The global sell-off in stocks that started late last week has been anticipated by even bullish investors for some time.
Stock prices on various measures have been rising for years as central banks around the world have forced investors into more risky assets, with low interest rates making cash and bonds deeply unattractive.
Famous Australian analyst Gerard Minack – previously head of developed market strategy at Morgan Stanley – has, as a noted bear, been warning for years that that US stocks in particular have been at “stretched equity valuations on sky-high earnings“.
Minack’s assessment of what’s happening right now is that it’s an overdue re-rating for stocks, at least in the US. His Downunder Daily note yesterday, which he’s now publishing from his Sydney-based consultancy Minack Advisory, was simply titled “Ouch!”. He points out the S&P 500 has just been through its “third longest period without a 10%-plus set-back”.
“Corrections happen,” writes Minack, “bear markets typically require recession. For now, recession doesn’t seem imminent in developed economies. However, I do not think that this correction ending will see a resumption of the bull market, at least not the bull market that has driven risky assets through the past four years.”
There are many analysts who see this as just a blip in a bull market that still has a long way to run. For example, BMO Capital’s Brian Belski argues that US stocks are just six years into a 15 to 20-year bull market.
Minack, however, sees something else at work. He argues markets are “now discovering that there is a limit to how far the valuation of risky assets can be lifted by low rates”. He shares this chart which shows the rollover in the S&P 500 is finally here – catching up with other global stock performance this year:
If this is the market reconsidering stock valuations based on high earnings multiples, Minack says it is “a big deal”, because “that would mean subsequent gains depend on earnings growth – but earnings growth is now hard to find, even in the US”.
“What this points to, in my view, is greater volatility, lower returns, and a greater dispersion of returns as the PE-driven beta in markets gives way to the idiosyncratic influence of corporate earnings,” says Minack.
In other words, there will be more focus on individual companies’ ability to generate steady profits in a period of low economic growth around the world. This means more muted overall stock market returns.
But Minack believes this adjustment is but a glimpse of what will be the foundations of a more significant crash in future, as investors realise the continuing availability of cheap debt cannot support the kind of stock valuations we’ve been seeing in the current bull market. Inflation – a crucial factor for the earnings growth needed to keep companies’ shares in demand – remains low worldwide, and the market doesn’t expect that to change:
The U.S. Federal Reserve is expected to start increasing interest rates in the coming months. But even as rates start to “normalise”, the cost of borrowing will remain extremely low for years to come. Minack says that if investors start to lose faith that super-low interest rates can generate the kind of stimulus required, all hell could break loose:
There is also a risk that we continue to see investors lose faith in the ability of policy makers to achieve their aims. By my reckoning, most investors already have little faith in the political leadership of many developed economies. But there has been a deep faith in the ability of monetary policy to both lift asset prices and, ultimately, generate an adequate inflation rate over the medium term. If investors start to doubt that – and the decline in break-even inflation rates suggests concern (Exhibit 8) – then things could get significantly worse. This is not my base case now. It is my base case for the next downturn, which will be the apotheosis of the disinflationary trends apparent for two decades, and likely to result in a profound bear market.
The market’s confidence in central bank determination to step in an provide stimulus has largely underpinned the global economic outlook in the post-GFC world. If that were it to evaporate, it’s a short walk from where we are now to Minack’s “profound bear market”.
Business Insider Emails & Alerts
Site highlights each day to your inbox.