Stock!. Want to know where the stock markets… | by Sagar Singh Setia | August 2022


Want to know where the stock markets are going?

Photo by Nicholas Cappello on Unsplash

“Mr. Market is some kind of drunken psychopath. Some days he becomes very enthusiastic; some days he gets very depressed. And when he’s really excited, you sell to him, and if he’s depressed, you buy from him. There is no moral taint attached to it.-Warren Buffett.

Stock markets are one of the most “embarrassing” places. You might be wondering why!

Well, the answer is that when someone buys a stock expecting the stock to go up, the other person sells the stock at the same price expecting the stock to probably go down.

Psychologists baffled by this anomaly have long been researching”behavioral economicsand are now convinced that stock markets are nothing more than a “psychological feeling”.

Robert Shiller found that the assumption of an efficient market does not justify price movements in the market. According to him:

The excess volatility can be attributed to the psychological behavior of investors. Substantial price changes can be explained by a collective reversal of the investing public, which can only be explained by his thoughts and beliefs about future events, i.e. his psychology.

The famous book of the famous psychologist Daniel Kahneman “Tfast and slow hikehas transformed many lives. After extensive research into heuristics and cognitive biases, he concluded that:

In fact, investment decisions are often driven by irrational considerationsdespite the convictions and best intentions of investors.

All investment decisions of retail investors, from fund managers to CIOs, involve various biases and are heavily influenced by investor reaction to the ever-changing global/local news feed.

Markets have long been a function of greed and fear. Investors, blinded by optimism and pessimism, often make gaffes and lament them later. Successful investors will always remind you that a person acting on his “emotions” can never triumph in the stock markets. Mr Market will always surprise you on the wrong foot!

Today we will try to examine where the stock markets are going. I will try to be rational and not let my prejudices influence my analysis.

The exquisite quality of Mr Market is that it is forward-looking. This unique attribute has charred many traders and investors, especially high frequency traders and quantitative guys, as these participants play on the “flow” of incoming news. The famous quote on Mr Market is:

Buy on rumor, sell on news!

No one can accurately imagine the future. However, the I-banks predict end-of-year targets for the S&P 500 ranging from 3200 to 4500! Indeed, psychological wonder reigns in every nook and cranny of the Mr Market ecosystem. However, we must never forget:

Stock prices are slaves to long-term earnings!

So let’s get started and discuss the knowns:

The Russian-Ukrainian War is fully integrated by the markets. Boris Johnson said in April that the war in Ukraine could last until the end of 2023. Therefore, we must be aware that stonks have a price the worst of the war. So the high prices of gas, oil, food and fertilizers are already reflected in stock prices.

American and European recession: As the leading indicators indicate, we are in a recession or soon will be. Bond markets are screaming loudly across the various yield curves to predict that a recession is not too far away. In fact, the 2s-10s is now the most inverted since the dotcom bubble (almost -40 bps). Thus, it is safe to assume that Mr. Market has already predicted a recession.

Source: Jim Bianco

That said, Mr. Market is also evaluating something that can potentially reverse course. Mr. Market, which tracks bond markets, expects a pivot from the Fed and substantial rate cuts from early 2023 (up to 100 basis points). However, if higher inflation persists due to foreign forces likely to strengthen over the coming months, then the bond market forecasts of rate cuts may turn out to be inaccurate, and Mr. Market will receive a brutal shock. We’ve seen dovish Fed officials talk about “doing more work” to control the threat of inflation.

Note that wherever you reside in the world, reading this newsletter, monetary easing from the Fed will boost your country’s stock markets (unless you live in hyperinflationary territory).

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Supply chain disruption and commodity prices: The supply chain chaos and skyrocketing raw material prices in the wake of the pandemic have had a drastic effect on the company’s raw material and logistics costs. Inflation in input costs has been one of the influential factors that has led to lower profits and falling margins for most companies.

However, in recent times there has been a substantial loosening of supply chains at all levels. Prices of key commodities have also cooled off their highs. So if over the next few quarters you get a year-over-year or quarter-over-quarter reduction in raw material and shipping costs, don’t rush to buy because Mr. Market has already priced in margin expansion for specific industries. (retailers with overstock will however see pressure on their margins)

Freightos Baltic Index (FBX): Global container freight index, source

Shipping costs, as measured by the Global Container Freight Index, while still high compared to pre-pandemic levels, are down 45% from all-time highs.

Crazy energy prices in Europe: The insane energy prices in Europe and the subsequent huge increase in electricity prices seem absurd and call for a sharp drop in equity prices in Europe. However, Mr. Market appears to have priced in the decline in earnings due to higher power prices and the upcoming demand squeeze very well.

The bear camp faced substantial losses over the past month. We all understand that bear market rallies are fierce and can result in huge losses for short sellers. Let’s look at past bear market rallies:

Source: Blonde Macro

The dot-com bubble and GFC bear market rally was huge (even reaching 19%!). The point to note is that the larger the rally, the greater the subsequent fall.

Also, remember that gatherings are always built around hope and storytelling (always remember the psychological part). The narrative of the current rally is that the fed will pivot and we are nearing the end of the tightening cycle, so a lower terminal rate and higher market valuations. However, as I said, we will be rational in our approach and we will look at the benefits.

Source: Charlie Bilello

Multiples have contracted, but we need to take a close look at BPA. For example, during the last two major recessions:

The Dot Bubble: EPS in 2000 was 56, which contracted to 39 and did not return to the same levels until 2004. (after four years)

GFC: EPS in 2006 was 88, which contracted to 50 in 2008 and only returned above 88 in 2011. (after five years)

The other important fact is that as income peaked, so didthe valuation/PE ratio. So can we say that we will similarly see valuation compression and earnings stagnation in the next recession?

Mr. Market will take a close look at the gains. As market participants predict that we will be in a stagflationary scenario for the next 2-3 years, a higher terminal rate (I predict a 2% > Fed rate for a long time) will keep the PE in check. So don’t expect multiple expansion.

It all comes down to how revenue reacts; some sectors might have pricing power, some would collapse in the stagflationary scenario, while banks are in a much better position than GFC (although bank profits may take a hit with increasing losses on lending due to a recession).

If we say 210 is the maximum EPS of the cycle and 19 is the P/E, and if we get a similar EPS in 2024 with a P/E of 17 to 18, then the S&P could range between 3500 and 3800 for the next two years. (unless earnings contract significantly)

As I said before, I see this time a shallow recession, which would not mean a significant reduction in EPS for S&P. On the contrary, a earnings expansion seems highly unlikely for the next two years unless we see another round of QE and fiscal stimulus by some of the biggest economies.

“Economic cycles are driven by financial flows, namely the amounts of savings and credits, and not by inflation or high interest rates.”-Michael J. Howell.

Another school of thought is that liquidity creates the fundamentals. For example, Michael J. Howell of CrossBorder Capital, after analyzing capital flows around the world over the past three decades, concluded that:

Barely a fifth of Wall Street’s huge gains over the past few decades have come from earnings: increased liquidity and investor appetite as riskier financial assets propelled stock prices higher.

The most appropriate criterion for monitoring liquidity is the supply of M2. Although we have seen an astronomical increase in M2 supply since the Greenspan era, most of the growth has come after the GFC.

Source: Fred

After trailing for years since the start of this century, the NASDAQ finally caught up and broke through the M2 supply last year.

We can see from the data that we are definitely in bubble territory when the NASDAQ crosses the M2 supply (2000 and 2021).

In addition, companies and banks that have plenty of cash on their balance sheets have resorted to a orgy of endless redemptions over the last 6 to 7 years, thus limiting the decline.

After analyzing all the factors, we can comfortably say that the increase remains capped as we will get neither an increase in earnings (due to the recession) nor an increase in liquidity (M2 decreasing as the Fed undergoes a QT).

However, the bigger question remains: are we in a big bearish rally? ?

The answer lies in earnings!

If we see a “significant” contraction in earnings, we could see the S&P 500 fall to even 3000 (worst case). However, with corporate balance sheets awash in cash, endless buybacks could support bearish markets.

Source: Charlie Billello

Apple has repurchased $522 billion in stock over the past 10 years, which is larger than the market capitalization of 494 S&P 500 companies. $AAPL

My opinion : “Carefully pessimistic!


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