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Why are stocks falling and how far could they go?

What’s the betting that Neil Woodford arrived at work this morning with a little extra spring in his step?

Why are stocks falling and how far could they go?

What’s the betting that Neil Woodford arrived at work this morning with a little extra spring in his step?

At the end of January he confidently predicted that runaway momentum - which had driven the second longest S&P500 bull market of all time and the price of US equity to a pitch-perfect 19.9 times expected earnings – would soon trip over the challenge of sky high stock valuations.

Two weeks later and the Dow yesterday experienced the largest day’s nominal points drop in its history (although in percentage terms the 4.6% loss doesn’t even break into the top 10 day falls).

That rapid plunge in confidence has very quickly spread to global stock exchanges although, to again contextualise that, many have only fallen back to valuations that were record highs just a few short months ago. While a shock, it is hardly a historically significant level of value destruction.

Bears such as Woodford have been sceptical of equity valuations, which in the case of the US have not traded near its historical median valuation for almost a decade, for years, however. So why now?

The answer appears to be increasing jitters about the cost of borrowing, and how much US corporates have to pay to service the $8.7 trillion (£6.2 trillion) they owe.

The yield on benchmark US 10-year Treasuries climbed from 2.6% in mid-January to a four year high of 2.85% at the end of last week, before falling back to 2.72%.  The longest dated, 30-year debt has moved out by a similar amount.  

Credit markets remain comparatively well behaved however, indicating that bond buyers remain intensely relaxed about the solvency of their investments.

But the higher return available on low risk US government bonds – and the expectation that those returns could beat expectations if the Federal Reserve has to increase interest rates more than the previously expected three times this year - has reduced the attractiveness of riskier stock markets.  

People have started taking more aggressive bets that the Fed will have to act since wage growth rose to a multi-year high of 3% in January, as the country as a whole saw unemployment fall to a 17-year low and 18 states lifted their regulated minimum wage levels.

The huge and immediate deficit-funded sugar rush of the Trump corporate tax cut, at a time when the economy does not have much spare capacity it can use to ease the pressure, has also made some nervous.   

How serious could it get?

Corporate earnings globally are expected to grow an extremely healthy 13.4% in 2018 according to analysts tracked by Reuters, and the spread between the highest and lowest individual earning global stock markets remains unusually low: most major countries are expected to report above or near double digit earning growth.

The most recent Fulcrum nowcasts on the state of the global economy suggest output growth remains fundamentally healthy, consistent with global growth of 4.5% a year, more than a percentage point above historical trend. Inflation remains modest and contained: these are not normally the ingredients which make up a sustained and deep sell off.

Bears such as Woodford see this as complacent however. They point out that anyone who has bought stock markets at their recent sky-high valuations can mathematically only expect a marginal return over any foreseeable horizon.

The risk to equity investors is that with less cheap debt to fund them, more and more people might find this persuasive.     

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Neil Woodford
Neil Woodford Average Total Return:
91/91 in Equity - UK Equity Income (Performance over 3 years)

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