Preparing for the next bull market

The stock markets have seen a sweet and wide-ranging rally. The earnings season has got off to a promising start, with heavyweights such as Nokia and Nordea or Ericsson still publishing their results this week. The bulk of the results will be published this week and next, after which we will have a better picture of how companies are performing. 

In this post, I’ll briefly discuss the latest inflation data and go fishing for stock market bottoms again. Then I’ll take a quick look at the results of major American banks and finally we start preparing for the next bull market. It's headlined by different firms than the previous one, and it may well be a bit more inflationary than usual.

Due to the busy earnings season, the next post will be published next Tuesday.

Inflation is running hot

Last week's inflation data in the US was a talking point in the market. At the headline level, inflation surged, with core inflation rising by almost 7% year-on-year. Month-on-month inflation accelerated to 0.4%. In times of high inflation, we would like to see monthly inflation in particular cool down. Services inflation is accelerating the most, as you can see from this graph. And that’s problematic because services inflation is stickier in nature, i.e., it changes slowly.

 
But the figures can be interpreted in many ways. Housing costs are a third of the CPI basket and are counted as part of services. However, it is difficult to measure the development of housing prices, i.e., rents, so they are less frequently surveyed. That's why inflation figures now show practically months of old data, amplifying it.

BCA Research's Peter Berezin pointed out on Twitter that rental indices have been falling for some time. Without food and rents, inflation would have been only 0.1% per month, he calculated.

At the time of writing, the Cleveland Fed's inflation gauge shows that October core inflation would also be close to 7% year-on-year. Although inflation appears to have peaked, it will take some time for it to subside from these levels.

 

Gone bottom fishing, again

The favorite topic in the investment debate is bottom fishing. It has continued to be a hot topic even though the best money is made by HODLing good companies over time, and don't need perfect timing for that.

Last week's sudden ups and downs in the market are relatively rare and have often occurred close to the bottom. The S&P 500 index was down 2% after the inflation figures but closed at +2% on Thursday night. That hasn't happened many times, as this graph shows. However, these have also happened quite close to the peaks.



This graph shows the times when the S&P 500 index has risen more than 5% from 52-week lows. That has only happened a few times in the last 15 years.

 

Or this graph from Bloomberg shows how options volume has exploded through the roof, which has coincided well with the bottoms of recent years.

 
These are funny signals that you don't see often, although I wouldn't reverse mortgage the house based on just these. And you can come up with endless metrics. If the stars aren't aligning in a desired fashion, you look for other stars in the sky and the next thing you know is that you're practicing astrology of investing.

For example, in this Bank of America super-messy graph, there are different signals that usually coincide with the bottoms. Only a few boxes have been ticked. As I have stressed before, I would rather focus on picking good companies at a cheap price than on when the big indices do or do not hit the bottom.



A peek into the economic arteries

The modern economy runs on credit. Banks are the arteries of the economy. Therefore, the banking sector's earnings season is an interesting period to watch for the investor.

The major US banks that have reported so far include JP Morgan, Citibank, Wells Fargo and Bank of America. The common message from the banks is that consumers enjoy credit and that the fall in purchasing power isn’t visible as lower consumption. Many also still have accounts full of cash saved during the pandemic.

Banks are bracing for cooler times, but so far the US, the world's economic powerhouse, seems resilient in the face of difficulties. On one hand, banks' results are weighed down by a fall in the stock market and a slowdown in big deals, but on the other one, they are boosted by rising interest rates.

This year, bank shares have tumbled: on average, the share prices of major US banks have lost around a third of their value.



You would think a rise in interest rates would hit the US economy hard. For example, a 30-year mortgage is now available at 7% interest. However, it’s worth keeping in mind that most American mortgages are fixed-rate mortgages. For most of those who have a loan at all, it has been acquired at a lower interest rate. Former Bridgewater investment boss Bob Elliot calculated that at current interest rates, household interest payments relative to income would rise to just over 10%, which is still historically low as you can see from the graph. Thus, the rise in interest rates isn’t immediately taking the best bite out of the economy. On the other hand, banks are enjoying interest income and so far, low loan losses. Businesses and the federal government should also be able to take higher interest rates in their stride.

 

Preparing for the next bull market

Bear markets don't last forever and when stocks are getting cheaper, it's a good time to think about how to position your chips for a new boom.

The dominant theme of the last decade was anemic economic growth, low inflation and, as a result, even negative interest rates. The next decade could look quite the opposite: a tidal wave of investment, high inflation and higher interest rates.

This scenario has been argued by market strategist Russell Napier. Before that, he highlighted the deflationary forces in the global economy, but he made a U-turn on inflation two years ago. So yeah, this guy has been on the right track. Here’s a link to his recent interview which I refer to in this post.

The key to sustainably higher inflation is that governments have, as it were, robbed central banks of the right to print money. This often-used metaphor is confusing, so I’ll try to explain it.

The central bank can’t print money in the sense that the money would go to the so-called real economy. After all, the central bank can’t force any person, company or state to borrow. It can spew so-called reserves into the banking system, but it’s not the same as the money we everyday people use for living.

By borrowing money from an ordinary bank and funneling it into consumption or investment, governments, consumers and businesses are real money creators in the real world. Even a commercial bank can't just throw notes down the street, but a real economic agent has to lend and spend so the money can circulate. So, in a sense and by only slightly cutting corners: if anyone is a printer, it's the ordinary borrower and the commercial bank in collusion.

Metaphorically speaking, the central bank only prints money if it directly finances government spending, but that isn’t technically the case.

Central banks can’t put the brakes on money creation while state-backed banks lend what they can. In the United States, for example, bank balance sheets are ballooning like crazy.

In the COVID crisis, governments guaranteed loans, so banks don’t have to fear terrible credit losses. Thus, the inflationary process of money creation continues apace. In principle, governments can control lending through guarantees or regulation. For example, by favoring green investments. This graph, in turn, shows the ratio of bank guarantees to GDP in different European countries.

 
The COVID pandemic has been followed by the energy crisis and the war in Ukraine, encouraging governments to support households and businesses. The central bank is trying to fight back by raising interest rates, but in practice its prescriptions for achieving the 2% inflation target go against the needs of governments, most households and businesses.

In addition to angry voters with electricity bills, governments have a high debt burden to worry about. There are many ways to deal with the debt, but the politically easier way is to inflate the debt away. Debt is often compared to GDP. In nominal terms, GDP and tax revenues can grow in tandem even with rapid inflation. At the same time, the nominal value of the debt remains the same, making it easier for the government to absorb even a large debt burden.

Napier thinks that an inflation rate of 4-6% would be enough, as it’s not too high to enrage savers. In a way, inflation is a transfer of income from savers and the elderly to younger, money-spending rascals.

Central banks may bark, but in the end they are toothless if the state, households and businesses aren’t working towards a common goal. It’s difficult for the central bank to fight against politicians elected by the people. Napier argues that we are rather entering an era of economic repression, where savers are being squeezed and debtors are being eased by depressing interest rates and fueling appropriate inflation.

Despite inflation, we have huge investment needs in the West. Climate change should be tackled by going green, which isn’t exactly free. Against Russia and China, we need to invest more in defense. Industry must be brought back from China to Europe and the United States.

In practice, we are facing a huge investment boom that will fuel economic growth and inflation.

For savers used to low inflation and interest rates, the Napier scenario may sound terrible at first, but on reflection it has the makings of a juicy bull market.

High inflation will not hurt equities if it becomes predictable.

Stocks fall at the beginning of an inflation storm as they adjust to the new environment. As valuation multiples have adjusted to higher interest rates and inflation, investors are better able to price in earnings growth. And that should continue apace if nominal economic growth remains strong. And why not continue if economies are moving back to a more state-led model. Below is shown forward P/E ratio for SP500, which has adjusted downwards while inflation is galloping.

Investment, climate change, defense and the re-industrialization of the West also mean opportunities for listed companies. According to Napier, those businesses that are well positioned for the investment boom will benefit.

This argument is distantly reminiscent of Spotify CEO Daniel Ek's comment that climate change and other problems of today aren’t only solved by software in the world of bits, but by atoms in the physical world. Thus, it may well be that the more traditional machineries, the arms industry, the energy sector, companies working on the energy transition and other companies in the physical world will be the winners in the next boom.

To my ears, the scenario Napier refers to seems like a realistic, somewhat provocative possibility.

However, this will require central banks to eventually back down in the face of political pressure to tighten monetary policy. And that’s not for certain. Secondly, although I mentioned the winning industries that he came up with, I think you can find them all over the place. Each sector always has profitable businesses.

The investment deficit is mainly in the West, while China, for example, is suffering from over-investment.

It’s also unclear whether politicians will eventually find the will to support such massive investments, or whether there will be a lot of misses. Climate change, however, is a problem that must be solved.

This is vaguely reminiscent of the basic ingredients of the bull market during the 1940s through the 1960s, when Europe had to be rebuilt after the war and inflation was rampant.



Stocks were doing just fine then, until finally the state-led economy ran into stagflation in its inefficiency.

But that scenario is still some way off.

Thank you for reading the post! Read analysis and make good stock picks!