At the risk of sounding like a U.S. politician, let me say this week’s stock market action was weird.
Its weirdness began this past Monday with the worst one-day plunge in Japanese stocks in 37 years. That was followed by shocking losses in Europe, the United States and Canada.
Weirdly, the market massacre didn’t begin with a single obvious cause. Some observers blamed it on a disappointing U.S. jobs report that stoked fears the U.S. is slipping into recession. Others pointed to fading enthusiasm for the AI story that has propelled tech stocks higher over the past year.
Then there were those who thought the key factor was a surprise increase in Japanese interest rates. Higher rates in Tokyo may undercut the carry trade – a strategy in which big institutional investors borrow in low-interest-rate Japan then invest the proceeds in countries with higher yields.
Take your pick. These are all fine stories to explain why stocks crashed and they probably all played a role in the downturn.
Still, it’s weird that stocks could fall so abruptly. Weirder still that much of the panic could dissipate by the end of this week.
The sturdiest explanation for odd behaviour may simply be that investors are nervous. As a result, they are hypersensitive to whatever economic data floats by.
Why are people so skittish? The U.S. stock market is expensive by most standard yardsticks. Its lush valuation makes sense only if you expect the U.S. economy to grow at an unusually rapid clip. However, that is looking rather doubtful. If anything, business activity seems to be slowing to humdrum levels.
This combination of expensive stocks and so-so economy suggests some recalibration is necessary. Call it the shock of the normal.
In a rational world, U.S. stocks would be repriced to reflect an economy that is looking increasingly average. But marking down U.S. stocks, which account for roughly 60 per cent of global stock market value, would send shock waves through markets everywhere.
One way to grasp the amount of euphoria currently embedded in U.S. stocks is to look at how much investors are willing to pay for a dollar of expected earnings. This metric – the forward price-to-earnings (P/E) ratio – used to be similar for U.S. and Canadian stocks. Up until about 2016, both traded for roughly 15 times forecast earnings for the year ahead.
Since 2016, though, U.S. stocks have consistently fetched valuations well above their Canadian counterparts (and their European and Japanese rivals, as well). Stocks in the Canada-based S&P/TSX Composite Index continue to sell for about the same 15 times forward earnings they did a decade ago, but stocks in the U.S.-based S&P 500 Index now trade for more than 20 times expected earnings.
The lofty P/E ratio for U.S. stocks might be rational if you expect S&P 500 profits to expand more rapidly than profits elsewhere. However, the usual prerequisite for booming corporate profits is a booming economy – and right now that boom appears to be fading.
Recent data show U.S. business activity is decelerating. The manufacturing sector is contracting, while the services sector is barely expanding. Unemployment is ticking higher.
All that said, there’s no immediate reason to panic. Torsten Slok, chief economist at Apollo Global Management, notes no weakness is apparent yet in restaurant bookings or air travel or Broadway show attendance – all areas that are usually quick to register economic distress. He thinks the U.S. will slow but avoid a downturn.
Others concur, but are hedging their bets. Analysts at Capital Economics now see a 27-per-cent chance the U.S. tips into a recession over the next 12 months, up from 22 per cent previously. Similarly, JP Morgan economists put the chance of a recession at 35 per cent, up from 25 per cent a month ago.
To be sure, even these darkening forecasts imply that the most likely outcome is still a soft landing for the economy. Investors seemed to be focusing on that optimistic message as the week wore on and stocks staged a comeback.
The weirdness that remains, though, is attempting to explain why investors should be willing to ante up premium prices for U.S. stocks that are tied to an increasingly ho-hum economy. Perhaps they’re betting on AI’s transformative power.
If so, they should ponder Warren Buffett’s recent decision to dump half his gargantuan stake in Apple Inc. and use the proceeds to raise the cash holdings at his Berkshire Hathaway Inc. flagship to record levels. This does not sound like the strategy of a man who sees great things ahead for either AI or the stock market.
Investors who want to stay in the market might want to consider a tip from CIBC analyst Ian de Verteuil. In a report this week, he recommended taking a look at low-volatility strategies. Low-vol funds focus on companies with steady, dependable earnings – grocer Metro Inc., trash collector Waste Connections Inc. and electric utility Fortis Inc., for example. Such stocks have a history of outperforming in down markets.
Think of low-vol strategies as a bet on the non-weird corners of an increasingly weird market. Right now, that sounds rather tempting.
