The stock market is at a crucial juncture. It has already retreated from all-time highs and now it appears that the bottom will come at some point. But the question remains, when will it reach that bottom? Here are some things to watch for.
A possible outcome of central bank communication
When it comes to understanding the central bank’s role in the stock market, it’s important to look at how different central banks communicate. Some of the leading central banks have been more transparent than others. Those who have been more transparent have been able to keep the interest rate volatility down.
The Federal Reserve Bank’s communication shows a general trend towards longer documents and more information. This makes it easier for people to understand the monetary policy decisions the central bank makes. That is a good thing, and should help ensure less market shocks.
Other leading central banks have adopted a strategy of forward guidance, which proactively shapes market expectations. This is similar to the RBA’s approach. It outlines the expected monetary policy outcomes.
PBOC officials will continue to communicate on a range of issues, including the renminbi’s internationalization and the Cross-Border Interbank Payment System. However, the progress of the PBOC in its ability to communicate with markets has been uneven.
A study from the Center for Strategic and International Studies (CSIS) found that the PBOC was the quietest of the leading central banks in terms of speaking frequency. Although this does not mean it is untransparent, it does suggest that there is more work to be done.
Central banks in richer economies like the United States and Japan tend to have more outspoken leaders. These differences make it difficult to compare the relative influence of different central bank governors in intra-regional comparisons.
But while the People’s Bank of China (PBOC) has been inconsistent with its communication, it has gained greater public visibility in recent years. Xi Jinping, the Chinese president, has instructed the PBOC to play a bigger role in financial governance. In order to comply with this directive, the PBOC has sought to increase the quality of its communication to market participants.
Despite its efforts, the PBOC’s communication to markets has remained unpredictable. However, the central bank has tried to follow the lead of other leading central banks in its use of social media and other tools to engage with market actors.
Overall, it is unclear if the PBOC will be able to achieve greater autonomy and more effective communication in the future. This is a matter of how the bank decides to communicate and the audiences it reaches.
A short-term respite
A short term respite is in order from the stock market yoke. There is no denying that the stock market has had its ups and downs of late. In fact, the biggest movers and shakes are a few weeks behind the calendar. What is more, it has been a decade since the good times.
The latest bottom-up consensus forecasts call for a 2 percent drop in the third quarter. Considering the record levels of unemployment, it’s no wonder stocks are under siege.
Thankfully, it hasn’t been as bad as ruminating over the stock market’s latest offering. Of course, there is always room for improvement. For instance, it would have been nice to have been the first in line for the big bucks.
Fortunately, the big boys have a good track record of keeping their tails close to the chute. But, a little more patience and a good deal of restraint is all that is required to make it to the winner’s circle.
A mild recession
A mild recession is when the stock market bottoms before a deep, severe one. The S&P 500 has fallen an average of 8.8% during the last four recessions since 1990.
However, the economy is growing at a healthy rate. That is good news for consumers. They are spending at a healthy clip. And the job market is strong. This means the risk of recession is elevated. But if the Fed starts hiking interest rates, it could exacerbate the problem.
Even a mild recession will likely push forward earnings estimates down by a few percent, as inflation remains a problem. Those factors will likely drive a de-rating of the US equity market, which makes the country more attractive in terms of valuation.
A mild recession is usually followed by a re-rating of the market. Investors will be tempted to buy back in because prices are cheap. Historically, this is driven by expectations of a recovery.
When the recession ends, the US stock market typically rallies strongly. The 12-month forward P/E ratio will typically fall to around 12x. Companies with a long growth runway can be expected to weather the short-term volatility better than others.
While it is still early in the cycle, it is likely that the next recession will be mild. Jack Ablin, chief investment officer at Cresset Capital, expects a mild recession in 2023. Ryan Detrick, chief market strategist for LPL Financial, sees solid GDP growth.
The health care sector is performing well, even in the face of weaker broader index performance. Healthcare stocks have traditionally been less sensitive to economic fluctuations. However, the auto industry, airlines, and other sectors can also be affected.
With a mild recession, the US stock market tends to bottom in the first three months of the recession. It then bounces back strongly in the second half. Buying distressed stocks during a recession can be risky.
As with any other type of investment, investors should plan ahead. If you are planning to invest during a recession, be sure to have plenty of emergency savings and be ready to look through the market.
A bounce in earnings growth
The S&P 500 is set for the biggest annual decline since the global financial crisis. As it nears a bear market, investors wonder if this will be the end of the equities bull market. It’s not impossible for the market to bottom. But there are many risks to consider.
A bear market can last for months or years. And it’s not just the S&P 500 that is at risk. Many companies are reporting rising costs and weak consumer demand. These factors could crimp corporate earnings. That doesn’t mean the market must face another year of losses in 2023.
Corporate profits should hold up better than past downturns, but a slowing economy is a headwind for earnings. The S&P 500’s price-to-earnings ratio has declined 26% from its peak. This is a sign that valuations are low.
Consumer spending is also a key consideration. Strong retail sales figures for July helped cool investor fears. Inflation is near four-decade highs, but uncertainty remains.
Lastly, the Fed is signaling that it will slow the pace of interest rate hikes. If it moves from a tighter monetary policy to an easing policy, that would be an all-clear signal to stocks.
Historically, markets don’t bottom until the Federal Reserve cuts its rates. Stocks can rebound in the short-term, but if the economy continues to fall, they will likely remain at a bear market until a recession breaks.
Even if the market does bottom, it’s hard to say when. Historically, a market’s reversal is preceded by seven months of valuation declines. Unless the Federal Reserve cut its rates, it’s unlikely that the stock market will bottom before the beginning of a recession.
The S&P 500 has rebounded from its early August slide. It’s up over 10% for the month of October. However, many investors are wondering if the market has finally bottomed.
Some analysts have warned that the S&P 500 will be in for another year of losses. While this is not necessarily bad news, it does point to the need for restraint in the face of market volatility.
Overall, though, the S&P 500 is holding above the 4,000 level. Analysts expect earnings to grow by 5% this year, but a more tame 3% next year. They also expect international stocks to outperform U.S. stocks in the coming years.