A market crash will depend on which part of the equation investors got wrong

The writer is the editor-in-chief of MoneyWeek

For those who are confused by this year’s market, I have a suggestion. Invest in a Real History of Financial Markets course run by the Edinburgh Business School (you can learn it online – no need to go to cold Scotland). One of the modules focuses on the history of extreme market valuations – what causes them and what causes them to crash.

The first thing to note is that, while we like to talk about bubbles, periods of extreme valuations in the stock market don’t really happen that often. According to Professor Russell Napier, of the 29 business cycles in the US since 1881, only a few end in a business cycle. However, while each has its own peculiarities, the underlying dynamics are the same: the ability for investors to have absolute confidence in something turns out to be impossible. Namely, thanks to some technological marvels, corporate profits will stay high (and can grow) indefinitely and interest rates will also stay low indefinitely.

In most cycles, investors don’t think this. They assume cyclicality – that rapid economic growth will lead to capacity constraints and subsequently to inflation and exchange rate appreciation, something that will slow both economic growth and reduce corporate profits – lowers valuation. We like to think of stocks as all sorts of things: right now, for example, too many investors see them primarily as benevolent signaling vehicles (seeing the collapsing bubble in energy stocks). renewable quantity).

But in the long run, stocks don’t really feel or present a nuisance: they are about the net present value of all future income streams discounted at any discount at at that moment. That’s it. So the discount rate goes up, the value goes down (usually when inflation hits around 4%).

A niche bubble can then develop only if investors do not assume cyclical normality but instead try to convince themselves (against all historical experience) that it is possible. in a high-margin, low-inflation environment. This always ends badly. Think 1901, 1921, 1929, 1966, 2000, 2007, 2020 in short, and possibly right now.

The only question is how quickly it ends badly. The key here, Napier says in his lectures, is which part of the equation investors got wrong. If you believe interest rates will never rise, you are inclined to accept a protracted bear market (since 1966, when inflation was hard to imagine in the late 1970s). The more confidence there is that corporate earnings will stay high forever, the shorter it tends to be and sharper (2020 is a small classic of this crash genre).

So here we are. Inflation has been at a minimum for many years. US corporate profits have been very high and rising for many years: they reach yet another high record in the third quarter of 2021. And of course, US stock market valuations hit a bubble some time ago: at the end of last year, the cyclically adjusted price-to-earnings ratio had reached around 40, which is high. more than double its long-term average. Investors are once again believing in too many pre-breakfast utopias – which they may begin to realize.

So here’s the question: where did we go wrong this time around? Is it the discount rate or the company’s profit? The discount rate may seem like an obvious thing, although an increase in interest rates clearly affects a business’s profit margin as well.

Cheap labor and globalization have long kept inflation from being a distant nightmare for older investors and a mystery to younger ones. As a result, most fell because of the nonsense from central banks last year that the rapid inflation they were seeing was only temporary. And even those who think it could last much longer, for example, Easter believes central banks will stop raising rates regardless.

So the reality is that high growth (US gross domestic product grew by 6.9% in the last quarter of 2021) could actually cause capacity constraints and create a starting inflation rate. The beginning of the last few years has become a terrible shock – as signs that central banks can really do something about it.

The Federal Reserve, under pressure from inflation itself and possibly from polls showing that inflation says it’s not helping President Joe Biden, is now changing its phase (no longer a “transitional one”). “). There’s even a “reasonable probability of seven rate hikes this year,” said Aegon Asset Management. Hallucinogenic things.

It also leaves investors with little choice: as long as the Fed holds this line, they should certainly not be buying down but selling rallies – at least when it comes to their most expensive holdings (they are the most expensive). one could argue about whether stocks like Peloton, which have dropped 80 per cent in six months, are still expensive.) In times of inflation, today’s value starts to seem like it might be worth more than it might be tomorrow (a bird in your hand is worth a lot more than an electric car flying in the sky). dust).

With that in mind, it’s worth noting that the FTSE 100, with its reasonably priced income-generating stocks, is outperforming the S&P 500 – to the point where it’s currently on track to outperform over a 12-year period. month at the end of this month. That’s something it hasn’t done in a year since May 2017. But it’s a change that I suspect most Real History students of Financial Markets are ready for.

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