In the markets this week: shares retreat on geo-political tensions and interest rate fears; and earnings season gets into full swing with the Magnificent Seven in focus.
So, just like that, the market is heading back towards correction territory. It’s not there yet, because the market is off only 6% since its cyclical peak at the end of March, but it would not take much for the market to fall back to a 10% correction, in a re-run of the slide from last July to October.
Given that the S&P 500 had risen by nearly 30% in the previous six months, it would not be unreasonable to see a pause for breath. Worth pointing out, too, that the kind of drawdown that we have just experienced is extremely common. In fact, since 1900 the stock market has been 10% below its most recent peak 50% of the time and at least 5% down around 65% of the time.
The market goes up over time but not in a straight line and so much of the time you would expect it not to be at an all-time high. The zigs and zags of the market are part and parcel of being an investor.
The latest jitters have been driven by two familiar themes. The Middle East remains a key driver of sentiment, with Israel’s retaliation to Iran’s retaliation the latest in a worrying series of tit-for-tat military actions.
The good news is that it now seems clear that neither side wishes to see things escalate further, and the oil price in particular has retreated somewhat in response to an apparent easing of tensions. The price of a barrel of Brent crude settled at around $87 at the end of last week and the price is now back below the level seen before the previous week’s drone and missile attack on Israel.
Clearly, it’s not in either country’s interests for the latest conflict to escalate into a wider regional fight. It is also clearly favourable to US president Joe Biden if a sharp rise in energy prices can be avoided in the run up to November’s Presidential election. He has made it very clear to US ally Israel that support will not be forthcoming for further action.
The second issue is arguably more important. It’s the combination of sticky inflation and rising real interest rates that makes it hard to justify the kind of historically high valuation multiple that the US market had reached during the 18-month rally from the October 2022 low. At that time, the S&P 500 traded on around 15 times earnings but had reached 21 times by the March peak.
If you look back at the spikes in volatility over that 18-month period, they have all come alongside fears about the outlook for interest rates. Any time investors faced the prospect of higher for longer rates on the back of persistent inflation, stock markets have run out of steam.
The link between interest rates, bond yields and share prices is well established over time. But it is something that we have forgotten about in the past 20 years or so when shares and bonds have been negatively correlated, one rising when the other fell. In the previous 40 years or so bonds and stocks were positively correlated, with rising bond yields (and so falling bond prices) coinciding with falling share prices.
So, the latest wobble for shares is not unusual and reasonable in the context of a changing narrative about interest rates. In the US, in particular, a robust economy, strong jobs market and difficulty getting inflation back to target have left investors wondering whether the new normal for interest rates is a bit higher than they hoped.
All other things being equal that is bad news for households and businesses alike and so makes it hard to justify a highly rated stock market.
Even after the recent fall in the market, the S&P 500 has only returned to its long run rising trend line. The number of stocks trading above their 200-day moving average has fallen, but only from a very high level of 86% to a moderately high level of 71%. The bull market looks to be still intact.
The equal weighted index, that gives all 500 companies in the S&P index an equal influence, looks a bit less healthy. The percentage of shares trading above their 50-day average has dipped from 85% to 37% but even that is hardly oversold.
Crucially, the dip in the market does not cast any real doubt on the prevailing economic story, which is that the US economy is enjoying a soft landing. It still looks to be the case that the economy looked at a recession and stepped back from the brink. It’s not dissimilar to the soft landing rally that shares enjoyed in the 1990s. But also similar to the situation in the 1960s when a similar soft landing proved to be a false dawn. Back then the Fed was forced by rising inflation to reverse course on its rate-cutting trajectory. A recession then was postponed not cancelled and this is a possibility that remains live today. What was expected in 2024 may still arrive in 2025.
So, all eyes remain on what’s happening to corporate earnings. The good news here is that estimates are still nicely positive, with forecasts of a low double digit rise year on year by the end of 2024. Currently trailing earnings are rising at about 4% year on year, reversing last year’s modest 3% fall.
An interesting aspect of markets currently is the divergence that’s emerging between the US and the rest of the world. While US earnings are forecast to grow at 12% the rest of the world looks much more stagnant. This helps explain the diverging expectations for interest rates in different parts of the world. Rate cuts look much more likely in the UK and Europe than they now do in the US, and that in turn is feeding through into the exchange rate. The pound has fallen back from its recent peak of $1.30 to under $1.24.
This week we get into earnings season in a big way, with a flood of first quarter results announcements. In focus particularly this week will be the Magnificent Seven stocks that have done so much of the heavy lifting for markets in recent months but which look to be selectively losing momentum.
Even the market’s recent darling, Nvidia, has come off the boil lately. From its high point in early March, the AI-focused chip maker has fallen 12%. And it is not alone. Tesla, which reports this week alongside Meta, is down 40% so far this year. Apple is 13% lower.
At the same time, however, Microsoft is 7% up year to date, Amazon is 18% higher and Meta has risen by 42% and Google 12%.
Increasingly, it looks like the Magnificent Seven name tag is nothing more than a marketing label that has clumped together a group of shares that really only share one thing - their size.
On the economic front, there are a couple of important announcements this week. The first is Thursday’s US GDP number. But there will also be some key indicative growth figures in the form of purchasing managers index reports for the G7 countries and India. Then at the end of the week we will get the latest Bank of Japan interest rate decision. No change in rates is expected - it remains the most accommodative of all the major central banks.
