Financial markets are now at their highest level of vulnerability.
We identify several important uncertainties that could make investment decisions more difficult in 2022: 1. High equity market valuations, 2. High probability of entering a bear market for equity markets, 3. End of stock price appreciation. liquidity-induced activity, 4. the end of ultra-low real interest rates, 5. a new inflation regime, 6. China’s new role in the global growth / inflation mix, 7. a new correlation regime between equities and rates interest, and 8. the inability of the risk premium to protect the equities in a context of rising inflation.
The global stock market is now worth $ 120 trillion, the highest in history, and the total US market capitalization has dropped from 130% at the end of 2018 to 200% of GDP. Our combined S&P 500 valuation indicator hit an all-time high since the dot-com age-old peak of 2000, with a 66% premium over the historical average. The weight of equities as a percentage of total US household assets reached an all-time high of 41.5%, down from previous highs of 38.2% in 2000 and 32.8% in 2007. These peaks in measures signal a mature secular bull market that started in 2009 and with it a lack of further demand for stocks. Historically, equity allocation tends to decline before the onset of a recession.
High equity valuations are associated with lower future returns and higher losses. The cyclical bull market that began in spring 2020 is maturing (+ 110%, or + 59% annualized for the S&P 500 Total Return Index). But a valuation spike doesn’t mean the end of the uptrend for equities. “Bull markets don’t die of old age. They end up in recessions, ”the stock market adage goes. The post-pandemic rally has shifted from a directional market driven by valuation multiples expansion to a market of relative opportunities driven by rotations, earnings and macro normalization. Regime change began in 2021 and could be more pronounced in 2022, depending on the pace of monetary tightening expected by the market. Weaker Sharpe ratios and greater dispersion are expected to characterize the next equity market episode in 2022. Concerns of stagflation should contribute to the deterioration of the Sharpe ratios for equities. The downgrading of US equities began in 2021, with the EV / EBITDA multiple falling from 19 times in January 2021 to 17 times today. The multiple is trading at a premium 56% compared to the historical average In 2011 the discount was -34%.
We use a composite market signal to assess the likelihood of bear market events, which is a cumulative market decline greater than 20%. The bear market risk is greatest when all cyclical components peak. Now our proprietary signal turns red for the first time since February 2020, surpassing the previous two peaks (February 2007 and September 2018). Asset price valuation components are still very high (equities, credit spreads, government bonds). The message of the business cycle is similar. The highlight since the spring of 2021 is the significant decline in unemployment (to 4.6% in the United States from 14.8% in April 2020, although still above the pre-pandemic rate of 3.5%) and the surge in primary and underlying inflation.
The catalysts that could trigger a sharp stock market price adjustment are: 1. an economic policy error, including an unexpected monetary tightening; 2. a squeeze in bank or corporate credit; 3. an explosion in commodity prices leading to a more severe economic slowdown associated with a tightening of monetary policy; or 4. a volatility shock (event driven). COVID-19 is a persistent problem, but it can be seen as already well integrated into the market risk premium. This means that new developments in the pandemic are expected to affect financial markets only marginally, given the higher vaccination rate and preventative political support from governments.
Financial markets are now at their highest level of vulnerability. Simultaneous hedging of inflation risk and market risk will be essential in 2022.