Market crash will depend on investors getting the equation wrong

The author is the editor-in-chief of MoneyWeek

I have a piece of advice for anyone who has been lost in the market this year. Invest in a practical history of financial markets from Edinburgh Business School (you can study online – no need to travel to cold Scotland). One of the modules focuses on the history of extreme market valuations – what causes them and what makes them crash.

The first thing to note is that while we like to talk about bubbles, periods of extreme valuation in the stock market don’t happen very often. According to Professor Russell Napier, only a few of the 29 business cycles in the United States since 1881 have ended in one. But while each has its own idiosyncrasies, the underlying driving force is much the same: the investor’s ability to absolutely believe in something that will always prove impossible. That is, thanks to some “miracle” of technology, corporate profits will remain high (and possibly rising) indefinitely, while interest rates will also remain low indefinitely.

In most cycles, investors don’t think so. They assume a normal cycle — rapid economic growth that will lead to capacity constraints, which then lead to higher inflation and interest rates, which slow economic growth and dampen corporate profits — thereby lowering valuations. We like to think of stocks as all sorts of things: for example, too many investors right now see them primarily as a virtue-signaling tool (witness the current bubble in renewable energy stocks bursting).

But stocks aren’t really sentimental or performance in the long run: they’re about the net present value of all future income streams, regardless of the discount rate at the time. That’s it. So the discount rate goes up and the value goes down (usually when inflation hits around 4%).

Proper bubbles can only form when investors do not assume normal cyclicality, but manage to convince themselves (contrary to all historical experience) that a high-profit, low-inflation environment is likely to persist forever. This always ends badly. Think 1901, 1921, 1929, 1966, 2000, 2007, 2020, and possibly now.

The only question is how fast it ends. The key here, Napier said in his lecture, is where investors got it wrong. If you believe that interest rates will never rise, you tend to have a long bear market (starting in 1966, when inflation in the late 1970s is hard to imagine). If it’s more of a belief that corporate earnings will stay high forever, it tends to be shorter and sharper (2020 is a mini-classic for this type of crash).

So here we are. Inflation has been at its lowest level for years.U.S. corporate profits have been very high and rising for years: they hit another record high in the third quarter of 2021. Of course, as a result, U.S. stock market valuations reached bubble levels some time ago: By the end of last year, the cyclically adjusted price-to-earnings ratio was around 40, more than doubling its long-term average. Investors are believing too many impossible things again before breakfast — and they may be starting to realize it.

So the question arises: where did we get the most wrong this time. Is it the discount rate or corporate profit? The discount rate feels obvious, although rising interest rates have clearly hit corporate profit margins as well.

Cheap labor and globalization long ago made inflation a distant nightmare for older investors and a mystery for younger investors. So most people are seeing the rapid rise in inflation that is temporary because of last year’s central bank bullshit. Even those who think it could last beyond Easter still believe the central bank will hold off on raising rates anyway.

So the fact that high growth (US gross domestic product (GDP) grew by 6.9% in the last quarter of 2021) can really hit capacity constraints and cause inflation from the start of seven is proving to be a terrible shock – There are signs that central banks may actually do something about it.

The Fed, under pressure from inflation itself, and possibly from polls showing inflation not helping President Joe Biden, is now changing its stance (no longer “temporarily”). Aegon Asset Management said there is “a reasonable likelihood of seven rate hikes this year, one at each meeting”. Illusion-shattering stuff.

It also leaves investors with no choice: as long as the Fed holds the line, they should certainly not buy the dip but sell the rallies — at least when it comes to their most expensive holdings (we can argue whether something like Peloton Such a stock fell 80 to a penny in six months, which is still expensive). In times of inflation, today’s values ??are starting to look like they might be worth more than they might be tomorrow (a bird in your hand is worth more than an electric flying car in the bush).

With that in mind, it’s worth noting that the FTSE 100 and its reasonably valued income-producing stocks have outperformed the S&P 500 — so much so that it’s now on track to outperform the S&P 500 in 12 months. This month. This is something that hasn’t been done all year since May 2017. But I doubt most students of the practical history of financial markets are ready.

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