Stock market crash? This time it’s (slightly) different

You don’t have to look far to find predictions of an upcoming stock market crash. Almost every analyst believes the current rally is going to run out of steam.

Since hitting a low of 3,577 on 12 October, down 25% since 1 January, the S&P 500 index has rallied by 12% to just over 4,000. The FTSE 100 index has rallied by 11%. It is barely down this year, but still 4% below its May 2018 peak.

The yield on the US ten-year Treasury bond has fallen from 4.3% to 3.7% (reflecting a rebound in bond prices); the ten-year gilt yield has slipped from 4.5% to 3%.

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Yet plenty of pundits are pessimistic, arguing that the bear market isn’t over yet.

Is a stock market crash around the corner?

Charles Gave of Gavekal says that US inflation has not peaked yet. “Every significant peak in the US rate of inflation has occurred during a recession or just after,” he writes.

The real (inflation-adjusted) yield on the ten-year Treasury is deeply negative and “it has almost never been profitable to buy the US stockmarket when real yields were negative”. In addition, “bull markets occur when energy is cheap and getting cheaper”.

Gavekal’s Anatole Kaletsky advises investors to “enjoy the rally while it lasts... [it] will end in a costly reversal”. To push US inflation down close to the 2% target, he argues, will require a serious and protracted recession, caused by interest rates being raised substantially more than markets expect. The alternative, of a 4%-5% inflation rate as “the new normal”, would mean bond yields of 5%-6% and so he is “convinced that the bear market in both bonds and equities has a long way to run”.

Sebastian Lyon, the manager of the £1.8bn Personal Assets Trust, says “this bear market has room to run. Stockmarket falls have been valuation-driven and we have yet to see the fall in profits that would result from a highly probable recession”. He has reduced equity exposure to 28%, the lowest since 2008.

Gerard Minack of Minack Advisors, meanwhile, believes that the long-term trend of bond yields, having been downwards for 40 years, is now upwards and that equity markets will continue moving, as they have this year, in the same direction as bond markets (in other words, a stock market crash is likely).

He expects a recession in which corporate earnings fall next year. This is not priced in: “there’s no sign in the day-to-day price action that earnings disappointments are in the price. Equities don’t normally bottom until the downgrade cycle is virtually over”.

Other bears are waiting for a phase of capitulation in which investors panic out of the market, valuations reach very cheap levels and vulture investors, like themselves, can pick up bargains.

The “most forecast recession in history”

Why might these pessimists be wrong? Minack admits that “this is the most forecast recession in history”, which means that companies have had plenty of advance notice to take action to protect earnings, as many have.

This may explain why analysts have been slow to downgrade earnings forecasts.

Against the trend, this downturn may only see mild downgrades. Moreover, as energy prices fall (except in the UK), economic forecasts are becoming less pessimistic. The International Monetary Fund (IMF) forecasts global growth of 2.7% next year, including 1% in the US, 0.5% in the euro area and 4.9% in Asia. With inflation falling, interest rates likely to peak soon and the dollar now declining, Ed Yardeni of Yardeni Research sees only a mild recession in 2023, if any. “There is no recession in forward earnings,” he says. “In a soft landing, earnings may continue to be depressed but revenues should hold up.”

In 2008/2009, investors thought the financial system would collapse. In 2011, the euro was about to fall apart. Now we will probably face a mild recession as interest rates are raised to bring inflation under control. Corporate earnings will be depressed, but will bounce back in the subsequent recovery.

So why should investors dump equities, causing a stock market crash, only to see them bounce back once the vulture investors have piled in? Sitting tight and riding out the turbulence is a better strategy.

A stock market crash, but this time it’s different

The problem is that the bears are relying too much on precedent and they believe that they are smarter than other investors. But, as Mark Twain observed, “history doesn’t repeat itself, but it rhymes”.

This time, rather than a final stock market crash in equities followed by a sharp recovery, we may have seen the bear market fizzling out to be followed by an insipid recovery.

And this is the catch. Interest rates will peak before long, but they are unlikely to start falling for some time thereafter. Inflation will persist (it always does) and growth in corporate earnings will be moderate with few positive surprises. US equities aren’t cheap enough to perform well without good news, and that will hold other markets back.

Maybe the recent sharp drops in bond yields, the oil price and those of other commodities heralds a worse economic outlook. But if so, inflation is likely to fall faster and monetary easing should be brought forward.

Corporate earnings would be worse in the short term, but equities should trade on higher multiples, anticipating a rebound in profits.

Gilts are again expensive, but 2023 should still see decent stockmarket returns – although investors will have to be patient and choose well.

Legendary investor John Templeton may have been right to say that “‘this time it’s different’ are the four most expensive words in the English language”, but “this time it’s the same” can be just as expensive.