The turning point for investing
Welcome to a new investment year, my esteemed readers and co-investors. All investors' YTD (year to date) returns are now zero, which should provide some psychological relief after the pain of last year (although the 12-month figures haven't changed much).
If your paper wealth have gone up in smoke recently, you're not alone. Around 25 trillion, or 25 000 billion dollars, has been lost from the value of all the world's shares. At present, shares are valued at roughly the same level as the world's annual GDP.
In this post, we discuss how forecasting models give a 100% probability of a recession in the world's most important economy, the United States. Then we’ll take a look at how masterfully strategists' earnings growth forecasts hit the mark last year, but the stock market still plummeted. After that, let’s take a quick look at the financial houses' forecasts for 2023. Finally, there is talk of a possible turning point in investing, where the lessons and experiences of recent decades are thrown into the scrap heap.
World's most important economy in recession by 2023
The world's most important economy and consumption engine—the US—is at risk of slipping into recession in fall 2023, if Bloomberg’s model and other forecasting models are to be believed.
So far, the economic data has surprisingly good. The labor market is tight. This graph shows continuing claims for unemployment benefits, which now stand at 1.7 million. But as you can see from the graph, at the beginning of recessions the number of applications rises to around 4 million or more, as was the case in the COVID crisis. That's why I had to trim the scale of that graph, because the COVID-19 peak would have made the rest of the development look like a flat plateau.
In addition to the labor market, household and bank balance sheets are strong. Consumer confidence has also remained reasonably high.
Still, several long-term indicators such as yield curves point to a recession in the coming year. This busy graph often shows the probability of a recession given by various yield curve models, as well as Bloomberg's own model. It expects a 100% recession within the next 12 months, but yield curves are also betting on an economic downturn. So, expecting a recession this year is the baseline scenario.
A mild recession would not in itself be a cause for drama, but it’s difficult to predict in advance how deep a recession will become. It would probably cool inflation, which is positive.
This graph shows the sales of investment goods and companies' investment intentions. Deliveries are drying up, which is directly reflected in economic growth. Businesses' appetite for investment also seems to be cooling. This at least foreshadows a slowdown in the economy, and cautious developments are typical in a recession.
Financial houses' expectations for 2023
The past year was a humbling one for many stock market prognosticators, with many expecting a real rally from 2022, but whipped by rising interest rates, stocks plummeted 20% last year. Despite this, the earnings forecasts were unusually accurate, i.e., the fundamentals developed as expected.
This episode illustrates well how in the short term the stock market can drift in a completely different direction from the results due to by liquidity, interest rates and inflation. In the long run, stocks go roughly in the direction of earnings, although not always at nearly the same pace.
A year ago, strategists expected earnings per share for the S&P 500 index in 2022 to be $221, a couple of dollars away from the current forecast of around $223. The Q4 results season is still to come, but I think it will be in that ballpark.
This graph shows the average accuracy of the strategists’ performance forecasts. The forecasts have missed on average by 9% annually and, in general, results have been expected to be higher than they have actually been. In practice, recessions cannot be predicted, because forecasts are off by as much as 20-30%. This is not a flaw, but a feature, because the future is unpredictable and it’s even more difficult to predict its twists and turns. There is also publicly available data on the strategists' forecasts, which is why it’s so easy to trash them. Surely the investors' own matchbook forecasts have missed by as much.
At this point, it's worth remembering that movements can also go the other way. Even if earnings fall this year, stocks could rise if monetary policy and liquidity conditions improve. That's another possibility to keep in mind.
I was reading up on the expectations of several financial house strategists for the year ahead. I have compiled some summaries in this table. Many forecasters expect at least a mild recession in the US and a deeper one in Europe. However, for example, Goldman Sachs argues that US economic growth will hold up on the strength of real household income growth. Most forecasters expect inflation peaks to be behind us, but at the same time inflation will persist at least above 3%. Only a few predict inflation to fall rapidly. Similarly, the Fed funds rate is seen peaking at over 5%, although opinions differ on whether rate cuts will be seen as early as 2023.
Many are cautious about equities and positioning is very defensive. Attitudes towards equities depend a lot on how deep a recession and persistent inflation is expected this year. However, value stocks, lower-cost small caps, dividend stocks and selected emerging markets seem to be attractive.
If one were to draw some sort of consensus view from this, then later in 2023 stocks will bottom and the downturn will be mild.
If the strategists are epically wrong again and the investor wants to counter this consensus, there are two ways of looking at it. Either we are already in a bull market and the economy will offer pleasant surprises, or we are facing a terrible recession and a beating for years to come. Investors don’t seem to be collectively prepared for these two scenarios.
The turning point for investing
It is easy to miss the forest for the trees. In the confusion of daily price movements and investment views, it’s difficult to discern the long-lasting waves that rhythm the day's events. And when the wave changes direction, you must be alert. It’s possible to identify major turning points in the field of investment, where investors' assumptions are being redefined.
I finally had time over the Christmas holidays to read an essay by Howard Marks called Sea Change, which is an idiomatic expression for a turning point. Marks started his career in 1969 and now feels a third turning point in his career is at hand. He sees the first turning point as the change in the investment mentality towards risk and return in the 1970s.
The second turning point was the early 1980s, when the interest rate and inflation environment turned around. Thereafter, interest rates and inflation followed a 40-year trend of cooling. US 10-year bond paid up to 16% interest in the early 1980s, while today it pays less than 4%.
Falling interest rates have boosted the economy and equities in many ways. First, the required return for equities is determined by the safer bond yields available. The lower the interest rates, the more you pay for your shares today. Lower interest rates allow for a higher debt leverage, which fuels overspending—or if spent on investing—it boosts investment returns. Lower interest rates also mean lower interest costs for businesses.
The lack of interest yields on bonds has forced investors to take more risk for the sake of returns than they are actually willing to pay.
It’s telling that if equity valuation multiples hadn’t widened at all over the past 40 years, the S&P 500 would be at 1,450 points today. In other words, earnings have multiplied by about 14 in 40 years, while equities have multiplied by up to 40.
Indeed, over the last 40 years, equities have delivered rich returns. The S&P 500 index has returned over 9% per year as it has risen from 100 points to its current level of just under 4,000 points. In between, however, there were 13 years of stagnation and a couple of stock market crashes, so investing hasn’t been quite as rosy as Marks paints in his essay.
During this period, investors forgot their previous caution and perhaps became overly optimistic. It's easy to be an investment genius when falling interest rates inflate the present value of all stocks. It has been easy to buy on the dip when the central bank bails out investors.
This may no longer be the case. This table in the essay illustrates quite well how many things are upside down today compared to the bull market of the last 10 years. There are many of them, but I’ll highlight just a handful of them.
The Fed's stance has changed from stimulative to very tight. Inflation is at a 40-year peak instead of a previous downward trend. Instead of a perpetual boom, a recession is seen as almost certain. A recession would hit companies’ earnings, which could further erode faltering investor confidence.
The investor sentiment could be described as more cautious than optimistic. The risk of disruption in the financial system is elevated, whereas in the past it remained hidden in the shadows. Investors' number one concern is no longer FOMO (fear of missing out), but instead the traditional loss of capital.
And the situation doesn’t seem to be changing immediately, despite the expectations of investors accustomed to the previous environment. Inflation is easing, but the structurally tight labor market may keep it higher than before. The megatrend of glottalization brought a huge headwind for businesses, but this too seems to be slowing down or even reversing. Marks doesn’t believe in a return to low interest rates, although he wisely refrains from making macro-forecasts. As a rule, they never hit the mark for anyone. Instead, he considers an interest rate of 2-4% to be realistic for the coming years, i.e., roughly the current level. As Marks often puts it, you can never know where the market is going, but an investor can try to get a sense of where we are now. And as we have just established, the current environment is more difficult.
However, there is a silver lining. Many investors like to invest mainly during good weather, but it’s usually the more severe storms that are better times to save and invest. The problem with the climax of a boom market is that the investor gets a lot of risk for a low expected return. When enough things come crumbling down, the situation is reversed.
Rising interest rates mean that investors are again getting satisfactory returns from lower-risk assets. Savings don’t have to be in shares but can be diversified elsewhere without having to compromise on the risk/return ratio. Lenders and discount prices seekers are in for a good few years, as cash becomes a scarce commodity again. You know what they say, cash is king.
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