Like everyone else, I’ve been surprised by the market’s rally since its October low. Not so much that it happened, but when it arrived. I expected the market to turn higher in the middle of the year about the time it was clear that inflation was on a sustainable downward path and interest rates had peaked. I know that the market likes to pre-empt recovery, but investors seem to have turned up to this party before the invitations had even been printed.
The US stock market has risen by 15pc over the past three months as investors have looked through gloomy economic forecasts for 2023 to an anticipated recovery in 2024. Last week, the FTSE 100 hit a new all-time high. The markets are making some heroic assumptions about how far interest rates will go and how quickly they will come back down again. Investors have decided to accept optimistic earnings forecasts, put their faith in a soft landing and ignore central bank warnings that their job is not yet done.
It remains a tantalising possibility that the market has simply seen something that the rest of us have not. This week Goldman Sachs said it thought there was now only a 25pc chance of a US recession this year, less than half the consensus view. Europe, which looked like it was heading for an inevitable contraction, now looks like it has dodged the bullet too. In the UK, the first cut of fourth quarter GDP may show that a technical recession has been postponed, for now at least.
And halfway through the fourth quarter earnings season, it also looks possible that the downturn in corporate profits this year could be subdued. Most companies are beating estimates, even if the bar is getting lower as analysts become more realistic about the outlook. Last week’s jobs data in the US showed that the labour market, if not every other corner of the economy, is remarkably resilient.
All this competing and sometimes contradictory information makes predicting the bottom of a bear market even harder than it always is. Forecasting turning points is notoriously difficult. Even with the benefit of hindsight, it took Russell Napier 300 pages to analyse the factors that caused the market to turn higher after the four biggest bear markets of the 20th century. His excellent book, Anatomy of the Bear, written about 20 years ago, is well worth a read if you can find a copy.
If anything, the big turning points are easier to spot than a mid-cycle changes of direction, which is what we are dealing with today. They have some common characteristics, such as a widespread mood of pessimism, extremely low valuations and a preference for safe assets like cash. That’s not where we find ourselves now. Deciding where the market goes from here is more nuanced.
One of the reasons why we tend to discourage people from trying to read the market cycles ups and downs is that it often is ‘different this time’. In every single market cycle that I have looked at, the relationship between the state of the economy, corporate earnings, valuations and the overall level of the market is subtly different. The sands are always shifting.
The basic framework looks something like this. First earnings and valuations rise together in a bull market. Then investors start to worry about a downturn and valuations fall even as earnings continue to grow. This is what happened last year. Sometimes you then get a period when valuations continue to drop as earnings also turn lower – a painful double whammy. Finally, there is light at the end of the tunnel and the market changes direction even though profits are still declining. The new bull market has begun.
If it were always this simple, we’d all be rich. Unfortunately, there are many variables. The depth of the earnings downturn, or whether it even happens, is one. How far ahead of the turn in the real economy the market changes direction is another. How deep the retrenchment in valuations is one more.
The early 1970s bear market may provide an interesting parallel with today. Then the market fell while earnings were still buoyant as central banks tightened policy in the face of worrying levels of inflation. Then the economy went into recession, earnings started to fall, interest rates stopped rising – and the bear market ended. Just when everything looked terrible, it was the time to buy again.
The reason I am concerned about the rally since October is not that the template from 50 years ago doesn’t fit but the fact that we haven’t yet reached that moment of peak gloom. Recession remains a possibility not a certainty, earnings are still flattish not really falling, and the US Federal Reserve seems happy to let the market rise without further comment.
We may not be at peak gloom, but we may be at peak Goldilocks. The market is convinced rightly or wrongly that central banks will pivot to easier policy just in time to avoid a recession and forestall a serious downturn in earnings. If that is how things pan out then Mr Powell will have achieved what most of his predecessors failed to, a genuinely soft landing.
Maybe he will, but we won’t know for a few months yet. And, in the meantime, I would expect the market to bounce around, revisiting the October low perhaps once or twice again. That’s OK. In fact, for anyone looking to build their investments, a prolonged period of consolidation before a renewed bull market begin may be a welcome opportunity to invest at a sensible price.
