Stock markets around the world have hit record highs this year.
In fact, markets have enjoyed a good run since end October last year – the US S&P index is up about 25% in that period. Principal driver was probably a benign view on where interest rates may go in 2024, coupled with a resilient enough economic back drop, especially in the US.
And many analysts are still quite positive. Many of the forecasts I see highlight the likely cuts in interest rates in 2024 and further growth in economies and company earnings as the basis for a positive view on markets – even if it is a modest enough call in terms of magnitude.
But how much of this positive outlook is already baked into today’s market levels?
I think there are a number of issues worth talking through, in assessing this consensus benign view on equity markets.
Is the market move too concentrated? Has the market rally been dependent on a small number of stocks? There has been much talk of the “Magnificent Seven” and how these stocks have dominated returns. In the US today the top ten stocks account for 30% of the broad index. However a useful piece by Goldman Sachs points out how the valuations on these stocks are nowhere near what previous bubble valuations looked like. They are also more profitable and have stronger balance sheets than were demonstrated in previous major out performance phases.
So there is an underpinning to these market leaders which may give some comfort to investors. However it is worth noting that a market that becomes dominated by a few stocks becomes increasingly vulnerable to some source of disruption or contagion.
What about political and geopolitical risks – are they fully discounted in market prices? There certainly is an abundance of risk events – notably conflict in Europe and the Middle East. Concerns over Taiwan have also surfaced intermittently. Yet markets don’t appear to be overly concerned. Blackrock produce a geopolitical risk indicator which seeks to measure investor concerns. This peaked at the time of the Russian invasion of Ukraine and has fallen since then. While risk rose again in October last, it still sits at levels well below its peak.
And as a further barometer of the lack of investor concern, we have seen a surge in flows into funds. For example, UK investors piled into equity funds at the fastest rate in almost three years, adding more than £2.6bn to their holdings in February. And in the US, equity funds drew a record $56bn last week, more than the previous peak of $53bn set in March 2021. Of course flows can easily reverse, but many investors are piling in.
We are likely to see continued event risk as 2024 unfolds. This will be a year with more elections that usual – with the US perhaps being the most problematic. It is difficult to see a smooth outcome after November in the US, irrespective of who wins.
But perhaps the key issue to consider in assessing market risk is simply whether markets today are cheap or dear – especially in the context of the economic and profits outlook. Focussing on the US, we’re on around 20 times prospective earnings which is probably supportable, but leaves little room for disappointment. Valuations may get some help from lower rates later in the year. But any declines in interest rates are likely to be measured. Also we are not embarking on an economic super-cycle or a surge in company profits. Broker forecasts are for modest growth in profits over the next few years – in the 6-10% range – on the back of unspectacular economic growth – around the 2% range. What price are you prepared to pay for such an economic/profit environment?
So while factors such as economic growth, interest rates, inflation and profits growth are pointing in the right direction, such moves may be modest and not without risk.
Investment strategies should take this into account.
Tradewinds 