Nowhere to go but up
Disclaimer: this is not investment advice. Before taking any investment decision, do your own research.
There’s a general sense that the current bear market is mostly over and future all time highs are around the corner. Which makes me wonder if the risk is moving towards the down side again. Let’s see why the current optimism may be exaggerated.
Been here before
My first point will be a little bit of a recent history review to point out that it’s common for bear markets to have periods of optimism that make people think “I’m glad that was over” and prices go up so much that’s difficult to believe that a new low is still a possibility. For that we will go back to the last bear market of 2007–2009.
The initial 20% drop that makes people start talking about being in a bear market went from October 2007 to March 2008 in the S&P 500. March to May there was a bear market rally that took the market up 14% and to only 8% down from the all time high. Just to drop down again by almost 17% to a -24% from ATH by July.
In the current move, it took a similar 5 month to get to a -24% low followed by a rally that last more than a couple of weeks. If the behavior this time is similar (which will likely not be), we would expect a 2 months downturn starting about August 15th.
If it results in a similar 17% drop, this next downturn could takes us down to 3500 in the S&P 500.
Of course looking at 2007 to predict 2022 is absurd. The exercise is just to note that so far, 2022 looks very similar to the 2007 bear market, which at least should warn us of too much complacency.
The punch bowl is not coming back
There’s not enough understanding of the consequences of the change of policies from the US Fed from the last decade to 2022.
For a very long time the Fed was very accommodative with very low fund rates and a large Quantitative Easing program. The effects of these policies was that all markets around the world were flooded with liquidity making all of them go into a raging bull market, generating the TINA (there is no alternative) mood of the last few years.
But now the Fed is saying that its priorities have change. The Fed has a dual mission of keeping inflation low and full employment. But inflation is the more sensitive objective. As long as high inflation is menacing in any way, the Fed will have contracting policies no matter how employment suffers (at least not until a 5%–7% unemployment is reached.) Even if the data moves back into deflation territory, the Fed will be slow to change course.
With the Fed removing liquidity (or at least not adding for a while), will the multiples keep as high as they have been? Should we expect multiples more in line with history, say going back to a Shiller PE Ration of 20? Will that be the low point? Markets overstretch moves, both on the upside and the downside. Although it would be a lot more reasonable to invest in stocks with a Shiller PE of 20, I wouldn’t be surprised seeing it go below long term average of 17.
Labor market may be deceiving
One argument against seeing the current bear market as a lasting one is that the employment market is strong, with unemployment rate at one of the lowest marks in decades. This made some people (including the US government) say that the US is still not in a recession. Although it’s true that not only GDP is considered by NBER to call a recession and that employment is an important factor in that, some other factors may be creating a false impression of stronger employment than what is actually happening.
The most important factor is the participation rate. One effect of the pandemic was people leaving the labor market for good (or at least for now.) Here’s an extract from Calculade Risk Blog:
In April 2020, 8.0 million people had left the labor force due to the pandemic. By November 2021, about 5.6 million had returned to the labor force, leaving 2.4 million fewer people in the labor force than prior to the pandemic. And this doesn’t count for growth in the 18+ population.
If we look at more recent data, the participation rate is still low compared to projections. And by looking at Employment-Population ratio, the job market doesn’t seem to have ever recovered 2007–2009 recession. Some of the lost may be to demographics, but still makes the “lowest unemployment in decades” argument a rather questionable one.
If inflation keeps pressuring households, more people will have to leave whatever comfort they found over the pandemic that made them drop out of the labor market and go back looking for a job. Consumer credit has already picked up in the last few months, which may be an indication of people resisting losing their lifestyle. But credit can help only for a few months.
Consumer sentiment
In June, the University of Michican Consumer Sentiment Index had the lowest value ever. It’s very hard to think that the future is bright when consumers are that pessimistic. Although a contrarian may point out that such a low value may indicate a bottom, the sentiment indicator usually leads over other recession indicators. It will likely bounce into less extreme levels, but if inflation persists, it will stay at a relative low value for a few quarters. And that may indicate a drag in the economy from consumers spending less.
What could happen with Tesla?
This is a hard question to answer. It’s reasonable to expect Tesla stock to go up with long term revenues growth of 50% GAGR. But that kind of growth will come with volatility. Can Tesla keep a 100 PE Ratio if multiple compression is the way forward for the market? Can it keep 50? How low can the PE Ratio go? That’s something I’ll leave for fortune tellers.
But any investor should be prepared for a wide range, going from 20 PE to 200 PE. Assuming a conservative 15 EPS for 2023, that would convert to a price range of 300 to 3000. And 450 to 4500 for 2024 with 50% EPS growth. That’s before the 2022–08–24 split.
Not for the faint of heart.
