Predicting nine of the last five recessions

The equity market white knuckle ride continued this week as tech stocks came into the line of fire. At the start of this year I suggested that global stock markets would end the year higher than they began and wrote “I’ll stick my neck out by predicting a rise of 5-10% in the major US and European indices.” That call is not looking good at the present time with European equities well into negative territory and US markets also now in the red, having held up well until this week. However I did point out that “it might pay to reduce the degree of risk exposure – perhaps by switching the top 10% of risky assets in the portfolio for something less risky” and that “a market which is so dependent on tech stocks is clearly vulnerable to a shift in sentiment.”

Despite my apparent over-optimism, I have generally been pretty cautious on stock markets in recent years particularly since the 10-year trailing P/E ratio on the S&P500, as popularised by Robert Shiller, continued to point to a market that was running out of line with fundamentals (chart above). And the higher tech stocks drove up the market, so it was inevitable they would also lead it down. As the chart below (taken from Bloomberg) shows, over the last 12 months the so-called FAANG stocks have outperformed the S&P500 by 14% and have contributed all the increase in the index market cap. At mid-year, the outperformance index was at 37% and it has been hard for some time to avoid the sense that tech stocks have been somewhat bubbly given their stellar rise. Yet the valuations of tech stocks have not been too far out of line. Apple, for example, is trading at a P/E multiple of just below 20x earnings and the Alphabet ratio (the company formerly known as Google) of around 26x is high, but not crazy. This is testimony to the extent to which the FAANG companies have been able to generate exceptional earnings growth.

But some cracks in the façade are beginning to show. Amazon’s narrow miss relative to Q3 expectations, and guidance suggesting that the Q4 earnings season may be weaker than the consensus currently expects, have dampened enthusiasm. Yet Amazon and Alphabet recorded earnings numbers that were 30% and 21% higher respectively than a year ago. So maybe things are not as bad as painted but when they are seen as invulnerable to bad news, any negatives can have a bigger-than-expected impact. I thus tend to view the moves in tech stocks as a catalyst for selling in a market that has become rattled by other issues in the global economy.

The number one concern is the ongoing trade spat between the US and China which is now beginning to impact on corporate America if this week’s Beige Book evidence is anything to go by. We also have to add the fact that the tax cuts implemented at the beginning of this year have given corporate earnings a big lift which will not be repeated next year. As investors look ahead to 2019, they see an earnings outlook that is far less rosy. Looking further afield, Brexit issues; the ongoing dispute between the Italian government and the European Commission, and the diplomatic spat between Turkey and Saudi Arabia add to the sense that all is not well in the wider macro world. Global investors have good reasons to be nervous. 

Then there is the Fed’s rates policy, which looks set to drive interest rates still higher. There are those who believe that the recent market wobble is a good reason for the Fed to pause. I do not see why. After all, if low interest rates were responsible for driving the market up, so higher rates might be necessary to get it back into line with fair value. In any case, it has been slightly puzzling that the market has continued to go up despite the Fed’s tightening, which can only be attributable to the one-off tax cut. A pause that refreshes can only be a good thing. Putting all the pieces together and it is hard to escape the suspicion that in the equity world at least this is as good as it is going to get. This does not mean to say that it is all over. As was the case in autumn 1999, when US markets also wobbled badly, it is possible that there may be a rebound before the final reckoning. 

Yet it does not feel like a rerun of the late-1990s. For one thing, the tech companies are delivering real products that generate earnings rather than the hype which characterised the tech bubble. The global economy is far less frothy – particularly in Europe – and investors are a lot more cautious. Nonetheless, many people I speak to are concerned that the US is setting itself up for a recession on an 18-24 month horizon. Maybe! Or there again maybe not! At times like this, it is always worth recalling Paul Samuelson’s famous phrase that the stock market has predicted nine of the last five recessions.