The market crash depends on what part of the equation the investor made a mistake in.

Date:

The writer is the editor-in-chief of MoneyWeek

For those who are confused in this year’s market, I have a suggestion. Invest in a Practical History Course in Financial Markets run by Edinburgh Business School (you can do it online, you don’t have to come to chilly Scotland). One of the modules focuses on the history of extreme market valuations — what causes them and what causes them to crash.

The first thing to note is that we love to talk about the bubble, but the stock market doesn’t really have a lot of extreme valuation periods. According to Professor Russell Napier, only one of the 29 business cycles in the United States since 1881 ended. However, although each has its own characteristics, the basic driving forces are almost the same. The ability to absolutely believe that investors have always found it impossible. That is, thanks to some “wonders” of technology, a company’s profits remain high (and probably rise) indefinitely, and interest rates remain low indefinitely.

Investors don’t think about this in most cycles. They assume periodic normality — rapid economic growth leads to capacity constraints, then inflation and rising interest rates, slowing economic growth and squeezing corporate profits — downgrading. increase. We like to think of stocks as all sorts of things. For example, too many investors now consider stocks primarily as a virtue signaling tool (witness the bursting bubble of renewable energy stocks).

But in the long run, stocks don’t really show emotions or ponies. They relate to the net present value of all future sources of income discounted, whatever the discount rate at that time. that’s it. Therefore, the discount rate goes up and the price goes down (usually when inflation reaches about 4%).

A good bubble is when investors can be confident that a high-profit, low-inflation environment can be permanent (for all historical experience) instead of assuming periodic normality. Occurs only in. This always ends badly. Think of 1901, 1921, 1929, 1966, 2000, 2007, 2020 briefly, and perhaps now.

The only question is how fast it finishes. What is important here is a bit of the equation that investors are wrong, as Napier states in his lecture. If you have the belief that interest rates will never rise, you tend to get a long-drawn bear market (since 1966, when it was hard to imagine inflation in the late 1970s). If there is a belief that a company’s profits will remain high forever, it tends to be shorter and sharper (2020 was a crash mini-classic of this genre).

So I’m here. Inflation has been minimal for many years. Corporate profits in the United States are very high and have risen over the years. Yet another record height And, of course, as a result, the valuation of the US stock market reached bubble levels some time ago. By the end of last year, the cyclically adjusted price-earnings ratio was about 40, more than doubling. Its long-term average. Investors have once again believed that there was too much impossible before breakfast. This may be beginning to be noticed by them.

So here’s the question: Which bit was the most wrong we were doing this time? Is it a discount rate or corporate profit? Rising interest rates obviously hurt corporate margins, but discount rates seem obvious.

Cheap labor and globalization long ago made inflation a distant nightmare for older investors and a mystery for younger investors. Thus, most people fell into the nonsense that the soaring inflation seen by central banks last year was temporary. And even those who thought it might go beyond that, for example, Easter still believed that the central bank would postpone rate hikes.

Therefore, the fact that high growth (US GDP increased by 6.9% in the fourth quarter of 2021) could actually hit capacity constraints and generate an inflation rate starting at 7 is a terrifying shock. It turns out that there is. The central bank may actually do something about it.

The Federal Reserve is now upset (no longer “temporary”) under pressure from inflation itself, and perhaps from polls suggesting that inflation isn’t helping President Joe Biden. .. “It’s likely that there will be one and seven rate hikes at each meeting this year,” said Aegon Asset Management. The one that breaks the illusion.

Also, investors have few options. As long as the Fed holds this line, you’ll have to sell the rally instead of buying the dip. Cent in 6 months, is it still expensive?). In an era of inflation, today’s value begins to appear to be worth more than possible tomorrow (hand birds are much more valuable than electric flying cars in bushes).

With that in mind, it’s worth noting that the FTSE 100, with its stocks that generate reasonably valuable income, far outperforms the S & P 500. As a result, it is currently surpassing by the end of 12 months. this month. This hasn’t happened for a year since May 2017. But this is the switch I think most financial market business history students were ready for.

The market crash depends on what part of the equation the investor made a mistake in.

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The post The market crash depends on what part of the equation the investor made a mistake in. appeared first on Eminetra.

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