“Are markets just plain wrong to keep looking through the Iran war?” ran the title of the 17 April Merryn Talks Money Bloomberg podcast as markets hit all-time highs. The answer, as was made clear, is almost certainly not. “If you think the market is wrong, it's probably not the market, it's you,” as John Stepek said on the show. Geopolitics famously does not affect markets that much, yet every time there is a disruptive geopolitical event, it is followed by an endless stream of experts claiming that a disaster for investors is inevitable.
Rarely have the experts been as wrong as this time around. From top to bottom in late March, both the S&P 500 and the FTSE 100 fell 9% before bouncing all the way back up again and more in the next three weeks. The pundits predicted the oil price would rise to $150 or $200 a barrel and that there would be a consequent surge in inflation, pushing up interest rates and leading to a recession. This would hit corporate earnings hard and stock markets would spiral downwards. The only safe haven was gold.
Instead, the oil price has struggled to get past $100, gold has fallen about 12% since the start of March, bond yields (except in the UK) have retreated, inflation has ticked only modestly higher and there is no sign of a recession, although interest rates will probably go up, especially in the UK. Anyone who listened to the pundits and took action to “reduce risk” will have lost money. It gets worse. The US market has not stumbled, as confidently expected, but surged ahead, led by the much-maligned “magnificent seven” mega-caps. The AI “bubble” has not burst; it is the potential victims of AI in the software and data-provider sectors that have suffered. Earnings forecasts have continued to rise. The predictions of inevitable disaster were heavily influenced by historic parallels that, on closer inspection, turned out to be false.
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The market holds little solace for doomsters
What lessons should be learned for the future? Further disruptive geopolitical crises are inevitable and when they happen, the “end of the world is nigh” crowd will be out in force, hogging the media's attention with their dire warnings of looming disaster and explanations of why markets are being totally complacent. The pessimists are already scanning the horizon for the next crisis to upset markets. With the tide having turned against Russia in Ukraine, that war is unlikely to provide solace for doomsters. If Ukraine's missiles can knock out oil facilities on the Baltic coast, they can surely destroy the Kremlin if Ukraine wishes to. A Chinese invasion of Taiwan has long been predicted by the prophets of doom, but that remains a highly risky venture for a country whose last military adventure, the invasion of Vietnam in support of the Khmer Rouge in Cambodia, was more than 50 years ago and was a disaster. Besides, modern drone technology makes a seaborne invasion even more risky than before.
Doubtless, some new reason to worry about geopolitical events will be found, but the key question is not what such events portend for markets, but what the market reaction tells us about the importance of such events. Nine times out of ten, as with this time, the market's reaction is right and the doomsters are wrong. Still, the parable of the boy who cried “wolf” teaches us that the time may come when those who cry wolf are, at last, right. It is nearly 20 years since stocks suffered a sustained bear market, as opposed to a short-term fall that was soon recovered. The US market is expensive and dependent on a pace of earnings growth that might not be sustainable. The UK and European markets are no longer cheap, just reasonably valued with limited prospects for earnings growth given sluggish or non-existent economic growth. Asian markets have advanced a long way in a short period of time.
“Buy on the sound of cannons, sell on the sound of trumpets,” Nathan Rothschild advised some 200 years ago. For now, taking some profits is starting to look like a better strategy than charging in, but it still looks as though markets will continue to make positive returns in the rest of the year. As US strategist Ed Yardeni reminds us, “earnings growth and economic expansion drive markets, not geopolitical shocks”. Earnings expectations continue to rise, with S&P 500 forecast earnings per share for the next 12 months at $344.30 and expected to reach $380 by year end. That puts the index on a forward multiple of 20.8, falling to 18.8 by year end. For the mid- and small caps, the forward multiple is around 16; for the “magnificent seven”, it is close to 27.
That sounds demanding, but, Yardeni notes, the information-technology sector, up 8% in the year to date, has benefited from a 33% rise in forecast revenue and 55% in forecast earnings in the last 12 months. The semiconductors sub-sector accounts for 42% of the sector, up from 15% a decade ago, and accounts for 47% of expected earnings. With expected earnings soaring, its prospective multiple is actually at a small discount to the S&P 500. Meanwhile, the application-software subsector has seen its multiple more than halve since 2021 to 23.4, the lowest reading since 2014, due to fears that AI will eat into its markets. Despite the $5 trillion valuation of Nvidia, this suggests that the exuberance of last year has given way to a more sober assessment, finding losers as well as winners.
The information-technology sector accounts for 28% of the S&P 500, but three of the magnificent seven, Amazon, Meta and Tesla, are not in it. Including all AI-related shares, technology accounts for 45% of the index and has doubled in three years. Liam Halligan of The Telegraph worries that this is unsustainable, just as the energy share of more than 25% was in 1980 (now 3%), or the more than 60% share of railways was in 1900. That is likely to be true, but doesn't prove that the US market is overvalued; rather, that its sector composition will continue to change over time. Meanwhile, UK and European pundits can only look on in envy; their markets are significantly cheaper, but their dependence on imported energy and their meagre exposure to technology means lower growth in revenue and earnings and a significant valuation discount.
Halligan is on firmer ground pointing out that the cyclically adjusted price/earnings (Cape) ratio for the US market is at an all-time high. This has been an unreliable indicator in the long term, owing to changing accounting rules, rates of corporation tax and its backwards-looking nature. It calculates the ten-year rolling average of corporate earnings in an effort to even out the ups and downs of the economic and earnings cycle. In recessions, earnings drop sharply, bringing down the Cape, so what the current level tells us is that there hasn't been an economic recession for well over ten years, merely short-term dips.
Stay invested, but be wary
No recession is visible, but they never are and when one comes, corporate earnings will fall. In addition, bear markets always expose overoptimistic accounting, weak finances and less than resilient business models. The best protection against this is a moderately valued market providing a cushion against earnings disappointments. A multiple of earnings above 20 and a ten-year US Treasury yield approaching 4.5% do not provide that, so investors are skating on fairly thin ice. Global diversification may not help; other markets may be better value, but have less earnings growth. Emerging markets are performing well, but are heavily dependent on the technology super-stocks of the Far East. If the US market falters, it is hard to imagine other markets carrying on regardless.
There is no need to panic, but investors need to be wary. If markets flatline for the rest of the year, re-establishing value, they can relax about 2027. If they continue upwards, 2027 could bring trouble, even if peace returns to the Middle East and Ukraine, oil prices fall and the political outlook improves.
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