Should You Buy The Stock Market Dip?

Should You Buy The Stock Market Dip?
Stéphane Renevier, CFA

almost 2 years ago6 mins

  • The massive spike in oil prices has increased the risk we see higher inflation and lower growth at the same time – the worst environment for risky assets like stocks.

  • It’s not the only problem: the Fed is about to hike rates, liquidity is being sucked out of the system, and credit conditions are deteriorating.

  • Throw in how elevated valuations are and the likelihood that both company profit margins and profit growth have peaked, and the outlook for stocks is pretty grim.

The massive spike in oil prices has increased the risk we see higher inflation and lower growth at the same time – the worst environment for risky assets like stocks.

It’s not the only problem: the Fed is about to hike rates, liquidity is being sucked out of the system, and credit conditions are deteriorating.

Throw in how elevated valuations are and the likelihood that both company profit margins and profit growth have peaked, and the outlook for stocks is pretty grim.

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The S&P 500 has now slipped 10% from its peak at the start of the year, which might’ve got you feeling hopeful that there’s upside back on the cards for US stocks. But as history has shown us, that upside heavily depends on whether we’ll see a recession in the next 12 months. And for my money, there are six clear reasons to think we will…

Stretched company valuations

US stock valuations reached an all-time high last year, and while they’ve recently come down, they’re still stretched by historical standards.

It’s not just because of the heavy weighting of tech companies in the index, either: the median stock valuation is higher than it was during both during the tech bubble and the global financial crisis. And since rising valuations have been a key driver of the bull market of the past decade, the lack of upside – or worse, the potential for a fall in valuations – puts a serious cap on future returns.

Next-twelve-month price-to-earnings (P/E) ratio of the S&P 500 and the median stock. Source: Goldman Sachs
Next-twelve-month price-to-earnings (P/E) ratio of the S&P 500 and the median stock. Source: Goldman Sachs

Sky-high oil

High valuations alone aren’t a reason enough to turn bearish on stocks: there needs to be some sort of catalyst to bring them back to their longer-term average.

The war in Ukraine may well provide that catalyst. The conflict has sent the oil price above $120 a barrel, which pushes up the prices of consumer goods (oil is used in plenty of products, after all), squeezes company margins (a higher price sends their costs up), and eats into spending (it sends disposable income down). In other words, a high oil price both exacerbates inflation and slows down economic growth.

In fact, a recession has followed every single time oil prices have deviated from their mean by as much as they are now – including in cases where stock market valuations weren’t as high as they are now. If the historical relationship between the oil price (orange line) and subsequent profit growth (blue line) holds, we’re about to witness a significant contraction in earnings – one that isn’t priced in yet.

Based on the current oil price shock, profit growth should turn very negative over the coming year. Source: @mrblonde_macro
Based on the current oil price shock, profit growth should turn very negative over the coming year. Source: @mrblonde_macro

Interest rate hikes

When growth is falling and inflation rising, the economy is in what’s called “stagflation”.

Stagflation has historically been the worst environment for risk assets like stocks, not least because it puts central banks in a tough spot: softer economic growth implies they should cut rates to kickstart growth, but that would only exacerbate inflationary pressures. The jury’s still out on whether they’ll prefer to be held responsible for an economic recession or to lose their credibility by tolerating higher inflation. But whichever route they choose, the outcome isn’t likely to be positive.

As the chart below shows, central bank rate hikes (i.e. tighter policy) reverses the flow of money from assets to cash, which now pays a more attractive rate. It also raises the discount rate used to discount future cash flows and reduces valuations, leading to a correction in asset prices and, ultimately, a bear market.

We’re at the liquidity tightening stage of the cycle. Source: Bridgewater.
We’re at the liquidity tightening stage of the cycle. Source: Bridgewater.

Looking at past tightening cycles certainly isn’t very encouraging: the US Federal Reserve has only managed a “soft landing” (hiking rates just enough to slow down inflation but not so much as to cause a sharp fall in growth) on two occasions, and neither involved inflation that was as out-of-hand as it is today.

Deteriorating credit conditions

When interest rates are low and credit flows to households and banks, it creates a lot of spendable money, which subsequently supports growth. But when credit conditions get worse, lending and investments slow down, which suppresses economic growth. So the fact that credit conditions have been getting worse for the past few months and are now reaching critical levels is worrying.

Credit conditions are reaching the slowdown phase. Source: TS Lombard
Credit conditions are reaching the slowdown phase. Source: TS Lombard

There isn’t much margin for error either, given high leverage in the system, the record level of public and private debt, the higher duration of credit markets, and the low premium investors currently required to hold risky corporate debt. So any further deterioration in credit conditions could easily exacerbate a negative environment for stocks.

What’s more, the risk of contagion from the commodity markets has increased: many Russian commodities have been used as collateral for loans, which means steep falls in their prices could lead to margins calls and pressure to sell. That partly explains why indicators of systemic stress in the European banking sector have spiked recently.

Peaking profit margins

US companies currently boast record profit margins as a percentage of the country’s economy, which does add a bit of a buffer against inflationary pressures. But it also suggests profit margins are unlikely to get much higher in this environment.

Profit margins could be peaking. Source: TS Lombard, BEA
Profit margins could be peaking. Source: TS Lombard, BEA

In fact, those margins are much more likely to regress to an equilibrium level well below where they are now – just like they have done in the past. If that happens, companies might find their profit growth under pressure and be forced to cut costs, which could impact wider economic growth. And given that there’s only one instance out of the last six where a margin peak hasn’t predicted the recession, you’ll want to closely track how margins behave in the next few weeks…

Flattening of the yield curve

The yield curve – the blue line below – might be the single best indicator we have at our disposal, since it summarizes what investors think about all the above factors.

A flattening of the yield curves means the odds of recession increase. Source: Clocktower
A flattening of the yield curves means the odds of recession increase. Source: Clocktower

I got into more detail here, but here’s what you need to know: the yield curve tracks the relationship of short-term bond yields and long-term bond yields. When it flattens out, it indicates that investors are increasingly worried that tighter financial conditions will lead to lower economic growth further down the line. That then raises the probability of a recession the following year (purple line).

And when short-term bond yields overtake long-term bond yields, the yield curve inverts. And when that happens, a recession is almost guaranteed. It hasn’t inverted yet, but it is reaching worrying levels

So is it time to buy the dip?

Honestly? I doubt it – at least not if you’re an investor with a longer-term horizon.

Based on the success of all these indicators at predicting bear markets and recessions (although generally with a lag of a few months), you arguably need a much bigger margin of safety to justify buying the dip right now. That’s not to say you should sell everything into cash, mind you: just that this might be the time to play defense. If you’re not sure how, we’ve looked into a few of your options here and here.

Of course, a high risk of recession doesn’t mean it will happen. Even an 80% probability means it won’t happen 20% of the time, after all. And there are certainly some factors that could lead to a rally in markets in the short term: geopolitical tensions could ease, the Fed could tolerate higher inflation, and global growth could pick up. And even if they don’t, investors could simply go back hoarding stocks simply because there aren’t many other returns-generating opportunities around. After all, investors gonna invest...

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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