August 2022. A treacherous calm has set in on the global stock market’s surface after a summer recovery rally. Sentiment- and macro-wise, this may look/walk/talk/smell like a bear market rally. So market strategists and traders suggest tactically reducing risk exposure as the sensible thing in the short run.

If they are wrong? A “pain trade” for short-term market timers would be "recovery" to new levels of low-interest rate market craziness. Fear Of Missing Out (FOMO) all over.

We are not in the business of making or trading these shorter-term market calls. PiggyBack is in the business of making long-term fundamental risk-reward calls.

Strategically, there are a few important stock market undercurrents to beware of today. Fundamental forces that will affect the long-term investor's expected returns. Beyond the next month/quarter/year leg price move in the markets.

Let’s say inflation does not come down fast with increased interest hikes into a global recession. Then we have a stagflation problem. (As we discussed here.) Here it is better to be safe than sorry in equity portfolio risk management.

But playing safe does not need to mean market timing, in terms of selling everything in hope of being able to buy back cheaper. As long-term investors, we can also express the inflation risk in our security selection.

If central banks fight inflation credibly with (much, much) higher interest rates, those interest rates mean higher discount rates and lower valuation multiples on stocks. Here the highest valuation multiple, “glamour” stocks are most susceptible to return headwinds. They get crushed via falling share prices, the classic valuation multiple compression. Especially if their businesses are cash-flow negative and rely on issuing new equity to keep their doors open. Like many recent year unprofitable growth tech darlings and SPAC IPOs. Falling share prices here means worsening dilution of existing shareholders, with each new round of capital needs.

Lower earnings/asset quality business stocks may face severe headwinds if higher interest rates deepen a recession. Even risks of being impaired in a restructuring/bankruptcy if cyclical customer demand drops to where it no longer supports fixed costs or debt loads.

And if central banks capitulate and let inflation run to “save” the economy, the same lower earnings/asset quality stocks may still destroy capital, only more slowly but steadily. Here the problem is lacking pricing power, to compensate for long-term cost inflation on inputs and reinvestment.

Note that low quality businesses include low quality value stocks. If shareholders do not demand strategic asset sales, mergers or liquidation in time, their initial asset discounts are like melting ice cubes.

So where to hide in stocks?

One can try to position in at least some stocks with built-in inflation protection, or even inflation upside. Think commodities, energy, infrastructure, utilities, staples, and well-positioned suppliers to such industries.

Another option are strong pricing power asset-light “quality” businesses with non-cyclical demand. Easier said than done to buy these at discount valuations, but bear markets present some such opportunities.

Related to inflation-fighting via higher interest rates are risks of tighter financing conditions. Given the levels of debt that have been propped up by near-zero interest rates and central bank purchases, expect some things to break if inflation interest rates continue higher.

While the timing, chain of events, and collateral damage in terms of regions and sectors are uncertain, major stress events to the global financial system are a recurring phenomenon after long periods of credit expansion. It is prudent to plan for short-term credit to tighten or dry up:

Geographically, the U.S. stock market is still historically expensive. See for example Research Affiliates’ excellent cyclically adjusted P/E (CAPE) summary.

The basic fundamentals: U.S. stocks price in low interest rates and near-record profit margins. In the long run. Nothing new here, but still time to reconsider. If we are to make a macro bet, do U.S. equity valuations provide worthwhile “bang for the buck” (risk reward)? Your Analyst doubts it, more broadly speaking. A market that is not a good value will still have its pockets of value though.

Let's end on a positive note. Research Affiliates' data also highlights an aspect overlooked by today’s U.S.-focused equities bears:

Many regions around are already getting more reasonably priced, or even cheap. Both from historical and fundamental valuation perspectives.

Global diversification we have already discussed. An active, long-term investor making use of that opportunity should currently have no lack of value stocks to pick apart. And PiggyBack.

This was a @commonstock republication of "Beware Of Undercurrents", an August 2022 stock market comment from PiggyBack. All references are to the original article.

Johan Eklund, CFA

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