- Looking at the data, it’s not as if the entire stock market is in capitulation mode – just its most frothy components and that appears to be driven by valuation.
- Correlations between bond yields and earnings multiples for stocks are no longer as reliable as they once were, which is what’s driving investors to fall back on first principles – valuation.
The thing about doomsday predictions is that eventually, they’ll prove to be accurate.
Whether it’s the caricatured bearded man walking down the street with a sign that declares “The End is Near,” or the tweed-coated economics professor declaring that the market bubble will “pop” – none of this is useful to investors (traders) who need to make real time decisions about their portfolios.
Sell now to cut losses and pick up when markets have bottomed out or buy now, knowing that there’s no real way to time the bottom?
That’s the billion-dollar question.
But looking at the data, it’s not as if the entire stock market is in capitulation mode – just its most frothy components and that appears to be driven by valuation.
For a relatively long time, naysayers had been declaring that stocks had become “too expensive” relative to fundamentals, only to rally harder, as if thumbing their nose at the pessimists, and persistently loose monetary policy has provided for that.
But now that the U.S. Federal Reserve is removing the punch bowl, punch-drunk investors are having to contend with an investment landscape that has become far more discerning and increasingly focused on valuations.
While the selloff has been brutal, not everyone has suffered equally – high-flying tech shares have been hammered, whereas companies that make everyday household items and churn out reliable profits have even rallied against broader benchmarks.
Suddenly, investors are waking up to the fact that companies need to generate profits to justify their share prices, when before it was all about growth.
Yet despite robust corporate earnings announced over the past few weeks, stocks have continued to tumble because investors aren’t sure if the earnings multiples that they’re paying for are justifiable against the current monetary policy climate.
Valuation and profits are of little to no use in timing market entries and exit – expensive stocks can always get more expensive, and naysayers have been proved wrong often enough to sound almost bigoted.
Correlations between bond yields and earnings multiples for stocks are no longer as reliable as they once were, which is what’s driving investors to fall back on first principles – valuation.
But there is simply too much uncertainty right now over interest rates, inflation and invasion for investors to call a bottom.
The Fed has provided some clarity on its interest rate path in the coming months, but where borrowing costs ultimately settle at the end of the year is perhaps more important because nobody knows what the multiples should be and where the Fed is in relation to inflation.
It’s entirely possible that by the end of the year, inflation pressures ebb, mangled supply chains are rehabilitated and the Russian invasion of Ukraine becomes a far more localized conflict, providing the Fed room to ease off the tightening.
It is also possible that the Fed is behind the curve and that inflation runs away forcing sharper rate hikes – but this is a less likely scenario.
The reason of course is that a recession is looming and that should in the interim at least, put a damper on demand.
Because the ultimate destination of rates affects what it’s worth paying for stocks, markets could still have far more to correct and the economy would need to be in far worse shape before it’s likely that the Fed would ease back on tightening.
And that’s why valuation matters in this environment, it’s almost the only thing that investors have.