At the end of May 2023, I published the article “5 Reasons To Get Out Of The Market“, which is still attracting readers, judging by the comments that still appear from time to time. As the title of that article suggests, I looked at 5 key reasons that should have warned investors about the recovery rally we have all seen in the major indices since the beginning of 2023. In many ways, I think those reasons still carry weight today, but that doesn’t stop the market from actively growing: since that article was published, the Dow Jones Industrial Average Index (DJI) has risen 5% and only started to cool off in August. S&P 500 Index (SP500) (SPX) (SPY) and NASDAQ Composite (COMP.IND) (NDX) (QQQ) followed.
A relatively long time has passed since that publication, and during that time I’ve been padding my macro take with new information as it has grown. But today I want to draw your attention to just 1 simple reason why investors should be selective and not buy the entire market at once via well-known ETFs.
And that 1 reason is the rapid growth of interest rates in recent weeks. Let me explain.
Why Do I Think So?
At the very beginning, I want to say right away what exactly I mean by “get out of the market.” I don’t mean that everyone should immediately run out and sell their stocks. Otherwise, why read investment articles at all? I’m primarily talking about broad market indexes and ETFs based on them: SPY, QQQ, and even DJI.
Because given the risk you take when you get in at the current price levels, they seem to me to be overcrowded.
And the primary issue here is not that valuations are too high or that most of the movement in the indexes has to do with only 5-10 stocks out of hundreds. It’s just about a single fundamental financial reason that the markets no longer take seriously.
The first really important topic in a financial management course, if we leave aside introductions, is usually devoted to interest rates. I know you’ve heard a lot about the theoretical negative impact on businesses of the Fed’s still hawkish monetary policy. The two main points that I think argue against the bearish thesis here are:
- Waiting for the arrival of a “dove” instead of a “hawk” due to systematically declining inflation, and
- The still rising corporate profits and consumer resilience due to a strong labor market.
This explains the phenomenal growth in the markets since the beginning of the year: if corporate profits are doing well and tight monetary policy is soon over, then TTM multiples (and even next year’s) deserve to be well above the norms. The dominance of the rally in Big Techs is also explained by the fact that future monetization of new trends like generative AI, cloud technologies, and automation will be easiest for giants like Amazon (AMZN), Meta (META), Google (GOOG), Microsoft (MSFT), NVIDIA (NVDA) and others.
But if the market expects monetary policy to ease, why do interest rates continue to rise so sharply?
Furthermore, when considering the situation from a long-term standpoint, this action seems to be extremely negative for bond prices (and positive for rates).
How exactly should higher interest rates affect the market?
Fundamental theory suggests that given the sharp rise in the risk-free rate, we – investors – should be more selective in our investment choices. Companies we buy should earn much more on equity capital than we can get on the bond market (given all the risks we are taking). The only thing that can support the market against the backdrop of rising interest rates is therefore the excess profits of companies.
Over the past year, U.S. earnings have plateaued due to changes in consumer spending patterns caused by the pandemic, which has squeezed profit margins. Although there was a slight uptick in margins in Q2, leading to earnings surpassing low expectations, BlackRock does not expect this trend to continue [August 14, 2023 – proprietary source].
The consensus view on profit margins appears overly optimistic, with evidence from Q2 earnings supporting this perspective. BlackRock writes that companies might struggle to pass on ongoing labor costs to consumers, as indicated by a low percentage of businesses reporting higher prices for their products.
We saw that the labor market has been affected by higher labor costs due to wage increases aimed at attracting workers in a tight labor market. Despite job recovery from pandemic-related losses, job growth has been slow.
The shift from spending on services to goods during the pandemic created disparities in production and consumption, affecting the labor market and prices. This shift led to increased profit margins, especially in the goods sector. However, recent data indicates that spending is normalizing, causing profit margins to do the same. As the labor market experiences shortages due to an aging population, companies are likely to allocate more revenue to hiring or retaining workers, which might negatively impact margins and lead to more inflation.
However, we do not really see this risk in the EPS consensus forecasts for next year and beyond. According to Yardeni Research [August 21, 2023], the operating profit margin of S&P 500 companies will increase despite all the challenges.
Back to interest rates – the main lever of the financial system. The higher they are, the higher the cost of borrowing, the higher the interest payments. High-interest payments apply not only to corporations but also to individuals. Consumers will begin to refinance their mortgages and other loans and will find that a much higher share of their paychecks goes to servicing debt. In addition, many of these consumers will be faced with another once-forgotten obligation – paying for their college education. As a layman, I see 3 ways to solve this problem:
a) reduce the consumption of discretionary items,
b) ask for a pay rise, and
c) find one more job.
Point “b” is pro-inflationary – bad for equities. Point “c” is hardly feasible if we look at current employment levels. So I’m leaning towards option “a”. If I’m correct, this point will hit the very companies that fueled the market rise YTD – especially Apple Inc. (AAPL) and the likes.
The Bottom Line
I may be wrong again about how events will unfold in the near future. The market could easily be up 100-200 (or even more) basis points again, as pessimism is high after the recent cooling off. In addition, corporate earnings may indeed help buyers weather the storm of risk factors piling up quarter after quarter. These are perhaps the most important upside risks to my updated bearish thesis.
However, I again recommend not fleeing reality into the world of AI-generated hope. I regularly try to challenge my theses, but I keep coming to similar conclusions, even if they change in the density of their red colors.
For now, I recommend investors avoid ETFs on the broad market – SPY, QQQ, DJI. Instead, I recommend spending more time looking for unsung and still undervalued companies with clear business models and good growth prospects. There are still many such names in the market.
I’m eager to hear your thoughts in the comments section. Thank you for your attention!