Greed has returned to the market
In this post, let's talk about what rising stock prices tell us about future economic developments. Investors are no longer waiting for a recession. Then let's take a look at how the surge in share prices has brought greed back to investors. Before these topics, I'll go through a few fun graphs from the market, as per usual.
Hot topics briefly
I’ll mention briefly that China's central bank has continued to inject record amounts of money into its financial system. The chaotic but rapid opening of the economy has increased the demand for loans and figuratively emptied the banks' coffers. At the same time, the property sector, which is rotting in China's hands, needs to be gently nurtured so that the bubble doesn’t spill over into the wider economy. China's economic performance has a significant direct or indirect impact on many Finnish listed companies. KONE is an obvious example, but in practice the lion's share of global demand for raw materials comes from China.
In turn, this is a funny observation, how the term soft landing is bandied about in Bloomberg news all the time. The term soft landing, borrowed from aviation, refers to a soft cooling of the economy, where inflation cools but nothing breaks. It’s something of a dream scenario for equities. At the beginning of downturns, talk of a soft landing increases in force. After all, before a downturn, the economy is at its hottest, earnings are at their best, and investors are in high spirits. In such an environment, it may be difficult to expect worse scenarios to materialize. Time will tell what happens to the soft landing comments this time.
What does the market say about the economy?
Speaking of a soft landing, right now the economy is roaring so hot you can't even see the runway to land on. According to the Bank of America portfolio manager survey, professionals' expectations of the likelihood of a recession are also starting to fade. By the way, such moments have usually been quite reasonable places to buy stocks.
Investors often look at the economy and company results and draw conclusions about where stocks should go. However, forecasting -especially macroeconomic forecasting- is extremely difficult and usually the stock market does something quite different from what you would expect it to do in common sense. Sometimes it’s good to look at it the other way round and let the stock market tell you where the economy and the world is going. In many cases, forward-looking stocks are themselves the best macroeconomic indicator.
In Germany, which had to return to the stone age of manufacturing during the energy crisis in the fall, the DAX stock index has rocketed 30% to near all-time highs. Meanwhile, the index's valuation measured in forward-looking P/E has returned to 12.5x, with a ten-year average of over 13x. Simply looking at history, the undervaluation of stocks seems to have come to an end. The DAX index contains many cyclical industrial companies, which are benefiting from better-than-expected global economic growth and the opening up of China.
Similar chatter can be heard about the index of cyclical European stocks. Stagflation fears of last fall have turned into optimism about future economic developments as the index has risen 30% from the bottom.
Similarly, I follow the share prices and valuations of Finnish private investor favorites Nordea and Outokumpu with a twinkle in eye. Nordea reflects well the state of the Nordic economies because the bank is a major financier. In turn, Outokumpu is sensitive to the global economy, for example in the construction and industrial sectors.
Outokumpu's share price is already flirting with last year's highs and the company's P/B valuation has risen by as much as 50% since last fall. Considering the company's historically modest level of ROE, one could say that investors are optimistic about the economy, and a recession is certainly not in Outokumpu's investors' cards. If the valuation would rise on par with the book value, things would be properly scorching.
Nordea's share price is approaching the highs of the 2000s. Like Outokumpu, Nordea has made huge improvements in its own operations in recent years, and comparisons with the past don’t do the company justice. Nordea's share is priced at 1.4 times equity, which is by no means too high for a bank with a return on equity of over 13%. In bad places, Nordea has been beaten below its book value, which is now running at less than 9 euros per share. On this basis too, investors could be said to be optimistic about the economy, and huge credit defaults associated with the recession aren’t expected to materialize.
Greed has returned to the market
“Be fearful when others are greedy, and greedy when others are fearful.”
This is what some gray-haired investment billionaire from Omaha has said in the past. This rule of thumb makes sense in the stock market but is difficult to implement in practice for people prone to herd behavior.
After last fall's fears and frustrations, investors have become greedier. Nothing changes sentiment like a rising share prices.
This graph shows the estimate of retail investors' cash flow into US equities as a 21-day moving average. Over the past month, an average of one and a half billion dollars more has been invested in equities every day. Most of the money has flowed into familiar household names like Tesla.
On the other hand, the use of the leverage continues to fall on an annual basis. However, this trend seems to be reversing and the level of debt has recently started to rise slightly. Shocking spikes, with a sample size of three in 1999, 2007 and 2021, seem to have been the worst times to buy stocks.
Now is not the worst time, but on the previous two occasions the amount of leverage was halved from its peak. Now it has fallen by only about a third. However, it should be noted that the amount of leverage seems to follow the stock market closely and in the last two occasions the stock market halved from the peaks. I don't think that's the baseline scenario even for bears now.
While retail investors seem to be greedy and cheerful, portfolio managers remain cautious. According to a global portfolio manager survey by Bank of America, more than 60% of the professionals surveyed consider the current bull market to be a bear market rally, which effectively means they believe in a new bottom at some point in the future.
In addition, portfolio managers continue to underweight equities relative to bonds. By the way, this has been a pretty good buy signal historically as you can see from this graph. This can be interpreted to mean that if all goes well in the world of investors, portfolio managers will have plenty of cash to buy stocks that are soaring, which will of course fuel further rises.
This is a funny graph of the level of greed of investors. The graph from a Twitter user called Game of Traders compares BBB-rated corporate debt, which is kind of a mediocre level, to the interest rates on 90-day bonds. In practice, the difference has disappeared completely, although BBB-grade debt is a much riskier pocket to shove money into. Many times, this has happened near stock market peaks in the past.
Here you can see the S&P 500's earnings yield, i.e., the inverse P/E ratio relative to the same risk-free return you would get from the market today. The gap between the two has narrowed to non-existent in recent times. The S&P 500 has a P/E of around 20 on realized results, implying an earnings yield of 5%. The interest rate on a 90-day treasury bill is 4.7%.
It should be pointed out that the comparison between the two is logically flawed. The expected return on shares is not the same as their earnings yield. The return on shares comes from their future share price rises or dividends, usually fueled by rising earnings. By the logic of this graph, one of the biggest bull markets in history in the 80s and 90s would have been a bad place to buy across the board, which of course is not the case.
Finally, I could raise the long-standing issue of this scattergun, i.e., the allocation of shares in relation to financial assets. Data is slow to update, and this is from the third quarter, after which stocks have risen. The weight of equities relative to other financial assets has fallen but remains historically high. Thus, “greed has returned to the market” summarizes the sentiment, but there are no alarming parties like 2021 and portfolio managers are not even part of the party yet.
Thus, “greed has returned to the market” summarizes the sentiment, but there are no alarming stock market bacchanals going on like in 2021 as portfolio managers have yet to arrive at the party.
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