Whats next for stocks?

Market volatility has moved into nausea-inducing levels. The S&P 500 has fallen 16% year-to-date, and according to some experts, we’re on a slippery slope – and yet to reach the bottom.

Despite the stomach-flipping rollercoaster feeling, it’s important to remember that the market experiencing weeks of losses is not abnormal. Equity markets generally fall 10%-20% at least once a year, with a deeper, more sustained drawdown of over 20% in year few years.

As much as investors anticipate the inevitable plunges, when dips like this occur, it can feel worse than the last. But why does this time feel like it’s the big one?

There are a couple of factors to consider. Loss aversion in behavioural economics tell us that when it comes to investing, humans feel a loss twice as much as an equivalent gain – so market drops are never going to feel good.

The participation of crypto in this correction makes it feel a little different, and not like any other pullback.

And sentiments are significantly negative because, like so many corrections before, the convergence of risk creates the perception that there is only bad news: the Federal Reserve is raising rates, inflationary pressures and geopolitical tensions are building. COVID-19 is making a comeback and the global economy is quaking in its boots.

Individually each one of these factors provides a bit of downside pressure but combined, they make a perfect storm.

The good news is that most of the downside risk has already played out in stocks. Potentially the most prominent factor was the Fed's reaction to rising inflation in the US, which is running significantly hotter than the stated inflation policy objective of 2%. In fact, it’s sitting at four-decade highs. This has forced Powell to change the Fed's approach to monetary policy: the sun has set on the days of unlimited loose cash.

Since March, the Fed has raised the fund rates 75bp, with the market pricing another 200bp of tightening by the end of the year. This shift in official rates has led to valuation repricing and a sharp pivot from growth to value investments.

The move of stocks with high-implied growth rates into stocks with low growth rates covers up the real pain that investors feel as high-flying tech stocks, which have been the backbone of the historic bull market, are down more than 30%.

The big question is, with all these contributing factors swirling around, how will the global economic backdrop survive?

According to the market, the second scenario is a deflationary recession, where monetary tightening reduces demand and growth, helping inflationary pressure drop.

Both scenarios one & two have already been priced in the market. They suggest that stocks have a reasonable risk to reward profile at the current price. However, there is a lower but still relevant scenario.

Finally, the most negative outcome is stagflations or inflationary recession. And this scenario is the one that the market is the least prepared for. Recent revaluation has focused on the "P" in Price and Earning (P/E Ratio) for stocks. The higher interest rates forced investors to reconsider the price of risk (hence the fall in stock prices). However, if we shift to a stagflation environment, the weak economic backdrop means earning expectations need to be reviewed. So far, the expectation is that company's earnings will remains strong. However, companies will suffer if the consumer faces a recessionary environment plus inflationary costs that cant be passed on. This is not good news for stocks.