How much further will stock markets fall?

How much further will stock markets fall?

As Wile E Coyote navigates the New Mexico desert, he will occasionally hit a canyon. Momentum carries him high into the air, his legs pedaling frantically, but he eventually succumbs to the inevitable, crashing to the ground in an inelegant heap. Depending on the mood of a range of investment managers, that is exactly what can happen in financial markets today.

They believe that the volatility observed since the beginning of the year is only the beginning of a long period of instability. Right now, markets are pedaling along, before accepting that higher interest rates, weaker corporate profits and declining economic growth will inevitably drag them down with a splat.

Every investor knows that the golden rule of long-term returns is to stay invested during tough times. While no one is suggesting exiting the market at these levels, in this context there may be an argument for maintaining “optionality”: in other words, keeping cash in reserve in case there is would have better buying opportunities in the future.

Earnings downgrades will make the difference

Many commentators believe that the stock markets are not yet pricing in the bad news. Anwiti Bahuguna, Head of Multi-Asset Strategy at Columbia Threadneedle, says: “So far this year [market weakness] has been an all-rates story. As rates rose, equity multiples compressed. Earnings have remained quite strong for this year, even with the damage we anticipate over the next six to 12 months. This year, we may see earnings growth of 6-7%, but expectations for future earnings are dwindling for 2023 and could fall even steeper from here. »

She also believes that higher rates are not yet fully priced into equity markets. “There is more damage to come in the bond market.” However, it’s earnings downgrades that will really make the difference: “Even if companies didn’t go in and downgrade to a negative absolute number, the trend is for earnings downgrades to be negative.” At the moment, valuations are in a neutral range, she said, which leaves plenty of room for market multiples to continue to decline. She concludes that there is potential for more pain in the stock market.

In this, his views agree with those of the BlackRock Investment Institute, which gave this grim assessment in its latest update: bursts of financial stability. risk – that stock markets may not yet fully appreciate. We remain underweight developed market equities in our tactical views.

He added: “We think equities are just starting to be priced from a deteriorating macro outlook. We believe stocks are more likely to fall as prices still do not fully reflect the combination of recession risks and higher interest rates. Consensus earnings expectations for this year and next still seem overly optimistic to us given the growth backdrop.

Cash = less loss

Let’s not forget that bonds aren’t fantastic either. The diversification benefits of holding bonds alongside stocks are largely non-existent today. Some economists have suggested that the benefits of diversification only exist when the market is focused on growth. When inflation is the concern of investors, both stocks and bonds do poorly.

Rob Burdett, head of multi-manager solutions at Columbia Threadneedle, says that in this environment, there’s a real question about where investors can find safety: “Gold isn’t working yet. Inflation pegging hasn’t worked – at least in the UK, where inflation-linked bonds have fallen almost 40% since the start of the year. Credit bond managers are not rushing yet. The shares haven’t fallen much. This is why cash can be a good choice, at least for the optionality.

He says the market has a lot to do this year. There is quantitative tightening, as well as ongoing issues with supply chains. Implementing net zero could be inflationary. He talks about the “rule of 20”. It is a measure of stock market valuation, which indicates that the stock market is valued at its fair value only when the sum of the average price-to-earnings ratio and the inflation rate equals 20. On this measure , the US stock market may have another 20-25% ahead of it. Bonds have weakened, but there could still be considerable pain ahead.

Are there exceptions? Bahuguna says Japan is the only country not to suffer corporate downgrades. There will also be certain sectors that will continue to thrive – healthcare, perhaps, or energy. Likewise, investors may want to look at relative value plays rather than directional plays. For example, most investors have long since lost faith in the focused absolute return sector, but the average fund is down just 1.1% over the past 12 months. Polar Capital Global Absolute Return, Gam Star Global Rates and Fulcrum Diversified Core all experienced a “good” bear market.

However, navigating this market would require exceptional asset allocation skills and considerable predictive powers. With that in mind, cash has a lot to recommend it in this environment. The fund manager’s cash levels peaked in July at 6.1%, their highest level in 20 years. It fell slightly in August to 5.7%, but remained well above the long-term average of 4.8%. Investors are still losing money in real cash terms, but they can lose less and it can allow them to buy as opportunities arise amid market turbulence.

Even with a contrarian trend, it’s hard to make a compelling case for the stock market today. Cash is always contentious, but strategic cash weighting could help avoid Wile E Coyote slamming to the bottom of the canyon.

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