By John Authers | Bloomberg,
April Really Was the Cruelest Month
Great poetry can lead to some inaccurate cliches. Any number of winters are dubbed a “winter of discontent,” for example. And then there is the notion that “April is the cruelest month,” the opening line from T.S. Eliot’s “The Wasteland.” It’s trotted out every year, even though April tends not to be cruel. For the stock market, it tends to be one of the kindest months. History’s big stock market selloffs have mostly come in the second half of the year. Remarkably, 2022 was the worst April for the S&P 500 since World War II:
Cruel indeed. Now we reach the month of May, the month of maying, when cliche has it that we should sell and go away. Over history, it’s unusual to get two such bad months in succession. So what exactly lay behind the selloff in April, and why did it happen when it did?
Reopening for Real
In economic terms, the market now accepts that the pandemic is over. One simple way to see this is in the performance of “stay-at-home” stocks that rallied in 2020, and are now revealing that they cannot keep minting money as they did during the lockdowns. Zoom Video Communications Inc., now an established part of our lives, is the clearest example, but the extreme punishments meted out to Meta Platforms Inc. and Netflix Inc., both trading below their pre-pandemic prices, have also shown that the market had somehow assumed that lockdown-like conditions would continue indefinitely:
The alarum at the end of last week after Amazon.com Inc.’s results, which have now seen the online retailer surrender almost all its gains compared to the S&P since the onset of Covid-19, was another example of excessive forecasts fostered by the pandemic being reeled in. That led to a dramatic adjustment in valuations. All the coronavirus-era bounce in the NYSE Fang+ index’s multiple to earnings, and almost all of its multiple to sales, has now been corrected. This can be viewed as a sign of prior excessive optimism, but it does also suggest that the market has at last adjusted to the reality that the pandemic’s beneficiaries will no longer be benefiting:
Consumer behavior shows the same pattern. According to gross domestic product figures released last week, expenditures on services in the U.S. have at last topped their level from the beginning of 2020. This is a significant sign that behavior is returning to something like normal, although it also suggests that spending on goods could now become increasingly challenged:
Expenditures on goods are still above what would have been expected had they just followed the pre-pandemic trend. Looking at goods’ share of American spending, it’s clear that there’s a lot of reopening to go. The pandemic marked an extraordinary reversal to a decades-long trend that had seen expenditures shift from goods to services:
It’s sensible to assume that goods expenditures will continue to decline as a share of the total for a while yet. April’s drastic selloff in part reflected an attempt to adjust expectations for that new reality.
What’s perhaps most disquieting about the April selloff is that it came against the backdrop of a perfectly respectable earnings season. Excluding Amazon.com, affected by post-pandemic problems and comparison to a very strong first quarter of 2021, FactSet’s John Butters shows that the S&P 500 companies to report to date have managed to grow earnings at a little above 10%:
The game of trying to set expectations at a level where they can be beaten also continues to go well for chief financial officers. Slightly more companies are beating forecasts than usual. Generally, that pushes share prices up. Earnings season is a great excuse to buy stocks. But not this time. As Butters shows, the reaction to earnings surprises in April was asymmetric. Negative surprises were punished far more than positive ones were rewarded. While this is usually the case, April’s asymmetry was extreme:
Some of this is driven by noise. Results have been unusually dispersed, with some of the biggest companies, which had been subject to the greatest hopes, disappointing mightily. As a result, as Deutsche Bank AG investment strategist Bankim Chadha explains, median earnings look decent even though the mean is disappointing:
Mega-cap growth (MCG) & Tech earnings are missing by -6.0% at the aggregate level but the median company in the group is beating by 5.7%, pointing to the outsized role played by outliers. There is a similar story for Energy beats (-2.3% in aggregate, 8.8% for the median company). The pandemic-impacted group has reported losses which are larger than consensus in the aggregate (-$7.8bn vs -$6.0bn) but the median company is seeing smaller-than-expected losses.
The MCG or “FANG” stocks were the focus of great hopes, and enjoyed over-optimistic multiples driven by the assumption that pandemic-era performance could continue in perpetuity. That has now been corrected.Now some other issues arise. The market might just have adjusted to the reality that behavior will not continue as it did in lockdown ad infinitum. But it arguably hasn’t adjusted to the high level of inflation. It’s straightforward common sense that higher inflation would lead to paying a lower multiple of earnings, because you expect future earnings to be eaten into by inflation. And common sense is borne out empirically; all else equal, higher inflation does indeed tend to mean lower earnings multiples. This chart from Bank of America Corp.’s chief equity strategist Michael Hartnett confirms that there is a clear historic relationship between multiples and inflation:
Unfortunately, Hartnett’s exercise also confirms that the S&P’s current p/e (marked with the big black circle) looks way too high given the historical pattern. It’s a major change in inflationary regime that seems to be under way, after all, and it’s no great surprise that investors haven’t yet adjusted accordingly the valuations they are prepared to pay. Or, alternatively, they know that inflation is high, but they’re confident that it’s transitory. If that’s the hope, then one other finding from the first-quarter earnings so far is very inconvenient. S&P 500 operating margins remain historically high, and are on course to rise a little compared to the fourth quarter of last year. This chart is from Deutsche’s Chadha:
That’s good news for equity investors in the sense that it confirms that companies have enough pricing power to pass on increases in their costs to customers as higher prices. It’s rotten news for those who want inflation to come down, as it implies that inflationary pressures are continuing to become embedded. That is also, therefore, bad news for equity valuations, as continuingly high inflation would imply paying lower multiples.
What About Inflation?
The resurgence of price rises has scrambled all kinds of market orthodoxies, and driven a sharp increase in projected future interest rates. So how bad is the news on inflation?
It’s more of a mixed bag than it has been for some time. Last week’s data on the personal consumption expenditures deflator, the Fed’s favorite definition of inflation, showed a continuing rise to three-decade highs. But a trimmed mean measure prepared by the Dallas Fed, excluding the biggest outliers in either direction, shows month-on-month inflation dipping back to conscionable levels after an extreme spike earlier in the year:
The growth in demand for services as opposed to goods should also dampen overall inflation pressure somewhat. But that must be balanced against the alarming data on employment costs, another indicator beloved of the Fed, which recorded its fastest rise since inception in 2001:
There is also mixed news on inflation expectations. For the market, 10-year breakevens for the U.S. briefly exceeded 3% last week, a concerning sign as the Fed has convinced everyone that it’s going to tighten until the pips squeak. Meanwhile, the rise in German inflation expectations is extraordinary. For the first time since 2009, investors expect German inflation to run hotter than the U.S. over the next decade:
This is quite a sea change. However, there’s at least one solid reason for hope that we’ve seen “Peak Inflation” — base effects are about to get very favorable. Year-over-year inflation numbers for each of the next three months will see a month of very bad inflation from last year drop out of the equation. Therefore, the eye-catchingly high numbers of late should soon moderate. The peak should be in.
This avoids the issue that inflation is way above levels that the Fed or anyone else would tolerate for the long term. Declining a little from a peak driven in large part by the shock of the invasion of Ukraine is beside the point. The issue is what inflation rate is possible within the next year. If the headline consumer price index is rising at only 3% by the end of this year, that would have very different implications from, say, 5%. Both these levels would be much lower than they are now, but since we know that inflation isn’t transitory as once hoped, its projected future course matters more.
A brutal month like April requires dreadful sentiment. And indeed it looks as though investors are thinking very negatively. The relative performance of discretionary consumer stocks and consumer staples is a classic indicator of a recessionary fear — discretionary stocks will underperform when investors think a recession is coming. At present this may be over-impacted by Amazon.com, which is a consumer discretionary stock, but the way staples have outperformed since late last year suggests investors braced for an imminent recession:
Then you can infer people’s sentiment by asking them how they feel. I wrote last month that the American Association of Individual Investors’ regular weekly survey showed that the number calling themselves “bullish” had collapsed. By April’s last survey, many were prepared to call themselves bears. In the last 30 years, bears have outnumbered bulls more than they do now just once. And that was in the second week of March 2009, in what turned to be the last survey before stocks hit rock bottom and started their great post-Global Financial Crisis rally:
So sentiment is looking very negative, indeed startlingly so, given the strength in the jobs market and the resilience of corporate earnings. That implies that a turn shouldn’t be far off. The risk is that one final cathartic collapse (as has often in the past happened on a Monday after a bad close on Friday) might be needed to get there. The next week, with the last big download of corporate profit numbers, plus Institute for Supply Management data on Monday and non-farm payrolls on Friday sandwiching what is likely to be a 50-basis-points rate hike and the start of quantitative-tightening bond sales by the Fed on Wednesday, will provide plenty of opportunities to change direction (or not).
Meanwhile, in China…
Chinese markets are on holiday for the next few days, which is perhaps just as well. The purchasing manager surveys that dropped at the end of last week suggested that Covid-zero lockdowns had driven a historic slowdown in new orders, particularly in the services sector of the economy. April’s numbers were lower than anything previously seen, bar the initial reaction to the lockdown in Wuhan in early 2020:
It’s never safe to take eyes off China. If these trends continue, they could scramble the patterns that are growing so clear in the rest of the world.
It’s not every day that the football club next to your old high school beats Liverpool, with the aid of a goal scored from behind the halfway line, but that happened this weekend. Don’t believe me? Watch this. There are always reasons to be cheerful out there.
For more profound reasons to be upbeat, spring is here, and the flowers are blooming. In my home neighborhood of Washington Heights, a new varietal of tulips has been planted that honors perhaps our most famous resident, Dr. Ruth Westheimer. Here is a Dr. Ruth tulip flourishing in Fort Tryon Park, as photographed with my phone:
Dr. Ruth, for the uninitiated, is a 93-year-old German-born Holocaust survivor who became hugely famous as America’s favorite dispenser of advice about sex. She’s extraordinary.
To see Dr. Ruth in action, you can watch her TEDx talk, or see her in conversation with David Letterman, Jerry Seinfeld, or Jackie Mason, or even co-presenting a show with Ozzy Osbourne. It’s also worth watching a documentary on Hulu that was made for her 90th birthday.
Have a great week everyone, and a happy Eid al-Fitr to all Muslim readers.
More From Other Writers at Bloomberg:
• Sanctions Haven’t Made Clear What “Russian Oil” Is: Julian Lee
• The Limits of Warren Buffett’s Freedom to Pounce: Justin Fox
• Powell’s Fed Set to Go Big on Inflation and Keep Going: Craig Torres
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
John Authers is a senior editor for markets. Before Bloomberg, he spent 29 years with the Financial Times, where he was head of the Lex Column and chief markets commentator. He is the author of “The Fearful Rise of Markets” and other books.
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