Quick Bites | Bull markets climb walls of doubt (part 2)

Yesterday we identified 5 reasons why many investors have little faith in the US market at the moment, despite it having risen by more than 20% since last October. Issues highlighted included:

  1. Earnings season could reveal nasty surprises.
  2. The yield curve is deepening.
  3. Global markets are skittish, especially China.
  4. Higher for longer rates are doing damage.
  5. US stock valuations are expensive.

We dealt with the first 2 issues yesterday, and follow with the remaining 3.

3. Global markets are skittish, especially China

Source: FactSet, WSJ 


While markets outside the US started 2023 on a positive note, that has rapidly faded. When China lifted its COVID-19 restrictions, optimism surged on hopes that Chinese consumers would spend up big and unleash economic growth at home and abroad. Asian stock indexes initially soared, as did those in Europe. Since then, excitement has wilted, Hong Kong’s Hang Seng is in the red for the year, while the Shanghai Composite has gained just 3.5%. China keeps on delivering weak and disappointing economic data, and risks falling into a Japan-like state of deflation – a far cry from earlier hopes that it would be the engine of global growth. It remains troubled by weak property markets, heavy debt burdens, high youth unemployment and a lack of confidence.

Europe’s Stoxx 600 is up around a meagre 5% for the year, and the eurozone has slid into recession. Investors worry about the war in Ukraine and inflation that remains more stubborn compared with the US.

4. Higher for longer rates are doing damage

Source: Deutsche Bank, WSJ 


Because of lags in the economy, the stress caused by rapidly rising interest rates is only just starting to really bite, and a lot more damage is expected. Even seemingly safe areas of the market are vulnerable to stress when interest rates rise.

The first casualties came last year, when rising rates sparked turmoil in UK bond and currency markets. Then came the regional bank crisis in the US, heralded by Silicon Valley Bank, whose collapse was sparked by a disclosure that the bank had booked a $1.8 billion loss on its bond portfolio due to rising rates. Even British utility Thames Water has recently come under stress as it grapples with a large debt load and rising debt-service costs. US corporate bankruptcies are surging to the highest level in a decade, commercial real estate is in deep trouble, and consumer credit is declining sharply.

Many investors say they are nervous about what could break next. A Deutsche Bank survey of market professionals in June showed that nearly all of its 400 respondents expect higher rates to cause more global accidents, although opinions vary as to the consequences. Some 18% of respondents believe the strains will be significant, causing “serious financial stress.”

Source: NYT


Struggling US companies began laying off workers a year ago in an effort to reduce costs. But they are now running out of time. Companies that were struggling before the pandemic and the end of ultralow interest rates have now reached their breaking point.

Consumer discretionary companies have been the hit the hardest, particularly retailers and restaurants, typically among the most sensitive businesses to challenging economic conditions. Close behind are financial institutions, health care companies and industrial producers.

Expect more bankruptcies up ahead, with tighter financial conditions expected to persist, potentially forcing companies to pursue more cost cuts, layoffs and, failing that, Chapter 11 bankruptcies. We expect the corporate debt default rate to rise.


5. US stock valuations are expensive

See below the chart showing the S&P 500 Index Price Earnings (PE) Ratio, last 12 months, over 152 years to July 2023. At present, the index is at 25.5x trailing earnings, well ahead of the long term average. The average trailing PE for the S&P 500 is 16x, the median is 14.9x, the lowest recorded level was 5.3x (Dec 1917, during the First World War), and the maximum was 123.7x (May 2009, during the GFC).

S&P 500 Index Price Earnings Ratio (trailing) – 1871 to 2023

Source: S&P 


After sitting on the sidelines at the start of the year, asset managers, hedge funds and individual investors have picked up buying activity, many inspired by the Artificial Intelligence stock boom and the performance of mega-cap tech companies like Apple, Alphabet, Amazon, Microsoft, Meta, Netflix, Nvidia and Tesla.

That enthusiasm has pushed US stocks significantly higher, even despite earnings concerns and the other headwinds mentioned above. Crowded trade in mega-tech stocks could be vulnerable to reversal if they disappoint in their results. Those eight stocks mentioned above now account for 30% of the S&P 500  index’s market capitalisation. Tech’s performance could magnify moves in the market if sentiment shifts and investors try to simultaneously exit positions.



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