About the author: Jacques Cesar is a former managing partner at Oliver Wyman, and now works on market valuation for the firm. The views here are his.
This year, the old saw is coming true: Investors would be well-served by selling in May and going away on a nice vacation.
But they should make sure to buy a return ticket. While there’s likely to be unsettled weather this summer, it’s unlikely to be a hurricane, much less the beginning of a new secular bear market. The 40-year bull still has life.
The Oliver Wyman Forum is finishing up a massive research project on the U.S. equity market’s performance since 1871, bringing together economics, history, sociology and finance to explain the market’s ups and downs over the past century and a half . Investors can use those insights to think about the future, both short- and long-term.
The work shows that equity prices are driven by the subtle and ever-changing interaction between corporate profit margins, risk aversion, real risk-free interest rates, and society’s propensity to own financial assets.
Let’s take each of these drivers and look ahead to the next few months.
Margins. The work shows that profit margins are headed lower than the equity market is pricing in, for four reasons. First, many models, including ours, show the economy was about to turn south even before the Silicon Valley Bank collapse. Second, the regional banking squeeze that followed is bound to amplify the downturn.
Third, wages react to prices with a lag, so when inflation accelerates, profit margins generally run ahead. But the reverse is also true, and that’s now the problem, because inflation has been decelerating over the past few quarters.
And fourth, the U.S. economy has had two- to four-year cycles of acceleration and deceleration for more than a century and a half, margins have always been cyclical, and a downturn for both is due.
Risk aversion. It’s no secret that the date when the U.S. government can’t avoid defaulting on some of its bills is coming, and that Washington politics are particularly fractious now. So, we would expect a spike in risk-aversion and a temporary market decline as the political process plays out. The closest analog is July-August 2011, when the S&P 500 declined about 15%.
Real risk-free rates. They have been near a 10-year high this year. Traditionally, the Federal Reserve starts cutting rates at the first whiff of recession. But today’s inflation is still way too high, and Jerome Powell doesn’t want to be remembered as the Federal Reserve chair who lost control of inflation. In other words, he would want to be remembered as the reincarnation of the hawkish Paul Volcker, not the dovish Arthur Burns, two earlier chairs. The Fed will cut rates eventually, but the history means that it will likely be slower to cut than normal. So the usual cushion to the equity market provided by declining interest rates will arrive late.
Demand for financial assets. The Oliver Wyman Forum work shows that the higher the demand for financial assets, the higher the price of equities. But right now, savings rates are low because households oversaved during the pandemic and are still burning through those reserves. This will put a lid on equity price growth until the end of the year, at which point conditions should start returning to normal.
The sour cherry on top: We are entering one of the worst periods in the quadrennial presidential cycle. Annualized six-month returns from May of the third year in the cycle are 5% to 6% below the other periods.
All in, it is easy to articulate the case for a 5% to 20% downside in equities in the next few months, whereas it is difficult to articulate the opposite. So, we forecast unsettled weather for a while.
But unsettled weather isn’t the same thing as a hurricane. Right now, it is nearly as difficult to make the case for a crash (setting aside a major geopolitical calamity) as it is to make one for a large move to the upside. Further, the cyclical difficulties we continue to face do not threaten to spawn a new secular bear market. The Oliver Wyman Forum work shows that the secular bull is still alive, albeit with one leg instead of the two that existed between the global financial crisis and the pandemic.
The secular returns after the financial crisis were particularly high because margins were expanding, but also because real risk-free interest rates were falling. Looking forward, we can’t expect real risk-free rates to continue to fall as they did last time.
But we can expect secular corporate profit margins to remain strong. Margins are driven by the seesaw between labor and capital. When labor is ascendant, margins go down, and vice versa. From 1929 to the early 1980s, the seesaw tilted toward labor; it has been tilting toward capital since then. So secular margins are likely to continue to rise—and the secular bull to run—unless and until the democratic process tips the balance once again.
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