Searching for a Bottom
Strong job gains and high inflation pose an extreme challenge to equity (and bond) investors, but the markets have declined sufficiently that we are testing for a bottom. Stocks and bonds are both attractive from a longer-term perspective, even if volatility continues to test the patience of investors. A 25% decline in equity prices will do that.
Investors remain nervous, since it is widely appreciated that the recession that is likely to occur in 2023 hasn’t even started yet. It is generally understood that corporate profits estimates are likely to be reduced in due course, even as companies report better than expected results. Such reports do nothing to allay concerns that profits will fall in the coming quarters. To the market, such good news only delays the inevitable.
As is often the case, the market fears the worst. The credit crisis of 2008 left scars, so with the Fed hiking rates now, investors fear another housing crisis and all housing related stocks have been crushed. Most home builders trade for 3 to 5 times current earnings, as do many suppliers of building materials, notwithstanding the fact that the U.S. suffers from a housing shortage that should limit the downside. Banks trade at 8 to 10 times expected earnings and 1.0 to 1.3 times book, depressed levels that reflect a widespread concern of major loan losses ahead. Yet banks are now highly capitalized. Covid cases are winding down, particularly deaths from Covid, yet life insurance companies commonly trade around 5 times earnings. At prevailing levels, prices already discount all but a deep recession.
It is impossible to project a bottom for stock prices. Markets always have the ability go down more than seems reasonable. Even so, current stock prices seem sufficiently depressed, at least to us, that we think prevailing prices will look extremely low when viewed in a year or two looking back with hindsight. While that may be obvious then, it is never obvious when you’re living in the moment. It is all too easy to imagine bad outcomes.
Fed officials have been very clear with their public statements that interest rates need to rise to moderate growth to bring down inflation. The labor market is very tight. The 3.5% unemployment rate, a historically low level, implies upward pressure on wages. The Fed needs to introduce some slack into the labor market, which makes it highly likely that a recession will occur. Investors understand that. That’s precisely why the yield curve has inverted. The bond market is already priced for a recession, presuming that rates will decline once the recession hits. Some uncertainties remain. Neither the Fed nor the market knows at this point how high interest rates or unemployment will go before inflation is brought to heel. Rates may need to go a bit higher than currently expected and that could also push stock prices a bit lower. But it seems safe to guess that we are far closer to the end of this process than to the beginning.
Market proverbs may give bad advice, with “never try to catch a falling knife” coming immediately to mind. It is unquestionably true stocks could fall further. But how much further? As we have seen many times in previous cycles, “no one rings a bell at the bottom”, a piece of advice contradicting the previous mentioned line. In fact, the average decline in stock prices in a recession is about 20%, so at minus 25%, it is hard to argue a typical recession is not fully priced in. And bounces off the bottom can be violent. Of course, we won’t know for sure until we have the full benefit of hindsight. But waiting is like trying to bet on the horse after the race is over. The opportunity doesn’t exist anymore. Prevailing prices are at attractive entry points, in our judgment.
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