Don't jump the gun, beware the bear market rally
By all accounts, 2022 has been a year of painful adjustments for investors, given the prolonged period of decline in value – known as a bear market. High inflation and an ensuing volley of rapid interest rate rises from central banks have sliced through the value of bonds and stocks. Investors, stunned by the sea change following more than a decade of rock-bottom interest rates and low inflation, have been keen to latch onto slithers of hope in economic data releases, as a sign of inflation abating – firing up a belief that central bankers will return their harsh policies to a gentler variety.
As a result, as we saw most recently in October, the market has taken pauses from its declines and reversed course into rallies – painting an alluring picture that a recovery is beginning in earnest. These are cautionary tales. Known as bear market rallies, we have seen three of them this year, in which markets have risen by more than 10%1 only for the exuberance to fade and markets to fizzle downwards again. Furthermore, history is littered with many examples. Indeed, there is a well-known saying on Wall Street: “Even a dead cat will bounce if it falls from a great height.”
At Alliance Trust, we think numerous economic and therefore stock market outcomes may be possible over the coming year, including a continued recovery in share prices. But it’s also possible that our current, rather grisly bear market, has not come to an end. It’s why we think the Company’s broad set of investments prepares it well for the various outcomes that may play out in 2023.
A crisis brews
2022 has seen inflation and interest rates rise materially for the first time since the financial crisis in 2008.
Inflation has been stoked by supply chain logjams and spikes in food and energy prices, hitting societies hard in the form of a cost-of-living crisis. In an effort to take the sting out of inflation, central bankers, perhaps a little late to the party, set themselves on a course to stamp it out by any means necessary. As a result, they have been aggressively raising interest rates and rapidly winding down their long-running money printing programmes – known as QE.
The impact has meant dramatically higher borrowing costs for businesses and people alike and increased the likelihood of pushing economies into downturns. This has hit bonds and stocks hard.
Within equity markets, companies with the majority of profits promised in the future, such as technology stocks, have been particularly beaten up. The US market, home to many of these types of innovative businesses, has shed more than $10 trillion in value at its lowest point.2
And yet, markets are not about the present day: they are a forward-looking reflection of the business environment. Recent numbers such as US inflation data are showing signs that inflation in food, energy and goods – a key driver of current inflation – may be declining. If true, it warrants the idea that central bankers could possibly begin to relax their approach. This view – the idea that they will pivot from their harsh interest rate hikes – has been the basis of the bear market rallies. Alas, the economists at Alliance Trust’s investment manager, WTW, think a couple of factors may pour cold water on this optimism.
Looking at the major economies
First, while there are signs that elements of inflation are dying down, unemployment is still very low in Europe and the US, which means pressure on wages is likely to remain elevated for some time. This could upset the inflation bandwagon more than expected in 2023 and lead to it becoming entrenched. If central bankers see evidence of this, they could tighten the screws even further, meaning the possibility of an even deeper and long-lasting recession than already forecast.
Regardless of whether this materialises, it remains likely that central banks will keep ratcheting up interest rates next year. The chart below shows the pace of rises this year.
Source: WTW – Global Markets Overview (November 2022)
Second, many of the falls in stock markets in 2022 have been driven by falls in the value that investors place upon shares. For example, last year, with the economic picture looking decidedly less grim, investors may have assessed a company’s profits of £1 per share and been prepared to pay £10 a share – a 10x multiple. This year, with the business environment having significantly deteriorated, they might only be prepared to pay £8 a share, or an 8x multiple. This is a fall in valuation.
What we have not seen yet is an impact on company profits in any significant way – another driver of stock market falls or gains. This puts companies sensitive to economic cycles at risk of further falls, if profits are affected by the looming recession.
That said, there is a beacon of hope. Given we are facing recessions by design of central banks’ efforts to curtail inflation, if price rises do come down, the interest rate levers could just as easily be reduced, releasing the downward pressure on economies and businesses and enabling stock markets to rise once more.
All told, it makes for a complex economic outlook, with numerous possible stock market outcomes.
Alliance Trust’s position
Alliance Trust seeks to neutralise the risks of the market darting off in unforeseen directions by focusing on individual companies. Within the Portfolio, there are stocks that are more economically sensitive if things improve; there are stocks that can defend their profits if the economy lurches downwards; and there are stocks that will be able to push through price increases to customers if inflation becomes entrenched.
This is why we consider Alliance Trust as a hard-working core holding in your investment portfolio – seeking to limit the risks of particular stock market outcomes and build wealth steadily for generations of investors.
Marcus De Silva is a Freelance Investment Writer
This information is for informational purposes only and should not be considered investment advice. Past performance is not a reliable indicator of future returns. The views expressed are the opinion of the Manager and are not intended as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell any securities. The views expressed were current as at November 2022 and are subject to change. Past performance is not indicative of future results. A company’s fundamentals or earnings growth is no guarantee that its share price will increase. You should not assume that any investment is or will be profitable. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. TWIM is the appointed Alternative Investment Fund Manager of Alliance Trust plc. Alliance Trust plc is a listed UK investment trust and is not authorised and regulated by the Financial Conduct Authority.