The three things I would tell my clients this week:
This summer equity rally is by all means welcome, and it’s happening for good reasons over the shorter term. The Fed Put is back and officials have signalled that we are near the end of rate hikes. Markets are mean reverting after a bad year. Despite poor earnings, companies are still beating analyst expectations. And low-volume summer rallies are still rallies.
Having said that, longer term factors signal caution. The S&P has already delivered double its average annual return in half the time. The economy is slowing, credit is tight and we are still in Quantitative Tightening mode. Meanwhile private (non-listed) companies, are faced with significant challenges.
We have often asked investors to remain sanguine during market falls. We advise the same during rallies. Despite the welcome rally, we simply don’t see enough pillars to support a longer-term Bull Market just yet.
Even as the global economy is slowing down, hampered by persistent inflation and the highest interest rates in more than a decade, the S&P 500 is up 18% year-to-date and back near its all-time highs, while the Eurostoxx is up 14%.
There are certainly good reasons behind the rally.
For one, the Fed Put is back. The US central bank has proven that it can both hike interest rates and protect financial markets at the same time. For investors, the SVB collapse was a litmus test and the central bank passed it with flying colours.
Second, Fed officials have signalled the end of rate hikes soon. By saying specifically that two more hikes are needed, even as headline inflation is edging closer to the 2% mark, the Fed has reassured investors that the end of rate hikes is near.
Third, mean reversion is at play. The basis of financial investing is mean reversion, the idea that what usually happens will happen again, on average. Bonds and stocks tend to go up over time. A bad year is thus statistically followed by a good one. 2022 was an annus horribilis, one for the history books, especially on the bond side of things. And while bonds haven’t recovered nearly as much as equities, investors are certainly more positive. We have always maintained that returns aren’t really lost over time. Some years they remain in arrears. As we reach the end of rate hikes in the US, and with credit tight and the economy slowing, H2 could be the time when bonds too begin to make a comeback.
Four, companies have once again managed down analyst expectations. The earnings season so far isn’t that good. Blended earnings are down 9% for the quarter. While only a fifth of companies have reported so far, this could be the worst quarter since the pandemic. But 75% of companies still managed to beat analyst expectations. It’s an old game, to be sure. But CFOs have become quite adept to it.
Five, it’s summer. There’s a typical lull in trading volumes around summer days. Investment desks might be manned by robots nowadays, but no one is allowing the little algo fellows to go on investment binges all by themselves. Low volumes may mean big market movements, but typically they don’t have legs.
Investors should not get too excited about this rally.
Out of the five reasons for the rally, only one, the Fed Put, is a true long-term support for markets. Rate hikes might be ending, but money is tight and will continue to tighten for at least a year, all other things being equal. The Fed is still in Quantitative Tightening mode, and that’s more important for markets than interest rates. Mean reversion is well and good but once it has played out it doesn’t support rallies. At -7% to -9% earnings are no reason to cheer, the economy is slowing and companies have problems obtaining credit. Things are especially difficult in the Private Equity Market by the way (you can read our quarterly here), where valuations are collapsing. As for the summer? Seasoned investors know better than to bet the farm on low-volume rallies. And, by the way, last week the NASDAQ decided to significantly reduce the weight of the biggest tech companies to allow fund managers to keep track of the index without going outside of their risk bands.
The S&P 500 has already given us double its average annual return, and we are still halfway through the year. It would take a good Bull Market for performance like that to continue in the next few months.
This is still a difficult economic environment, with many twists and turns. The Fed managed to save US regional banks without much fuss, but the next challenge (and one will probably appear as credit tightens), might be a more difficult one.
We have often asked investors to remain sanguine during market falls. We advise the same during rallies. Despite the welcome rally, we simply don’t see enough pillars to support a longer-term Bull Market just yet.