David Rosenberg: You don’t need a recession for investors to have a tough year

david-rosenberg:-you-don’t-need-a-recession-for-investors-to-have-a-tough-year

Heightened volatility will be a major theme for this coming Year of the Tiger

Author of the article:

David Rosenberg

A trader works on the floor of the New York Stock Exchange (NYSE) in New York, U.S., on Monday, Jan. 3, 2022. Photo by Michael Nagle/Bloomberg Eighty per cent of the stock market rally these past three years has been multiple expansion. Indeed, the expanded multiple in the 20 per cent annualized surge in the S&P 500 was four-fifths multiple expansion to just one-fifth earnings growth.

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Historically, it is normal for 70 per cent of the move up in the market to be dictated by earnings (the fundamentals) and 30 per cent to the expanded multiple (liquidity-induced animal spirits).

What did the past three years have in common that justified (for lack of a more appropriate term) the flip in that ratio? The United States Federal Reserve eased each and every year.

In 2019, it was 75 basis points of rate cuts. In 2020, it was 150 basis points of rate cuts alongside US$3.2 trillion of balance-sheet expansion. In 2021, it was another US$1.4 trillion of balance-sheet expansion. Only six other times in the past 90 years have we seen such a three-year stock market performance and through a pandemic to boot. Three years of Fed feast, but what happens to the market multiple when the famine starts?

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After my CNBC Closing Bell interview on Friday afternoon, I saw my friend Jonathan Golub on the program, who was predictably optimistic. But his comment that “there’s no recession coming” is what caught my ear. The thing is, you don’t need a recession to have the market incur a rough year when liquidity conditions tighten up and P/E multiples mean revert.

We didn’t have recessions in 1987, 1994, 1998, 2002, 2007, 2014, 2016 and 2018 and all of them proved to be very challenging years for passive investors who were all in. Even the years that were saved by the Fed (1998, 2007 and 2018) were filled with heightened volatility — a major theme for this coming Year of the Tiger.

I keep hearing how great inflation is for the stock market (Golub’s argument, and he isn’t alone), since earnings are measured in nominal dollars and get a natural boost from accelerating price trends. Never mind that this didn’t work out so well in the 1970s because it was cost-push in nature and margins got squeezed.

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This inflation is not really caused by demand, outside of the early jump we got in the reopening trade, which basically allowed the services sector to refill a deep hole, and the stimulus cheques, which had an impact for a few months and that is pretty well it. The Delta variant was the major cause of the inflation surge this past year and was the big added hit to global supply chains.

Beyond that, it is tough to find eras of inflation where financial assets perform very well, at least compared to real assets (real estate, precious metals, commodities). If this was demand-led inflation, one can envision a world where volumes and prices accelerate together. That is a benevolent universe for the stock market, but not one we are in today. Inflation leads to resource misallocation, distortions and poor business judgments (as in building inventories to juice up inventory valuation adjustment (IVA) in the earnings data).

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More On This Topic David Rosenberg: If you receive kindness, remember to also give some in return David Rosenberg: Investors should be skeptical of the Fed’s ‘surreal’ positive outlook David Rosenberg: Housing heads the myriad vulnerabilities facing Canadian households David Rosenberg: The metaverse offer investors a new universe of opportunities Rising inflation may well artificially boost sales revenues, but it also tends to camouflage what is really happening beneath the surface. This is why inflationary periods tend to see P/E multiples contract as opposed to expand, which is the normal course of events in a disinflationary period (when companies are more consumed with investing in productive technologies than in “how to beat” inflation). Not to mention that volume growth, as opposed to nominal growth, has a much more profound impact on the market multiple. Don’t forget that when the promoters and hucksters sell you the line that inflation is a positive for earnings.

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Article content The move in the P/E multiple exerts a far more powerful influence on market valuations than earnings growth. And the history of the past four decades shows there is a 30-per-cent inverse correlation between the inflation rate and the direction of the market multiple. Stick that factoid in your back pocket when this debate comes up.

David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. You can sign up for a free, one-month trial on Rosenberg’s website .

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