they will stop lending. Or else they would go bust themselves. If banks don’t grant new loans, the debt-driven wheels of the economy will start to grind to a halt.

This busy graph (sorry about that) shows three different interest rate curve spreads: 10-year / 3-month, 10-year / 2-year and 30-year / 5-year.  All three have reversed for the first time since before the financial crisis. I've also included the S&P 500 index in the graph to help you better grasp the dramatic turning points. On the previous two occasions, the index halved after the yield curve inverted. NB: this process takes several years, which is why this warning sign tends to be overlooked by investors. And that can be heavy on your wallet.



If the interest rate curves seem difficult and vague, here's another graph. The white curve is the yearly change of LEI, or Leading Economic Indicator index. It includes 10 economic indicators such as building permits, new industrial orders, unemployment claims, the credit index and the S&P 500. This graph shows the development of the LEI and highlights where the current annual dip has been reached in the past. To make the dramatic message easier to get across, the good ol’ S&P 500 index is again used as a companion. The indicator is a fairly good predictor of recessions, and recessions devastate earnings and therefore stocks. It’s no wonder that often when this gauge starts to dive, stocks in general also take a dive.

A few words about industrial orders. In the last post, I showed the Empire Index, a gauge of New York State industry sentiment. That offered a positive surprise. But if you look at the Empire Index subcategories for new orders, it looks like this. I'm sorry but that index is also in a recession zone, and deep in it. 

 
Despite the risk of recession and inflation-driven profitability pressures, listed companies are still expected to deliver strong earnings growth. Forecasts have been cut, but only by little so far. 12-month future-looking earnings forecasts dipped by 20% in the COVID crisis and by 40% in the financial crisis. Stocks would suddenly seem more expensive if earnings were to plummet to those levels. This graph shows the 12-month EPS forecast for the S&P 500. It has only fallen by a couple of percent.



Earnings forecasts have also started to decline in Europe, but earnings growth is still expected in the coming years. This year, the energy sector has seen a big surge in earnings. However, earnings forecasts for this sector have also taken a breather.

 
To summarize, analysts' earnings growth forecasts have become more cautious, but there is no recession in the forecasts. If an investor believes in earnings growth, it's worth making the forecasts yourself and a couple of stories lower.

In an interview with Bloomberg, Howard Marks, a legendary investor, said that the best buying opportunities are still ahead. While overall corporate balance sheets are in strong shape, there are many indebted individual cases that are heading for promising distress. At zero interest rates, it was a borrower's market, but now it’s a lender's market. Finally, liquidity has become a scarce commodity again. For example, the banks that financed Elon Musk's Twitter deal are reselling Musk's debt at discounts of up to 30%.

Well, the logic of the fixed income side is of course quite different from the life of an equity investor. His comment on interest rates is interesting. Marks believes that although inflation has peaked, interest rates will remain around 5% for the next five to ten years.

If this were to happen, the current valuation of equities would have room to take a hit. In simple terms, if you could get 5% interest on safe interest rates, who would be satisfied with the current earnings yield of 5% on equities. The earnings yield can be calculated by reversing the P/E ratio. The P/E ratio of the S&P 500 index is now around 19 on realized earnings. The average interest rate over the last 60 years, measured at the 10-year rate, has been just under 6% and the average P/E ratio at actual earnings has been around 17. Naively calculated, the equity multiples should therefore come about 10% downwards. Of course, this is not really how valuation levels are derived; they're derived from future cash flows. However, this certainly drives home the idea of how at higher interest rates equities shouldn’t be so expensive.



That 5% may not even be enough. There have been statements from Fed members that the funds rate should be tightened to well above 5%. The Bloomberg economic model spits out the assumption that if the labor market tightening during the pandemic remains permanent, the need to raise the funds rate could reach 6%.

 
If that’s the funds rate, you get a bit more from risk-free rates. I could ask again out loud, who would like risky stocks if you could get 6% on safe interest rates in this uncertain global environment?

Of course, long-term interest rates are more influenced by the economic outlook and, as the yield curve inverts, it should be noted that a recession scenario would likely depress inflation. A stagflationary scenario, where inflation remained high at a time when the economy is actually in recession, would be catastrophic for equities at current valuation levels. I wouldn't be surprised if the stock market roughly halved in that case.

One wild card in the global economy is how much the digestion of numerous housing bubbles affects the rest of the economy. Housing prices almost everywhere in the world, such as in the US, Canada, New Zealand, Sweden or China, have taken quite a leap in recent years. In the US, for example, housing prices would have to fall by roughly 15% to be at the same level relative to income as before the pandemic. In Sweden, a fall of at least 15% in housing prices is forecast. China's housing bubble is massive and will indeed test the Communist Party's ability to navigate through the economic straits. Housing is the most important part of the wealth of ordinary households and consumers. Therefore, a downturn or even a collapse in the housing market could have a broad impact on consumer sentiment around the world and thus also on equities.
 

The economic turmoil is rapidly spilling over into world politics. US politics have become polarized. Russia, stagnating in terms of living standards, is seeking to rebuild the old empire. China's growth in living standards is stagnating at the present rate, and the Communist Party is already diverting public attention in nationalist and imperialist directions, the first victim being Taiwan. Higher food and energy prices have brought down governments before, especially in the poorer countries of the world. Stocks don’t live free from this reality.

To sum up, it is easy to paint a threatening picture for equities from many directions. If inflation remains high, it will eat into firms' profitability and interest rates will remain high. This means that it's really not worth paying as much for stocks as you have to pay for them today in general. If there is a recession, the inflation problem is likely to be replaced by a fall in earnings. This naturally hits equities, especially if there is a long-term earnings tailwind. A severe recession could trigger housing bubbles and other bubbles around the world, making the debt-fueled global economy suddenly unstable.

In order for this post to be more than just painting a threatening picture, we need to highlight solutions. If you believe in such darker scenarios, cash is never a bad choice. Inflation erodes the value of cash, but I'd rather take a 5-10% hit from inflation than a 50% hit from a stock crash. You can do anything with cash, like pay off loans, it gives you peace of mind and then you can buy the dip when stocks get cheaper. If you believe in disinflation and a recession, fixed income funds are an excellent consideration and alternative to equities.

Not all stocks go down in the same way in a downturn. For example, an excellent real estate and branding company like McDonald’s, which many people think of as a junk food chain, took hardly any hits in the financial crisis. However, McDonald's stock fell 70% in the tech bubble because investors paid far too much for it in the boom. Even defensive stocks won't help if you pay too much for them. This graph shows, on a logarithmic scale, the evolution of McDonald’s and S&P 500.

 
Of the domestic companies, I could bring up Sampo, although Inderes now has a Reduce recommendation on the stock. Sampo's insurance business and investments are doing well in the face of inflation and high interest rates. The problem with this stock too is that it is now very highly priced. For many, Sampo is a dividend stock. Sampo's projected dividend yield is at its weakest level since 2015. That year was one of the worst buying moments in Sampo's stock performance history.



During the bursting of the tech bubble and the inflation storm of the 1970s, so-called value stocks, or lower-priced companies, did reasonably well. If you want protection and peace of mind in all weathers, a value portfolio might not be a bad idea.

Thank you for reading the post! Read analysis but remember to take forecasts with a grain of salt and save money for better buying opportunities.