Bear markets are a bit like freckles. Initially they all look similar, but on closer inspection they can vary greatly. Consider the latest one.
This year global stock prices have already collapsed by about 25 per cent, typical when foreshadowing an economic recession. Yet so far market earnings estimates reveal no expected profit decline ahead.
That is not so unusual as a trend. Corporate bosses usually exude optimism. If products or services continue to sell, and customers pay on time, of course they will emphasise a rosy view. As a result, even time-hardened analysts may not wish to second-guess their covered companies on the facts.
Eventually though companies start warning of problems with, say, excess inventory or clients that have stopped spending. This can have a disproportionate effect on a company’s share price. One example, big box US retailer Target noted it had too much stock in its warehouses in its first-quarter results in May. Investors panicked and the shares immediately hit an air pocket, falling 25 per cent on the day.
Today, company executives regularly offer some caution when discussing outlooks. Yet global earnings estimates still point to growth to come this year and next.
If we exclude the energy sector given the Ukraine-induced spike in profit, world earnings per share growth are expected to rise roughly 3 per cent this year and almost 9 per cent in 2023, using MSCI data. In a recession, these rates would typically register a decline of a fifth or more. The US, which weighs heavily on these aggregate figures, is expected to deliver 0.5 per cent earnings growth this year and 9.7 per cent next year.
Other regions — Europe, Japan, emerging markets — have higher estimated rates of earnings growth for this year (partly because of currency effects from the strong dollar) but still strong profit growth is expected in 2023.
We have been here before. This year’s bear market resembles the tech wipeout of roughly 20 years ago starting in 2000, thinks Andrew Lapthorne at Société Générale. High valuation stocks took the hit first, usually those companies with plenty of promise but little or no earnings.
Back then a ratio of tech stocks against the S&P 500, a measure of relative performance, hit a peak not seen since the late 1960s, Bank of America pointed out recently. The technology heavy Nasdaq 100 plummeted by three quarters in the two years to September 2002, while the broad-based US benchmark S&P 500 index fell by less than half. Market-wide profit trends did not begin to deteriorate for about a year after the bubble burst early in 2000.
This year the tech sector has led the way again in the sell-off although the scale of sell-off is far from the spectacular bursting of the late 1990s dotcom bubble. Notably the ratio of tech stocks against the S&P was at its highest level since the earlier dotcom peak. And like the earlier bear market, profit forecasts are holding up.
An expanding US economy has supported earnings for US companies. Inflation also helps. Rising prices have pumped up nominal sales growth, even though profit margins are beginning to fall, says Lapthorne. Note that last week P&G reported a healthy single-digit increase in quarterly sales, down to its own product price increases. But profits growth did not keep up, crunching margins.
The broader trend is likely to continue until the US Federal Reserve quells inflation by raising rates. Eventually this will hit broader profit growth, perhaps in the early part of next year.
This brings us to the key difference with the bear market of two decades ago. Asset allocators and macro investors cannot easily shift into bonds. Normally, they would seek out these and high income stocks as harbours from an approaching storm.
Not this time. A vicious bear market in the bond market has also taken hold. Volatility in the fixed income market is extremely and persistently high as shown by various measures including the ICE BoA Move Index. This index is at its highest in three years. UK gilt volatility has leapt even higher. Until central banks stop lifting interest rates, this is likely to leave markets on edge. That might not happen until there is stark evidence of inflation falling, probably accompanied by economic weakness and rising unemployment.
Even if inflation is brought under control, that will mean less of a boost for topline revenue growth from rising prices, exposing underlying earnings weakness. Profit growth should then tumble quickly as in a more typical economic cycle. That is not a great outlook for equities. Cash holdings by investors are rising. The bear market should continue into next year.
