Juggling Dynamite

Worthwhile macro listen.

Stocks have fallen for a number of reasons this year. But there’s another shoe that’s about to drop that should send equity prices even lower: margin compression. Despite companies’ profits getting squeezed by higher input costs due to hot inflation AND rising costs of capital, Wall Street analysts are still projecting robust earnings growth for 2023. Those estimates are going to have to come down soon in order to better match the unfolding reality. Next month’s earnings calls are likely to be the catalyst for that, as companies reveal the havoc this current margin compression is having on the current and future earnings. So even if markets experience a short-term bounce over the next few weeks, it’s likely to be short-lived once the Street is forced to take margin compression seriously. Here is a direct video link.

While the price of equities has been falling, earnings estimates (the “E” in PE ratios) have remained elevated.  As shown below, the decline in global purchasing manager indices (in dark blue since 2000) suggests a significant earnings decline (light blue) is likely over the next year.  If this unfolds, equity valuations will be revealed as much higher than presently estimated, and equity prices should follow lower.

Danielle was a guest with Jim Goddard on Talk Digital Network talking about recent developments in the world economy and markets. You can listen to an audio clip of the segment here.

Retail investors have not yet dumped their stocks, but as shown below since 2016, the outflows from bonds have been capitulation-like year to date. Stocks have catching down yet to do.

Lived experience tends to influence thinking, especially regarding financial decisions. Whether the latest memories are smooth sailing or adversity, it’s typical to expect more of the same, discounting the undulation of cycles.

The March 2020 market freefall was highly unusual in its brevity. As the world economy unexpectedly shut down, many found a windfall of free time and government handouts coupled with an internet full of speculative suggestions. As unusual inflows spiked prices, many erroneously believed that the escalation into 2022 was ‘normal.’ Others with more experience should have known better but forgot or decided that this time was different.

It’s well-documented that the masses over-confidently funnel most into assets near cycle tops (often borrowing to do so) and the least near cycle bottoms. Indiscriminate buying can look smart in bull markets where pullbacks are fleeting. But once cyclical downturns arrive to grind prices down over months, and even years, early dip-buying is a time-worn path to psychological and financial frailty.

Exhausted retail buyers finally morphing into panicked liquidators helps catalyze bear market bottoms and the most valuable investment opportunities for those at the ready. We aren’t there yet.

Stocks and stock funds made up a whopping 70% of retail holdings at the end of May, and while the average portfolio loss is down more than 30% year to date, net retail flows have not yet turned negative. History and understanding of human nature promise that they will. At that point, strong hands will once more be buying from the weak. See ‘Buy the dip’ faith has a last bastion: individual investors:

Both official flow-of-funds data and ASCII surveys show that the share of their portfolios U.S. households allocate to stocks jumped during the Covid-19 crisis to hover around historic highs, and has only come off slightly this year.

However, investors of any stripe can only tolerate so much pain. As of Tuesday, the average retail portfolio measured by VandaTrack was down 32% from its previous peak. And this hasn’t been a lightning-fast correction like in early 2020, but painfully drawn-out across six months.

…But if the selloff resumes and they stop believing that the market can fly, they might also remove one of the few forces keeping it in the air.