WealthNotes June 30, 2022
Markets in Trouble
As you know, the stock and bond markets are both down 20% in value this year to date. Many investors are worried and confused about what they should do about their investments. It’s a strange feeling for most because the market has been rising for the years that they have been invested in the markets. They, and many advisors have not experienced a bear market.
I hope these remarks will clarify what I think is going on, and why I believe there continues to be significant risk in the markets.
My primary observation is that all the massive stimulus, including money printing, zero interest rates and historical fiscal deficits did not work. GDP failed to respond as growth averaged a miserly 1.5% to 2.0% or less if the actual rate of inflation is applied.
Much of the newly created money went into financial assets, not into the economy. All financial assets, real estate, stocks, and bonds inflated in value to unprecedented levels. The theory was that the “wealth effect” would stimulate the economy. It didn’t work well.
Zero interest rates left investors with nowhere to go except real estate and the stock market. The demand forced both assets into atmospheric valuations Stocks traded at extremely high multiples of earnings and commercial real estate was trading between a 2% and 3% capitalization rate.
The zero cost of money also encouraged investment in deals that are not economic at the “normal” cost of money. The consequences of this malinvestment are not going to be pleasant as interest rates escalate.
The cheap cost of money encouraged corporations to borrow billions to buy back their stock. This action increased the demand for their stock, but the borrowing did not add to corporate profitability, it just increased per share earnings that pumped their share prices higher. Balance sheets were weakened for no good reason.
The debt servicing costs will escalate as rates are increased and this will have a negative impact on future profitability. I am in the camp that opposes corporations trading their own stock. Among other things, the Boardroom is conflicted by the potential profits from stock options.
The massive stimulus that drove asset values to extremes is gone, instead of printing money, liquidity is being withdrawn from markets. Interest rates are escalating, and I think we have entered a recession. Most economic indicators are slowing.
During the market enthusiasm, corporate profit margins expanded from a historical 10% - 11% to about 14% of revenues. A slowdown will inflict a contraction of margins on lower revenues. It’s a double whammy, that will attack earnings per share, and of course, share prices.
I am bothered by bank and broker analysts forecasting S&P 500 earnings growth of 8% to 11% for 2022 & 2023. It is likely that earnings forecasts are going to be reduced as the slowdown is more apparent. The markets are now discounting this likelihood.
My guess is that S&P500 eps over 2022 and 2023 will decline to about $175 from the current $205, a decline of about 15%. This may be conservative because there are many distortions in the system. Keep in mind, I am guessing, but have access to much information.
This estimate indicates a current multiple of eps of 21.8x on forward earnings compared to the analysts forecast of 18x.
THIS IS IMPORTANT! It means that despite a 20% correction to date, the market has become more expensive in p/e terms. It could mean that the correction still has a long way to go, and losses could be extreme.
Remember, the business cycle is a permanent part of economic reality. It has never been possible to avoid the cyclicality of markets and the economy.
A recession does not arrive unannounced. Early signals are usually apparent in the numerous economic indicators economists and businessmen follow. The character and depth of the recession is only observed in hindsight.
SHOULD YOU SELL OR HOLD ON THROUGH THE DECLINE?
If you are over 50, I think you should give more consideration to this question than younger folks. It has taken many years for markets to recover from previous corrections. The markets are higher than any time in history. Consequently, the period of zero returns could be longer than previous recoveries.
Most advisors recommend being patient and just hold on. This advice is calculated by long-term charts from point “a” to “b”. It does not measure the duration of the trough period and the time it has taken in the past to recover to pre-correction values.
Our consultant’s math forecasts a period of 8-10 years of zero returns until markets return to today’s values.
I do not know of any Financial Plan that anticipates 8-10 years of zero returns.
Admittedly self-serving, but I cannot pass the opportunity to point out that my investment process constantly adjusts the asset mix of our client portfolios through the 4 phases of the business cycle. It is not market timing; it is an intelligent process designed to capture the upside of bull markets and soften the drawdown during bear markets.
It’s time like these when risk management replaces aggressive growth policies. I will describe our process in a future Wealth Note.
Our client’s portfolios are defensively positioned to protect against losses and prepared for bargain hunting opportunities.
I hope yours is too.
Please call or email me if you wish clarification or additional information.
Global Wealth Builders Ltd.