In support of the bulls
We’ve recently shared several posts, and appeared in the odd media interview, explaining why equity investors might have cause to pause. After a significant rally in the U.S. S&P500, there are several reasons why we anticipate a sell-off in equities in the upcoming days and weeks. However, markets consist of both buyers and sellers. To provide a more balanced perspective, in this article we delve in the reasons behavioural finance experts believe the U.S. equity market rally might persist until the year’s end.
Current equity market landscape
Remember, at the beginning of the year we put our ‘flag in the sand’ to say 2023 should be a good one for equities, especially innovative growth stocks. Well, our enthusiasm has since eased. The U.S. market has surged, led predominantly by the riskier stocks, with a notable return of complacency and reduced volatility.
Meanwhile, we are approaching what some stock market behaviouralists (is that really a job?) describe as ‘bearish’ seasonality between August and October, a time when corporate news flow slows.
Investor behaviour and market dynamics
Some analysts highlight that retail investor surveys suggest bullish sentiments, the flow data from exchange traded funds (ETF) and mutual funds, as reported by the global industry association for investment funds, the Investment Company Institute, contradicts these sentiments.
Brokers, anecdotally, claim the most frequently asked question they receive from investors relates to the timing of a correction of the market, so they can deploy their cash reserves.
If such anecdotes reflect wider investor behaviour, any dip in the market could be short-lived. Importantly, retail investors tend to invest later in the life than institutional investors, many of whom, have mandates to remain fully invested. Institutional investors have also increased their equity allocations, which helps to explain the market’s rally.
The role of FOMO
Perhaps a reason that U.S. retail investors haven’t increased their allocations to equities, is that the fear of missing out (FOMO) is not as strong as the return on cash deposits.
Federal Deposit Insurance Corporation (FDIC) member Sallie Mae, for example, is offering 5.55 per cent per annum on an 18-month term deposit. In comparison, the earnings yield on the S&P500, as of 21 August 2023, was 5.38 per cent. It’s arguable the earnings yield on equities isn’t sufficiently high to warrant investors switching.
But economic rationalists, who compare yields to explain investor behaviour, haven’t considered FOMO. Perhaps the market hasn’t rallied enough (which would push the earnings yield even lower) to frighten comfortable cash depositors, out of their slumber.
Bulls versus bear markets
Historically, bull markets tend to outlast their bearish counterparts. For instance, since 1942, the average bull market has lasted 4.4 years, compared to the average bear market which lasted 11.3 months. Notably, some bear markets are brief. The bear market of 1957 began to recover after just three months. Other bear markets are more enduring. During the global financial crisis, U.S. equities plummeted by more than 56 per cent and lasted for about 18 months.
More recently, in February 2021, retail fund flows turned positive. The S&P500 had already rallied over 68 per cent. During last year’s bear market, U.S. retail flows turned negative in September. The market had already fallen 24 per cent and their net selling coincided with the beginning of a rally. According to estimates, net selling has continued despite the market rallying almost 23 per cent.
Will investors jump back in inspired by FOMO?
Perhaps today, with three-month U.S. Treasury bills yielding 5.42 per cent, there might be less incentive than there was in February 2021, when Treasury bills yielded just five basis points or 0.05 per cent. There’s much less pain in missing out, for those earnings almost 5.50 per cent. Eventually, FOMO does kick in, but this time, a more significant rally might be required to stoke those animal spirits. Yet, none of this explains why the market might continue to rally. The answer may lie in the fundamentals.
Diving into market fundamentals
Equities typically rally during years when earnings growth is negative because investors sell in anticipation of adverse earnings growth (such as what happened in 2022) and then rally in the second half of the subsequent year in anticipation of a recovery in earnings. This might explain the shorter lifespan of bear markets.
As one U.S. analyst recently noted, there has been a positive inflection in quarterly year-on-year earnings growth. The 2023 financial year consensus estimates went up after the second quarter earnings season, not down as the bears had predicted. According to financial data provider Factset, for the second quarter of the 2023 financial year, “79 per cent of S&P 500 companies reported a positive earnings per share (EPS) surprise, and 65 per cent of S&P 500 companies have reported a positive revenue surprise”.
Analysts project an earnings growth of 12.2 per cent and revenue growth of 5.1 per cent for the 2024 financial year, at August 2023. Transitioning from negative to positive year-on-year growth could be a catalyst for further equity market gains. That may then spur retail investors to drive the rally further.
Policy influence and valuations
Meanwhile, another argument proffered by some bullish analysts is that President Joe Biden’s 50 years in Washington will translate to economic pump-priming during an election year, to score votes. Biden’s announced initiatives, which require substantial spending like Infrastructure, Clean Energy and the CHIPS and Science Act, (which makes a nearly $53 billion investment in U.S. semiconductor manufacturing), research and development, and workforce, are set to kick in during 2024 – the election year.
Lastly, while the S&P500 may appear expensive on an aggregate basis, it is worth remembering much of the gain has been driven by a small handful of mega-cap tech stocks.
The price to earnings (PE) multiple for the S&P500 hovers just below 20 times, the equal-weighted S&P500 index is more palatable at 15.7 times, suggesting there is some value that could appeal to investors as well.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
