Are the Market’s Good Times Over?

February 7, 2022
Scott Kingsley

It probably hasn’t escaped your attention that markets have been turbulent this year, and with this period of volatility giving investors pause for thought, I have found myself wondering “how long will this bearish, flighty mood last?.”

Even for financial professionals (sometimes especially for us!) this type of widespread market weakness tests our ability to resist our innate desire to avoid pain (as I wrote about here).

But are markets rolling over due to deterioration in the underlying economic case, or is this correction short-term and fuelled by the realisation that gains accumulated recently on most assets – profitable or not – might not be forever?

These themes will help me explain my views:

  1. Whether inflation will persist and what this means for the global economy, with a focus on the US.
  2. Market breadth (I know – what is that?!).
  3. How does this compare to most people’s go-to reference point - the Global Financial Crisis (GFC) of the late 2000s.

I’ll also share with you my own mindset to successfully navigate this time.

But first, some context.

January Blues

The major US indices, and many prominent ones globally, ended January 2022 resoundingly down. The Dow Jones shed 2.5%, the S&P500 4.6% and NASDAQ 8.3%, and the differential between them all is illustrative, more on which later. January was the worst month for those indices since the GFC.

1. Is higher, more persistent inflation inevitable?

How many times the US Federal Reserve will raise interest rates remains to be seen but their highly hawkish tone, alongside a lack of absolute clarity on the number of rates rises in 2022, is a clear indicator that inflation is running hotter and, most likely, for longer than we thought it would last year.

In part, inflation – just the right amount - is what the Fed wanted when they cut rates and bought bonds by the truckload. The goal being to stimulate demand and to move beyond the era of disinflation as well as, of course, to give confidence that markets and asset prices will survive the Pandemicycle (which is, apparently, a thing.).

So, the wheels have long been greased, but what we don’t want is a runaway inflation train.

There’s a difference, though, between just enough inflation and too much, and the line is a relatively fine one. Throw into the mix that central banks are having to deal with the unknowns associated with recovery from a pandemic, and more ups and downs are likely.

What’s important, though, is that higher volatility, higher inflation, higher rate environments have been before and will be again. Crucially, there are companies who can perform well, regardless.

2. Market Breadth (& Why It Matters)

US market rises had, until December, been dominated by well-known technology heavyweights like Google, Microsoft, Apple, and Amazon. In all, 33% of returns in the S&P500 came from just five stocks.

How many stocks are actually influencing moves in an index - market breadth – is important because it helps us to understand how many stocks are moving up versus down. If it’s only a few then what can looking at an index like the S&P500 or NASDAQ actually tell us about the health of the overall economy, and the majority of companies?

Not much.

One month of poor returns is too early to draw any conclusions, other than that people are nervous.

The worst thing an investor can do is panic based on headline measures. The devil, or absence of it, is in the detail.

3. History Lessons

The January Blues needn’t suggest a prolonged bear market is coming nor should the refrain I hear quite a lot now, which is that it has been a long time since the last crash, and what a crash that was.

Weak periods will inevitably follow expectations of rate rises, as markets and their participants ponder questions they can’t know the answer to. “How many?,” “how much?”, “when?”, and so on.

The signs are, though, that history isn’t doomed to repeat. Here’s why:

Fear levels are lower

The Cboe Volatility Index (VIX) is used as a ‘fear gauge’ by investors to determine market turbulence over a 30-day period. Since the new year it’s been steadily rising but not as acutely, and not to the same degree, it did at the start of the pandemic. And it is certainly not scaling the heights it did pre-GFC.

Does this mean we should ignore concerns and throw caution to the wind? No, that wouldn’t be wise. We must always be watchful of the various singing canaries – like employment, media sentiment, and inflation – but avoid reacting in the moment.

We’ve learned from experience and shored up the financial system

One of the major legacies of the GFC was the hypersensitivity of central banks to dramatic falls in stock markets and waves of panic amongst investors. Then, the Fed and other central banks knew then that the financial system was dysfunctional and a root cause of the turmoil.

So, they stepped in accordingly.

Right now, markets are functioning normally. Volatile, yes, but working as they should. So, the idea that large crashes are unequivocally underwritten by central banks is not a given.

That being said, my strong belief is that we are not facing economic or market Armageddon.

There is the risk that markets do not gently adapt to interest rates normalising, but we don’t have gaping holes in the very financial framework that underpins them. Volatility does not equal instability. The Fed Governor said as much in 2018.

In conclusion…

With reasonably solid labour markets and several factors on both demand and supply sides of inflation which indicate a (though admittedly longer than thought) short term spike and not long-term spiral, I’m confident that we emerge from 2022 a little battered, even bruised, but still breathing.

And with all this herd-driven short-term angst, let’s not lose sight of how stocks are actually priced in the long haul, when the noise has died down. This is by discounting a stock’s future cash flows back to the present day.

Yes, as rates rise, this generally erodes their attractiveness. But there are companies who still generate attractive returns regardless. Rate rises will be a stock market death knell for the terminally unprofitable, for sure (back to that early reference to the difference in DJIA/S&P500 versus NASDAQ performance since the turn of the year. By far the highest concentration of unprofitable stocks is in the NASDAQ.).

And forget the vague, wishy-washy value-versus-growth debate. You’re searching in the wrong place. High quality growth companies exist, and the best fund managers find them.

Overall, holding excellent quality investments in the longer term pays off – provided investors can hold their nerve now.

Why not talk to me to discuss investing and seek advice about which steps to take next?

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