After a torrid 2022 for most equities, analyst Edmond Jackson examines the outlook and weighs prospects for investors.
If taking an Occam’s razor approach – the simplest theory is often best – you would follow Benjamin Graham’s advice in his 1949 classic The Intelligent Investor: regard stocks as businesses and figure out how much they are “worth to a private owner”.
You do not fret what the economy might do, what charts suggest, whether to buy stocks on a Monday, or in January. Instead, market price versus investment value is your sole concern.
Warren Buffett wrote a postscript to revised editions citing how various graduates (including himself) of Graham’s school, followed this approach with highly satisfying results.
It entices, particularly after a torrid 2022 for most equities. But like I showed in my 2022 review, stock stances are affected by macro change – and I justify my wariness in this article.
Last May, I suggested to average into two quality housebuilders; but MJ Gleeson (LSE:GLE) has fallen even to a 25% discount to net tangible assets, and Persimmon (LSE:PSN) still yields over 9% albeit on a lower stock price with downgraded forecasts.
A fat discount to net tangible assets meets any reasonable definition of “worth to a private owner” unless land values slump. Yet a stock price reflects discounted cash flows and the market fears the effects of higher mortgage rates are as yet early.
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The S&P 500 index is seemingly back to an upward trend-line since the 2008 crisis, having experienced a “blow-off” top during March 2020 to end-2021.
I do not assume this constitutes support. Both bull runs were driven by loose monetary policy, excessively so during Covid lockdowns.
The US central bank has switched dogmas: from allowing no one to suffer hardship, to proclaiming a 2% inflation target come what may. Take care, how a forward price to earnings ratio on S&P 500 stocks is around 17x is high enough if 5% plus interest rates bear down on company profits.
Markets are in a no man’s land until company updates reveal the effects of interest rates on economic demand and debt costs. In the UK, the effects of strikes may also show as trade unions dig in.
An indisputably tough, medium-term financial outlook
The monetary environment contrasts with 2008 to 2021, during which investors became hard-wired to “buy the drop”.
Only recently, they turned bullish in the US from mid last October through November, with a naive belief in the “Fed pivot”: that inflation hence interest rate rises, had peaked, and the Federal Reserve would cut rates by next spring and summer. A relief rally in UK equities was helped also by the Liz Truss government being deposed.
Yet in a mid-December news conference, the US Federal Reserve governor cited median projections to raise its key interest rate over 5% in 2023 versus 4.5% currently; where consensus has been for a 4.5% peak and some economists looked for 2.5% thereafter.
Services’ inflation is considered sticky in the US (and UK), which also explains the Federal Reserve guiding for rates to remain high for some time.
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An argument exists that central banks will capitulate: cutting rates as social pain rises, also to “inflate away” public and private debt by allowing inflation to settle around 5% - which would halve debt in a decade or so. But it does the same to the value of assets and income, hitting the middle class especially. Ingrained inflation will also drag on employment and the wider economy.
While consensus expects inflation to fall back to low single digits from 2024, so it supported the central banks’ mantra of “transitory”. My distrust of excessive quantitative easing (QE) helped me warn of circa 10% inflation in macro articles, given I can recall bitter lessons from the 1970s: how raising the money supply has inevitable such consequences.
I suspect pay awards will retain inflation in the system; if it is genuinely to fall, a tough recession will be required.
Amid UK skills shortages and a reduced middle-age workforce post-Covid, stagflation remains my base-case scenario: slow economic growth at the same time as high inflation.
George Soros used to claim that he helped the UK out of early 1990s recession by forcing a devaluation of sterling, hence an exports-led recovery. Are we so adept, post-Brexit?
Forecasting companies is thus made very tricky
In principle, fear is a friend of the equities' buyer. In practice, unless you are happy to speculate, you must have a sense of numbers to derive “worth to a private owner”.
Hesitant buyers potentially enhance scope for takeovers, and weak sterling empowers foreign buyers. Yet I would write down the prospect of private equity bids amid higher interest rates. The August 2021 takeover of Morrison supermarkets by US private equity is reportedly strained already by debt servicing costs.
If “higher for longer” is true of interest rates, not only will it bear down on company profits, but also the capability to buy back shares – which has helped prop equity prices in the UK and US, besides enhance earnings per share.
Where might equity pricing opportunities arise?
Key upshots from my 2022 review were to expect stalwart stocks – such as leaders in healthcare, defence and smoking – to retain a premium for scarcity.
This, however, goes against Benjamin Graham's “value” principles because you are not meant to pay for any speculative aspect. You should instead favour a “margin of safety”, traditionally defined as net tangible assets and especially cash – but in the modern sense can include brands, for example.
I suspect that we are likely to see overshoots on the downside in cyclical stocks, like three insiders have just exploited – buying substantial shares in energy services group Petrofac Ltd (LSE:PFC) after a trading update.
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Rather than try to guess such situations in advance, best weigh them up as they happen. On exploiting “Mr Market’s manic-depressive swings”, I would agree with Benjamin Graham.
The cost of indulging QE finally comes home
Nothing much is said about this, but will it further strain government finances especially in the UK?
Abnormally low interest rates from 2008 meant negligible costs for central banks to pay the coupons on bonds they bought off holders (thus injecting cash into the economy) with digitally created money. Yet higher interest rates increasingly leave central banks with losses, the costs borne by taxpayers given central banks ultimately transfer their profits/losses to a national treasury.
The US and eurozone alike, are estimated each to bear losses of around £550 billion equivalent at end-2022. I do not know numbers for the UK, but the Bank of England appeared to indulge QE similarly and for too long.
Is China’s volte-face on Covid, a bull or bear factor?
Equities gained some encouragement over Christmas: how China’s sudden determination to drop its zero-tolerance policy may help the global economy avoid recession.
It seems a glass half-full assumption because unless a current intense wave of new infections abates, another round of supply-chain disruptions to Western industry and consumers is possible.
A big difference in the West’s recovering from Covid has been effective vaccines, extensively administered.
Time will tell if China has its act together, to cope.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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