XM does not provide services to residents of the United States of America.

Is the risk/reward in US stock markets worth it?



The new year got off to a solid start for US equity markets, with the tech-heavy Nasdaq leading the charge higher as fears of an imminent recession abated. Alas, this rally seems unsustainable. Valuations are still expensive, corporate earnings are contracting, and investors can now earn 5% returns in risk-free bonds instead of taking chances in riskier assets. That’s a dangerous mix for stocks.  

Euphoria returns 

Stock markets kicked off the new year with a bang. The Nasdaq has gained almost 10%, drawing fuel from a streak of encouraging data releases that highlighted the resilience of the US economy and calmed nerves around an imminent recession. 

Buybacks by businesses have been another driving force behind this rally. In fact, corporate America is on track for new records in share buybacks so far this year. When companies buy their own stock, they reduce the supply of available shares and create artificial demand in the market, which ultimately boosts share prices. 

Liquidity injections by foreign central banks also played a huge role, essentially by neutralizing the Fed’s quantitative tightening efforts. Since the Fed started to reduce its balance sheet last year, it has drained roughly half a trillion dollars out of the financial system, which in theory is negative for riskier investments such as stocks. 

However, the Bank of Japan alone has increased its balance sheet by roughly $800bn since October, more than offsetting the Fed’s entire quantitative tightening campaign so far. The People’s Bank of China acted in a similar manner to support its slowing economy. Liquidity is a global phenomenon after all, so it is no wonder that US markets staged such a powerful rally. 

Expensive valuations, falling earnings

The underlying problem with the US market is that valuations are way too expensive for the current economic environment. With the S&P 500 trading at 17.5 times this year’s estimated earnings, there isn’t any room for error. Markets are already pricing in a ‘soft landing’ for the economy. 

Such elevated valuation multiples were normal during the last decade when interest rates were extremely low, but with investors now able to earn a 5% return on risk-free US government bonds, it’s difficult to justify these valuations. When bonds can deliver decent results, there’s less incentive for investors to take chances in riskier plays. 

What’s making the valuation even more bizarre is that profits are declining. Corporate earnings of S&P 500 companies fell in the final quarter of 2022, contracting by more than 3% compared to the previous year. Analysts expect this trend to continue in the next few quarters, as higher interest rates slow down consumer spending. 

Fed blues

Another issue is that the strength of the US economy and the persistence of inflationary pressures are leading the Fed to become even more aggressive with its rate increases. Markets are currently pricing in a peak for interest rates at around 5.5% and expect them to stay there until the end of the year. 

And while recession nerves have calmed for now, they haven’t disappeared. The New York Fed has a model that calculates recession probabilities based on bond market moves, which currently points to a 57% chance of recession over the next year, even higher than the ‘dot com’ or 2008 crashes. 

In essence, the thinking is that today’s strong economic data pulse might lead the Fed to overtighten. It takes several months for higher rates to impact economic activity, so today’s excess tightening might show up later this year when the economy is already slowing down, compounding the weakness.  

The recent stress in the banking system is a testament to these risks. 

New lows? 

While the outlook for stocks seems negative, it is not a disaster either. Even if there is a recession, the hope is that it might be brief and shallow, since the weakness is being driven by policy decisions, not some massive external shock. If the Fed is engineering an economic slowdown to defeat inflation, it can also help turn the ship around once the job is done or the pain intensifies. 

Over the last century, the average decline during S&P 500 bear markets has been around 33% from top to bottom. If we assume something similar this time, that would give a ‘target’ near 3,200 in the S&P 500, which represents around a 17% decline from current levels. This region would be more consistent with ‘fair value’ in valuation terms, and is also important from a chart perspective. 

The risk/reward would become much more attractive for long-term investors as we approach that region. Of course, the market usually doesn’t bottom until after the Fed begins to cut rates, so it might take some time before the S&P 500 gets there - if it does at all. 

In conclusion, the latest equity rally seems built on shaky foundations. Valuations, earnings growth, and the macroeconomic landscape suggest the market could still hit new lows. Even so, investors shouldn’t miss the big picture - every crisis ultimately passes and stock markets move higher over the years.

Disclaimer: The XM Group entities provide execution-only service and access to our Online Trading Facility, permitting a person to view and/or use the content available on or via the website, is not intended to change or expand on this, nor does it change or expand on this. Such access and use are always subject to: (i) Terms and Conditions; (ii) Risk Warnings; and (iii) Full Disclaimer. Such content is therefore provided as no more than general information. Particularly, please be aware that the contents of our Online Trading Facility are neither a solicitation, nor an offer to enter any transactions on the financial markets. Trading on any financial market involves a significant level of risk to your capital.

All material published on our Online Trading Facility is intended for educational/informational purposes only, and does not contain – nor should it be considered as containing – financial, investment tax or trading advice and recommendations; or a record of our trading prices; or an offer of, or solicitation for, a transaction in any financial instruments; or unsolicited financial promotions to you.

Any third-party content, as well as content prepared by XM, such as: opinions, news, research, analyses, prices and other information or links to third-party sites contained on this website are provided on an “as-is” basis, as general market commentary, and do not constitute investment advice. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, it would be considered as marketing communication under the relevant laws and regulations. Please ensure that you have read and understood our Notification on Non-Independent Investment. Research and Risk Warning concerning the foregoing information, which can be accessed here.

Risk Warning: Your capital is at risk. Leveraged products may not be suitable for everyone. Please consider our Risk Disclosure.