Presumably due to the stock market’s strong performance during these bizarre times, people have increasingly been asking me when ‘we’ are going to have a correction. After all, the market can’t just keep going up forever, can it? Of course not. However, I submit the severity and length of the next market downturn is more important than the timing of it. While everything that goes up must come down at some point, it might come down to a higher elevation.
Catch my drift?
Way back in 1991, 30 years ago, I got into the financial services industry. Over the course of my career, I have witnessed three significant, memorable bear markets and a number of lesser, forgettable ones. The former were: the tech bubble collapse from 2000-2002, the global financial crisis of 2007-2008, and last Spring’s pandemic related swoon.
These were ‘black swan’ events which continue scare people and keep them up at night. While some of you might remember how awful the 4th Quarter of 2018 was, and it stunk, it doesn’t scar the average investor’s psyche like 2008, does it? It isn’t even close. In fact, I would be willing to bet more than one person reading this paragraph had the following reaction: “oh yeah, I forgot about that. That was bad.”
As such, I suspect people are actually asking the following when wanting to know when ‘we’ are going to have a correction: “Whenever the other shoe falls, it isn’t going to be as bad as last Spring, 2008, or 2000-2002, is it?”
The quick answer is: without something unforeseen, extraneous, and awful happening, more than likely not. However, the flipside of the coin, if you will, is I would answer “more than likely not” if you were to ask me if the stock market will perform the same way in 2022 as it has in 2021. The reason has to do with interest rates.
As I type, the price of money, as defined by the US Treasury market, is less than the trailing 12-month Consumer Price Index (CPI), or inflation. At some point, inflation will have to either fall OR interest rates will have to rise. After all, lenders don’t like to give away ‘free money’ for long periods of time. It isn’t good for business.
If interest rates are less than the CPI, what does that mean for investors? That’s right, they stand to lose some of the purchasing power of their money by investing in bonds or leaving it in cash. As a result, stocks look more attractive, and this is the reason why the Price/Earnings multiple on the S&P 500 has remained as elevated as it has. Investors have been willing to pay more for stocks since the potential for return elsewhere is less.
As I have told plenty of people: “stocks are the most reasonably valued of all overvalued asset classes.” While I am trying to be funny with this, I am not joking. Some ‘back of the envelope’ calculations suggest the yield to maturity on the 10-Year US Treasury would have to increase over 200 basis points (from where it currently is) to be comparably valued to the S&P 500. As for cash, let’s try around 350 bps.
The likelihood of that happening over the next 12 months is pretty slim. Conversely, it is also unlikely that interest rates will fall significantly from here given the recent elevated CPI numbers. The probably case scenario is interest rates gradually climb higher as the markets finally react to inflation and the Federal Reserve starts to take its foot off the proverbial gas pedal. If the Fed has its way, this will be an orderly process.
As interest rates gradually rise, the price of fixed income securities (in general) will fall. This makes bonds an unattractive asset class in absolute terms. However, on a relative basis, they will become a little more attractive to equity investors. As a result, the Price/Earnings ratio on the stock market is likely to fall as rates rise. This has happened in the past, and there is no reason to think it won’t happen in the future.
Before I go too much further, let me explain a little something about stock returns. There are two primary levers: multiple expansion and profit growth. Ideally, as we have seen over the last 12 months, a combination of the two will lead to outsized results. You can still generate positive results IF one of the levers is negative as long as the other is more positive than it is negative. I hope that makes sense. Even so, stock returns will or should ‘moderate’ as interest rates rise, but that doesn’t mean they will collapse.
This means the next ‘stock market correction’ will likely be due to an increase in interest rates as the financial markets get back to some sense of normalcy in regards to the price of money. Right now, it is ridiculously cheap. This could play out over years, and very likely will. However, the probability of continued multiple expansion AND sharp growth in corporate profitability is decreasing. If for no other reason than maintaining double-digit growth in anything is difficult as the base increases.
All of this means, drum roll please, the next correction will likely be more of a ‘return to the mean’ than a ‘black swan event.’ Given the outsized results in the stock market over the last several years, the easy bet is returns will be less than the historical average (9-10%). In other words, lower than they have been recently. Again, this will be due to a general upward trend in interest rates and a slowdown in corporate profitability. However, this is far from a death knell scenario.
So, does the prospect of a few years of single digit returns interspersed with an occasional negative quarter or two keep you up at night? Even if that quarter might be a whopper like the 4th Quarter of 2018? At this point in time, I imagine a lot of people would probably be okay with that scenario. The good news is THAT is the probable case scenario.
As for timing of this period of slower, lower returns, we will have to wait a little while, and I am not complaining about that in the slightest. The Congress is getting ready to throw literally trillions of dollars at the US economy, and the Federal Reserve has made it pretty clear it intends to be as accommodative as is possible for as long as possible, inflation be damned, transitory or what have you. And what is the old saying in the investment industry? That’s right: don’t fight the Fed. You will lose if you try to do so, every single time.
In the end, the next correction probably will NOT be a ‘black swan’ event, if for no other reason than we already know what the likely cause of the next downturn will be, without any ambiguity: higher interest rates, at some point and at some level. While higher interest rates will lead to lower returns, they weren’t the reason behind the tech bubble collapse from 2000-2002, the global financial crisis of 2007-2008, and last Spring’s pandemic related swoon.
…and those are the types of corrections which keep investors up at night. Am I right?
Take care, have a great weekend, and be sure to listen to our Trading Perspectives podcast.
Chief Economist
As always, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our investment committee, are subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the reset of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself. Finally, we do NOT make a market in any of the companies listed in this newsletter, and I do not own them personally.