The price of investing in stocks may have fallen this year, but the hedge fund bridgewater He believes they haven't hit rock bottom yet. They have compared the current situation to the inflation-driven bear markets of the past. In his opinion, the current situation should worsen in order to begin to see improvements. Let's see then why Bridgewater fears that investment in stocks will continue to decline...
What needs to happen for stocks to continue falling?
Bridgewater has identified that bear markets tend to follow two stages, as we explained in another article. Let's review those two stages:
The ratings are lower.
Increases in interest rates reduce the present value of a company's future cash flows (FCF). And since higher interest rates tend to cause all sorts of problems for the economy, they also damage investor confidence, meaning they stay away from investing in stocks. Therefore, for investing in stocks to appear more attractive, company valuations have to go down. So far, that's pretty much what we've seen this year.
Comparison of the profitability of shares with interest rate drops. Source: Bridgewater.
Lower profits.
This stage is less about valuations and market sentiment, and more about the real economy and company profits. The interest rate increases lead to lower economic growth. The thing is that they affect different sectors of the economy with different delays, so not all sectors will slow down at the same time. Therefore, even if a leading sector like housing begins to slow down, company profits could take a few months to follow suit. And if earnings slow more than the market expects, as they often do, stock prices typically fall again. It could be said that we have not yet experienced that stage, but we could be getting closer to it.
The decisive factor for the future of investing in stocks will be profits. Source: Bridgewater.
What needs to happen for stocks to recover?
From Bridgewater they affirm that three conditions must be met for stocks to rebound in an inflation-driven recession. First, the economy must slow sharply. Then central banks must relax current conditions, that is, lower interest rates. Finally, the expected long-term returns on stocks must be high enough to incentivize investors to choose them over safer assets like bonds. Bridgewater published this table, where we can see that these conditions occurred almost every time investment in stocks recovered in previous inflationary bear markets.
Table with the course of different inflationary bear markets. Source: Bridgewater Associates.
So, have stocks hit bottom?路♂️
At the moment, it doesn't look like investing in stocks. This is for several reasons: The economy is still too strong. To be sure, some leading indicators (such as the housing market and consumer confidence) have plummeted, and other metrics such as the ISM Purchasing Managers' Index (PMI) are also slowing. But so far, key indicators such as consumer spending and the labor market remain surprisingly strong.
The expected long-term returns on stocks are too low. Source: Bridgewater
Furthermore, investors remain wary of investing in stocks. The long-term expected returns of the S&P 500 look more attractive right now than they did at the beginning of the year, but we could argue that they are still too low to attract investors. We have yet to see a real capitulation (when investors throw in the towel). Although valuations have returned to their average, they have not overshot downwards as is often the case in bear markets. And given current yield levels, investing in stocks remains relatively less attractive than investing in bonds, so prices may have to fall for investors to start buying stocks again.
What is the opportunity?
Like Bridgewater, we too believe we have hit rock bottom yet. If the Federal Reserve's record interest rate hikes push the economy into a recession in the coming months, corporate profits could fall more than the market currently expects, and stock investing will likely feel the impact. . Slow economic growth could push inflation in the right direction and allow the Fed to finally ease its aggressive monetary policy. At that point, Bridgewater rebound conditions could occur.
Forecast development of inflation in the US for the next 2 years. Source: Bloomberg.
If you agree with Bridgewater, we could buy Treasury bonds. This is because they should benefit as the economy and inflation weaken. Gold could also do well, especially if inflation remains firmer than expected. But if you are not sure what is going to happen, the safest thing could be to design a balanced portfolio of assets that generally perform well in different macroeconomic scenarios, as we propose in this article.