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Looking for a stock market bottom: It’s all about inflation

Ok, we’re not fans of seasonal market trends for one simple reason: it’s never that simple!

Nonetheless, September, which has a history of lower returns and higher volatility, certainly gives seasonal supporters strong evidence this year. The S&P 500 was as high as 4,119 and as low as 3,688 – let’s call that a 10% variance.

And the month is not over. The TSX and many other markets are showing similar trends. Last year was a great year for investors and 2022 is turning into the exact opposite, with stocks and bonds losing substantial value.

The root causes are well known and widely discussed. Rising inflation and central bank responses have been behind lower asset prices for stocks, bonds and even real estate. This is now complemented by recession fears and earnings implications, which in many cases remain bullish. You have to search hard to find a feel-good story. We read a lot of macro perspectives from internal sources and many research centers in North America and beyond, and the vast majority have a rather pessimistic view of what lies ahead.

What will put a floor for this market? In most bear markets, it takes several months or even quarters before economic activity bottoms out and several months before earnings growth bottoms out. Thus, a risk of future recession is not good news, but the market is already pricing in some of this risk. The fact is, most bear markets bottom when the root cause begins to improve. In this case, it is inflation. I’m not saying it has to go away, but if it shows a few months of improvement, that may be enough to trigger a market rally. After all, if you’re waiting for the “everything is clear” you’ll probably have missed a lot.

Inflation has shown no signs of improving, as evidenced by the latest US CPI numbers. It should be noted that Canada has seen an early sign of improvement, but it is the US data that matters most. The next release of the US CPI is October 13, in a few weeks. In the meantime, some survey data on inflation expectations could provide some insight. Still, we probably have to wait for an improvement in inflation. But make no mistake, an improvement in this area could easily trigger a strong rally in stocks and bonds (dare to dream).

Let’s move on to reviews –Valuations can provide a decent signal during bear markets. No, they never bottom out, but as prices fall and valuations improve, downside risk diminishes as upside potential increases. If you buy something at $8 instead of $10, your expected return has improved (it could still be negative, just less negative relative to the $10 entry).

s&p 500 index stock market valuations indicators analysis chart image year 2022

Valuations have improved even for the more expensive S&P 500. There are solid reasons for the US market to be trading at a premium. Historically it has; the breadth of companies is very enviable compared to most other major stock indexes. The United States benefits from energy and food security. But is it cheap? Not really.

The two charts above show the S&P 500 and the TSX, including the valuation phantom lines. These thinner lines indicate where the index would trade at various multiples. The S&P 500 saw its multiple drop, approaching 15x. Not cheap but definitely better value than years past. There should be some multiple compression given higher yields, but the big question is whether that’s enough. We should also point out that the forecast of 15% profit growth over the next year still seems too optimistic.

Canada, on the other hand, is now trading at 11 times earnings. Yes, more of those earnings come from much more cyclical sectors such as energy and materials, but the TSX is certainly pricing in a more muted outlook. Integrated earnings growth for the next 12 months is 10%, which is also more reasonable. International markets are also approaching the cheap end of the spectrum.

In our opinion, this provides a better margin of safety for Canada and international markets compared to the United States. This does not mean that the markets are about to bottom, just that the average return expectations for these valuation levels are tilted upwards from normal.

And now the feeling – During market extremes, sentiment tends to trump valuations, fundamentals, economics and often common sense. There is no denying that markets are oversold and sentiment is close to the extreme bearish (which is bullish).

bullish bearish investor sentiment aaii survey september year 2022

Make your choice:

The AAII Investor Survey shows the most bearish 61% since the 70% reading on March 5, 2009 (note that the S&P bottomed on March 6, 2009). The chart above is the average of the four-week bulls minus the bears,
which currently sits at -32. Readings at these levels tend to imply strong market advance over the next 12 months. However, in 2008 there were many bearish signals before the market bottomed out. It just shows that things work most of the time, but not all of the time.

The market breadth is also giving off flashing buy signals, as seen in the chart above. The percentage of S&P 500 companies trading below their respective 200-day moving averages is 20%, which will drop further by the close on Friday, September 23, as the S&P is down more than 2%. Of course, the magnitude can go down, and it was slightly lower in mid-June before the S&P rallied more than 15%. Still, this is an extremely bearish reading, which is bullish.

Impact on portfolios

Our fall strategy remains intact. We reduced US equities in mid-August, as we believed it was a temporary bear market rally, and increased liquidity. We expect inflation to start to subside very soon as the recession talk gets louder, in which case we plan to deploy some of the funds raised. We believe a rally could result from a reversal in inflation. Current sentiment readings are encouraging as almost everyone is bearish, but we have yet to expect any significant moves.

Note: Our path remains data dependent and may vary; we will notify you of any portfolio changes.

Source: Charts sourced from Bloomberg LP, Purpose Investments Inc. and Richardson Wealth, unless otherwise noted.

Twitter: @ConnectedWealth

Any opinions expressed herein are solely those of the authors and do not represent the views or opinions of any other person or entity..