Life happens when you’re making other plans
From Proverbs to John Lennon, many people have said it - and the last nine months have been a reminder of its truth: life happens when you are making other plans. While investors were worrying about the recession that sharply rising interest rates would surely lead to, fretting about the cost of living and waiting for unemployment to rise and earnings to drop, the stock market was quietly building a powerful rally.
After the trauma of 2022 when shares and bonds both fell in tandem, leaving nowhere for investors to hide, it was inevitable that the priority for many would be capital preservation and income generation not growth. But while everyone was seeking out safe money market funds or clipping the coupon on bonds offering a decent yield for the first time in years, the stock market has been on a tear.
Between the market’s most recent peak at the start of 2022 and its low point in the middle of October last year, the MSCI World Index fell by 27pc. To regain its previous high, it needed to bounce back by 37pc. So far it is up by 29pc. It has, therefore, clawed back almost four fifths of its earlier fall. If this had been no more than a bear market rally, it would most likely have run out of steam after regaining half its losses. It is starting to feel like a proper bull market.
But it is a bull market that no-one has noticed. It has crept up on the rails, out of sight. Last month, the S&P 500 rose by 3.1pc, while the Nasdaq added 4pc. It was the fifth month on the trot that the US stock market had risen - a run it had not achieved since the post-vaccine surge in 2021.
One of the reasons this secret rally has passed many investors by is that it has been achieved on the back of the performances of just a handful of shares. The Magnificent Seven tech giants have done all the heavy lifting while everything else has bumbled along worrying about the future. In the first five months of 2023, an equal weighted version of the S&P 500 fell by 1pc while the market leaders soared.
But since the beginning of June, the rally has broadened out as investors have gained confidence that this is the real McCoy. In the last two months, that equal weighted version of the US benchmark has risen by more than 10pc. US small caps have outperformed the S&P 500 in recent weeks. Meanwhile, the rest of the world is catching up too. Over the last month, the best performing investments have included Chinese and UK shares, which had been left out of the rally so far in 2023.
All of this has happened despite a catalogue of things to worry about. The war has ground on. China’s economy has resolutely refused to bounce back after Covid restrictions were lifted. Cracks are showing in the UK housing market. This week Fitch questioned the US’s creditworthiness. Most importantly, interest rates have continued to rise as central banks err on the side of caution.
It might seem strange that markets have shrugged this off. In fact, it is normal. Typically markets move a good six to nine months before the real economy. So, what are they telling us now?
First, that the economy is holding up a lot better in the face of the last 18 months’ interest rate assault than anyone had the right to expect. Tomorrow’s non-farm payroll employment data will most likely show that America is still creating jobs. Unemployment remains historically low. Consumers, protected by long-term fixed mortgages and with secure jobs, continue to spend. The soft landing - falling inflation, no recession - that felt at times like so much wishful thinking, looks more and more likely.
From an investment perspective, the key is how that benign economic backdrop feeds through into corporate earnings. With half of America’s leading companies having reported their second quarter profits, about 80pc of them have beaten expectations. It means that a shallow decline in earnings for 2023 as a whole, after good growth in 2021 and 2022 and ahead of a decent recovery next year, looks plausible. That really would be the very definition of a soft landing.
The next important question is whether, after the strong rally of the last nine months, investors are paying a fair price for the growth in prospect. Since the October low, the multiple of expected earnings at which the US stock market is priced has risen from 15 to 20. That is quite a vote of confidence in the future and cannot be expected to go much further in the absence of evidence that the earnings recession is coming to an end.
This is a dangerous moment for investors. The bull market which has crept up on us, hidden in full view, is now out in the open. People like me are writing about it. Investors are looking at their pension statements and extrapolating their gains. The baton is about to be handed on from a market re-rating to actual delivery of earnings growth. It could happen smoothly. But we should expect a wobble or two along the way.
The biggest risk for investors is that just as they were more interested in grabbing 3-4pc from a super-safe money market fund six months ago they now start to chase the 10-20pc that they hope the stock market can continue to provide. Being slightly late is why most investors’ achieved returns are lower than the headline market data suggest they should be. As John Lennon almost said: ‘man proposes but God disposes’.
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