This article has been written by an expert contributor, Kerry Craig, Global Market Strategist, J.P. Morgan Asset Management.
Market rallies
Equity market rallies during periods of overarching market weakness are not uncommon, and there can be multiple rallies in the equity market even during a more prolonged downturn. Analysis by J.P. Morgan of the past five major bear markets in U.S. equities showed that the market rallied by more than 10% on average five times during those bear markets.
The four P’s framework can be used to consider if a bear market rally will become a bull market or if the lows will be tested again.
Policy
The aggressive change in tone towards inflation and getting interest rates quickly back to a neutral level were the most significant factors behind the weak performance across stock and bond markets in the first half of the year. The high valuations on equities became tenuous, as risk free rates rose and expected earnings in future years were discounted at higher rates, making them worth less in today’s money. The pain was most acute in the pockets of the equity market where things looked the most overvalued.
Central banks are still focused on bringing down inflation, but inflation has appeared to have peaked, in the U.S. at least. The combination of weaker demand and falling commodity prices is helping to slow price rises. For the U.S., consumer prices were unchanged in July, in other words there was no inflation from June to July. This is better news for the U.S. Federal Reserve and suggests the pace and size of rate hikes could gradually reduce in the coming months as inflation starts to fall.
Positioning
Risk sentiment became very weak in the first half of the year and investors pulled money from global equity markets. The Bank of America Fund Manager Survey for July reported that a net 44% of asset managers were underweight equities in their portfolios. The last time the underweight to equities was this large was October 2008 in the depths of the financial crisis. When asset allocators have more cash than usual to put to work in the market, it can sometimes be seen as a contrarian indicator and a positive sign for things to come. To paraphrase Warren Buffet, the best time to be greedy is when others are the most fearful.
Price
Equity markets are forward looking and often reflect expectations for what is to come rather than what is being experienced today. At the start of the year when valuations on equity markets were well above long run averages, the common theme was that equities were too expensive, now it’s whether they have become cheap enough. Valuations could fall further if there was another shock to the global economy or central banks signalled that interest rates will be much higher than current market expectations. However, the decline in valuations so far this year already captured much of the market risk.
Profits
The final piece of the puzzle is profits and whether companies can continue to remain profitable in a slowing economy as revenue growth is tempered and margins pressured from rising input costs. The U.S. second quarter earnings season has just wrapped up and the news wasn’t good. Our analysis shows that corporate earnings declined by 9.5% compared to a year ago and 4.6% between the first and second quarter. What was more important for the market was that expectations for earnings were so low heading into earnings season, it wasn’t a particularly high hurdle for corporate America to overcome. 70% of companies have beaten analyst expectations for revenues and 63% have beaten revenue estimates. Revenue beats mean that the companies have been able to pass on higher costs to end users, protecting margins and profitability. This may not always be the case if household budgets continue to be squeezed and spending in the economy falls.
Summary
It is currently not clear whether equity markets have found the bottom or whether they will retest their lows at some point. While the market is likely to remain cautious given the still uncertain economic outlook, a framework that considers policy, position, prices and profits should help provide you with some context to how far a rally can go.
For more from the author, Kerry Craig, check out our episode with Kerry on the Equity Mates Investing Podcast on 21/07/22. Expert: Kerry Craig – J.P. Morgan Asset Management – State of global markets and what it means for investors
Kerry is responsible for communicating the latest market and economic views from J.P. Morgan Asset Management’s Global Market Insights Strategy Team. With more than 10 years’ experience, Kerry provides valuable insights and perspectives on the economy and markets to investors. As a frequent commentator on Bloomberg, CNBC, the AFR and the wider financial press, Kerry is able to explain complex economic and market issues in a language that investors understand.