September 26, 2022

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Christian Lie: When will the market turn?

Christian Lie: When will the market turn?

The summer was pleasant in many ways. Not least in the financial markets, where interest rates have risen after a difficult first half of the year. On the other hand, the near-perfect autumn storm of uncertainty associated with interest rates, energy and economic growth is once again weighing on investors. Perhaps the summer gathering was just a break in time. But what does a bear market really take to turn into a reality, and where are we today?

Even in boom times, rates must climb the wall of anxiety

Although we are now in a year of anxiety and poor development, the saying “all bull markets are climbing a wall of anxiety” still holds true. The point is that financial markets are always characterized by uncertainty. Sometimes more than others, and even in good times, rises are halted by major and minor price dips. We see the same in bad times, where even the negative trend is interrupted by big and small rallies. The challenge for those of us who follow the markets is that we cannot know for sure whether changes in trend are temporary or long-term. In an analysis, investment bank Goldman Sachs attempted to identify indicators that have historically provided credible warnings of a transition from a bear market to a bull market. The use of scientific terminology derives from the terms “bear markets” for long-term price declines and “bullish markets” for long-term rises in the stock market.

Three types of bear markets

As discussed earlier, Goldman Sachs believes that bear markets are either structural (1929/financial crisis), event-driven (epidemic) or cyclical (1980/1990). While the average price decline in the last two categories was 30 percent from its peak, the structural price decline was twice as large and lasted longer. The current downturn is a lot like a cyclical bear market. Although there are many structural changes underway both economically and politically, Goldman Sachs believes that these changes will primarily affect financial markets in the future. Analysts point to valuation, economic prospects, interest rates, inflation, as well as investor sentiment as good indicators of when the mood in financial markets tends to shift after these recessions.

Low rating is necessary but not sufficient

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Uncertainty about yield opportunities, financial prospects, and corporate profits often makes investors less willing to pay much for the securities they purchase. In the stock market, this contributes to the decline in price to profitability, i.e., prices (Price (P)) fall in relation to the expected profits of the firms (Earnings (E). Given that the denominator in the fraction, the expected profits of the firm, is realistic, this means that The stock market gets cheaper.The higher the fear, the lower the valuation.Because the price-to-earnings level has historically explained a high percentage of return variance in the US stock market over the next ten years, the valuation level today can be of great interest to long-term investors today. , global stocks are priced at a P/E multiple of 14.4, exactly at the average level since 1987. In principle, this indicates normal returns over the next 10 years, assuming the relationship between the P/E and future returns of global stocks is continuous.

In isolation, a sign of faint and positive returns going forward

Goldman Sachs uses four different methods to evaluate the global stock market and finds that very low valuations (among the lowest readings at 30 percent) led to the highest returns over the next 12 and 24 months, while only 10 percent higher readings produced negative results. return. Thus, their method also shows that because the valuation is close to historical average levels, this, in isolation, indicates weak but positive returns. Although historically very low valuations suggest the best future returns, Goldman Sachs points out that other factors are needed to trigger a long-term recovery.

The highest return when the economy is weak but up

Intuitively, it is tempting to think that the return is better when the economy is strong. However, history shows that market development has been at its best when economic development goes from weak to less weak. Thus a stronger economy is priced by investors up front. The lowest returns are often achieved when the fear of an economic crisis increases.

If we use the ISM PMI in the US as a starting point for the strength and direction of the economy, levels above 50 index points indicate progress, while below 50 index points indicate a decline. There was the highest return in US stocks when the ISM rose from its bottom level to 50 and the second highest when it rose from the 50 level to the highest level. The lowest return came in periods when it fell from 50 to the lowest level, as investors feared a recession. In practical terms, this means that the probability of achieving the best return is highest when the economy is at its weakest, and lowest when the economy is at its strongest.

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It is impossible to say when ISM reached its bottom

The challenge with attempts to time the market is, of course, that you don’t know then and there whether the ISM has reached the top or bottom. ISM less than 48 was higher three months later in two out of three cases historically, while ISM less than 46 was higher three months later in 95% of cases. In this regard, Goldman also notes that the market turned around on average three to six months before the ISM index itself appeared. This asserts that investors are more concerned with the change in the rate of change, i.e., the second derivative, than the level itself.

By combining valuation and ISM, the analysis shows that lower valuation with lower ISM provided some of the best conditions for high returns in the following quarters.

What about interest rates and inflation?

As discussed earlier, the downturn in financial markets caused by expectations of monetary tightening can turn into a rebound when those expectations are reversed. It was factors like these that caused prices to soar this summer. This year, rates often fall when inflation rises and approaches its peak, and then improve as inflation slows. However, whether prices will continue to rise when the central bank finishes raising its key rate depends on whether investors expect a soft or hard landing in the economy. In those cases where a moderate decline is expected, the starting point is better than if low price growth is observed in relation to the risk of recession. In these cases, signs of a lower interest rate were not always enough to lift the markets. Based on data since 1940, the stock market, on average, started to rally before the two-year US Treasury yields plummeted.

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A bad mood is often a positive sign

After both minor corrections and bearish markets, stock markets tend to reverse when pessimism and risk aversion were prevalent. It is often in these times that herd mentality contributes to lowering expectations the most, with low ratings associated with it. However, as in other financial markets, moods can fluctuate a lot in both ups and downs. Thus, it is the extreme levels that also give here the best signals about the future direction of the market. Based on the Goldman Sachs Sentiment and Positioning Index, a final, positive market signal is only given when levels are among the lowest of 20 percent.

How would you sum up today’s situation?

Goldman Sachs believes that its framework does not yet indicate a high probability of a new, long-term recovery. The rating has gone down, but it is at more normal levels than low expectations. The economy and the ISM index will likely be able to decline further before turning around again, and there is still uncertainty about whether inflation will fall fast enough for the central bank to end the interest rate hike. Sentiment and positioning are more pessimistic than optimistic, but still closer to normal levels than at many historical turning points in the market.

Good chances for a quiet landing

The wonderful and sometimes difficult thing about being an investor is that market developments rarely happen as you think. In today’s situation, there is a lot that could go in the right direction. For example, resolving the war in Ukraine and restoring a better energy balance could have significant positive consequences for inflation, interest rates, and growth prospects. Goldman Sachs is also one of those who believe that there are good chances of a soft landing in the US economy. As explained above, this will increase the chances of the markets turning “real” when interest rates eventually approach their peak.