Why this rally marks halftime in the bear market

Greg Canavan

Fat Tail Investment Research

Since bottoming on 20 June, the ASX200 has rallied around 6%.

The S&P500 is up around 10% and the NASDAQ100 is more than 12.5% above its lows.

With US reporting season having kicked off, and some numbers coming in better than expected, there is hope that this is as bad as it gets.

In Australia this week, retailer JB Hi Fi [ASX:JBH] reported solid preliminary results for the financial year (specifically the second half) which got investors all excited too.

Sorry to disappoint you, but these reported numbers are largely backward looking. There has been little commentary on outlook. In Australia, that will come in the next month as annual results start to hit the ASX.

And the reality is that the second half of the year will be much tougher than the first half.

That’s what the sharp stock market correction into the June lows is telling you. But stocks went too far, too fast. It was a reasonably high probability bet that you would see a rebound given sentiment had become so bad.

Even I could see it (which is saying something). In a note to clients written on the day of the low (20 June) I said:

Reading the headlines on the weekend suggests were nearing a short-term bottom.

It was all about inflation, central bankers’ determination to fight inflation, and a looming recession in the US.

Remember, when it’s in the headlines, it’s in the price.

The ASX 200 fell around 6.5% in just four trading sessions last week. US stocks were also smashed. As I’ll show you in a moment, sentiment is now at extreme lows. Prices usually bounce from such levels.

Having said that, a caveat…

The very real risk is that central bankers continue to raise rates aggressively, even in the face of sharply slowing demand.

They are determined to crush inflation, even though inflation isn’t really a demand issue. It’s mostly related to supply constraints. So if they want to get inflation under control, they will really have to suppress demand to levels that will slow the economy sharply and lead to earnings downgrades, which will put more pressure on stock prices.

The other point to note is that inflation numbers are a lagging indicator. So by the time evidence emerges that inflation is slowing, and central banks take their foot off the brake, there will be a lot of damage done.

But that doesn’t mean we can’t have another good old bear market rally in the next month or so.

A bear market rally is exactly what we’ve had.

It’s a half time break before hostilities resume.

I say half time because the second half will likely be very different to the first half.

The first half of this bear market was all about a compression of earnings multiples.

As central banks increase interest rates, and the ‘risk free rate’ increases, valuations must come down.

Let me give you a very simple example:

Say you have $1 million in earnings, and you ‘capitalise’ those earnings with a 5% discount rate to get a market valuation.

That gives $20 million ($1m dividend by 5%). And you would say this ‘company’ trades on a P/E multiple of 20.

But if the discount rate increases to 10%, the capitalization drops to $10 million ($1m divided by 10%). And the P/E multiple drops to 10.

Note in this example the earnings ($1 million) haven’t changed at all. Yet the market value has dropped from $20m to $10m. It’s all down to interest rates. Rising interest rates increases the risk free rate which in turn increases the discount rate that is used to value companies.

That’s largely what has played out in the first half of this bear market. Speculative stocks and quality growth stocks have all been savaged because rising rates are impacting valuations.

Not that speculators care about valuations. I mean, how do you value a company that has no earnings and is unlikely to have any for years?

In a bull market, you get ridiculed for asking such questions. You’re paying for future growth, no matter how far into the future. And speculators are willing to do so because a rising share price is telling them they’re right.

But when the momentum turns, they’re out. The distant future is all-of-a-sudden covered in storm clouds. The punters can only see a few months ahead and they don’t like the view at all.

This is one of the great things about bear markets.

They compress investors’ time horizons and give you the opportunity to buy quality assets at prices that don’t come around very often.

Investors freak out about growth stocks and hide in relatively low growth defensive companies.

To show you what I mean, check out the chart below…

Telstra [ASX:TLS] and CSL [ASX:CSL] are up the top and outperforming the growth stocks down below (James Hardie [ASX:JHX], Xero [ASX:XRO] and Domino’s [ASX:DMP].

CSL is actually up a bit since the start of the year, TLS is down around 6.4%, while the growth stocks are all down around 40%.

As multiple compression works its way through the first half of the bear market, growth stocks get crushed while capital flows into defensive plays with more attractive valuations.

It’s a good place to hide, but where do you want to think about being as we head into the second half of the bear?

You want to start looking at the beaten up growth stocks!

These are companies that reinvest a good portion of their earnings and generate attractive rates of return on these reinvested profits. That is, they are wealth compounders. The market pays a very high price for these businesses in a bull market but doesn’t want to know them in a bear market.

That’s your opportunity.

But you have to get through the second half first.

What does that entail?

Well, the rising interest rate environment doesn’t just have an impact on earnings multiples. With a lag, it will have an impact on earnings too.

Rate rises will suck money out of the economy at the same time as high inflation has given every wage earner a big pay cut in real terms.

In Australia, the RBA started raising rates in May and is still in the early stages of that process. While I don’t think it will increase rates as much as the market is pricing in (3.75% by March 2023) they will clearly tighten dramatically over the next few months.

100-150 basis points is likely. As I’ve written before though, by the time the Fed meets on 20 September, the world will look a little different, as will future interest rate assumptions.

All this means a slowing economy will start to weigh on earnings.

Add in a higher cost base as the general price level increases year on year (a result of the inflationary shock just experienced) and company earnings are likely to struggle.

This probably won’t show up in the upcoming results for the year to June 30. Don’t forget, the previous government forecast nominal economic growth of 10.75% for the year. Nominal growth is basically real growth plus an inflation estimate (which they call the ‘GDP deflator’) of 6.5%.

That 6.5% inflation will benefit some companies and hurt others. But the point is that 10.75% nominal growth is very strong.

Now you know why JBH is killing it in this environment. Add in a NSW government handing out $1,000 for a wet verandah (no questions asked) and you can see there is still a lot of money in the economy.

Notwithstanding the likelihood of weaker outlook statements as annual results roll in, the numbers themselves should be healthy.

But it is THIS financial year (FY23) you should be concerned about.

The former government budgeted for nominal growth of just 0.5% this year. That’s quite the fall. The number itself will probably be wrong. But the change from FY22 is likely to be drastic.

And that’s going to show up in weaker earnings in FY23.

The market started to price this in as it fell sharply in June.

But now, it’s getting ahead of itself in thinking that the worst may be over.

Don’t be fooled though. There is worse to come as we get ready to start the second half.

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Greg Canavan
Editorial Director
Fat Tail Investment Research

Fat Tail is Australia’s largest independent financial publisher. Greg is Editor of its flagship newsletter, Greg Canavan’s Investment Advisory, where he writes market commentary and looks for out-of-favour ASX 200 stocks on the cusp of a re-rating.

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