Tom Stevenson

“After months of policy turbulence and market swings, investors are pausing for breath. The August lull has come early, but shares are holding onto their rally since the April low.

The six-month scorecard

“Shares peaked in February before tumbling on the announcement of swingeing tariffs in April, which threaten to push the average import levy to its highest level in over a century. But markets have rebounded strongly: the S&P 500 is at a new all-time high around 6,300, and the FTSE 100 is flirting with a close above 9,000.

“Elsewhere, the US dollar is having its worst year since 1973 as concerns grow over the sustainability of the US budget deficit, economic policies, and pressure on the Federal Reserve’s independence. The so-called Big Beautiful Bill may deliver short-term growth, but long-term debt risks loom.

What’s driving shares higher?

“An unexpected feature of the current rally – now stronger even than the surges in 1998 and 2018, after similar market corrections – is the fact that once again earnings growth is being boosted by rising valuation multiples.

“A higher price-earnings ratio has pushed the US market 6% higher by itself, while earnings have added another 8% or so. Throw in a couple of percentage points of dividend income, and shares have enjoyed another mid-teens return year to date. That’s remarkable after the strong 20%+ rallies in 2023 and 2024.

“And it’s not just a US story. Wall Street is no longer the only game in town, with the falling dollar boosting emerging markets, and both Europe and the UK back in favour.

Earnings season

“It’s early days yet, but with around 60 of the biggest 500 US companies having declared results in the second quarter season, more than 80% of them are beating expectations. That’s not unusual – companies tend to massage forecasts lower in the run up to results season. But it does suggest that earnings growth will continue at around the long-run average of 7%.

“This week sees a wide range of companies reporting. Highlights will include Alphabet and Tesla. Tech stocks have been a key driver of the recent rally, with both Microsoft and Nvidia back into record share price territory and Alphabet and Apple well off their spring lows.

Also on the radar this week

“The Japanese market is closed today but it will be in focus this week following another bad loss for the previously dominant Liberal Democrats in the weekend’s Upper House elections. For the first time since its founding in 1955 the party has lost its majorities in both houses of parliament, amid a shift to the right that will look familiar in many other countries around the world.

“In Europe, the main event will be the latest rates announcement from the European Central Bank, although no change looks like the most likely outcome after a year of sharp cuts in the cost of borrowing. Unlike the Fed or the Bank of England, the ECB has halved interest rates to just 2% and it looks likely to pause for breath, with just one more cut pencilled in for later in the year.”

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Tom Stevenson

The price of gold exceeded US$2,900 an ounce last week for the first time. Since October 2023, it has risen by more than US$1,000 an ounce. The price is three times higher than it was a decade ago. It has grown ten-fold since 2000. What is going on, where does it go from here and how best to invest?

Gold should not really be this high. Traditionally, the precious metal performs badly when interest rates rise. That is because, unlike bonds, shares, cash, or property, it does not pay investors an income. When the yields on those other assets are attractive, there is less incentive to hold ‘the barbarous relic’ as the economist John Maynard Keynes called gold. That is the case today, but still gold is hitting new records.

The gold price should also prefer a weak dollar. The metal is denominated in the US currency. When other currencies are strong versus the dollar, they can buy more gold. When they are weak against the greenback, they can buy less, and so the price should fall. Today’s Trump-fuelled strong dollar should be a headwind for the gold price. Clearly, it is not.

So, the performance of gold is telling us something else. The message it sends is that all is not well with the world. It says that investors are worried, and history shows that it is unwise to ignore the signals that gold sends at times of stress.

In the run-up to the financial crisis, for example, the S&P 500 rose strongly between the bottom of the dot.com bust in 2003 and the end of 2007. It nearly doubled in value in less than four years. But, over that period, it underperformed the gold price by around 40%. Gold investors did not trust what the stock market was telling them. And they were right.

So, why is gold so strong today? Several reasons. The first is gold’s perceived safe-haven qualities when the world looks uncertain. The election of Donald Trump has massively increased the unpredictability of US policy, on many fronts but notably on trade and tariffs. At the same time, gold is a hedge against inflation. Many Trump policies, not just tariffs, are likely to be inflationary. It is a perfect storm for gold.

Uncertainty goes right to the top. Central banks around the world are also hedging their bets. Ever since the invasion of Ukraine, and the sanctions that followed, countries such as Russia, China, India, and Turkey have been increasing their purchases of gold, in a bid to reduce their exposure to the US dollar. Gold has long been a store of value and a diversifier, without the credit risk associated with paper currency reserves. Central bank purchases exceeded 1,000 tonnes for the third year in a row in 2024.

Adding fuel to the fire last month was DeepSeek’s announcement that it could outperform OpenAI’s ChatGPT, at lower cost. At a stroke, this cast doubt on Silicon Valley’s assumed dominance in artificial intelligence. And with it, the fragile valuation of that crucial driver of the US stock market’s outperformance. Investors have accelerated their search for safer places to invest their money. Once again, gold has ticked the box.

One further reason to like gold is its growing use in a range of key industries of the future. This has never really been a key part of the case for gold because, at just 6 per cent of demand for the metal, industrial applications have been much less significant than jewellery (50 per cent), investment (23 per cent) and central bank buying (21 per cent). But its uses in nanotechnology, electronics, even the fight against malaria, mean this source of demand is growing.

With the price having moved so far, so fast, however, investors are right to question whether the gold ship has already sailed. Historically, the gold price moves in steps, rising rapidly and then consolidating or falling, often for many years. Might there be a better way to hedge against the uncertain outlook?

One that is receiving some attention now is gold’s less fashionable counterpart, silver. The two are similar – both precious metals, historically used as currencies – but they are also very different. More than half of the annual demand for silver comes from industrial uses, in myriad electronics applications – notably renewable energy, AI, and defence. Also, in the chemicals industry and in medical equipment – bacteria will not grow on silver. But, as with gold, macro drivers such as inflation and interest rates, geo-political stress, and policy shifts are an influence on the silver price.

There is around fifteen times as much silver under the ground as gold. And for many years, that simple equation governed the ratio of the two prices. More recently, however, the relationship between the two has changed dramatically. Today, the gold price is one hundred times that of silver. The preference for gold as a risk management tool justifies this in part, but it does not recognise the growing deficit between supply of and demand for silver. The price differential has widened significantly in the past decade. The traditional correlation between the two metals has broken down and gold looks overvalued compared to silver, which remains well below its recent peak.

There are only two sensible ways to invest in both gold and silver. Holding the physical metals is expensive, risky, and impractical. It is much easier to invest via an exchange-traded fund holding the metals themselves. Or by investing in the mining companies that dig the metals out of the ground. In theory this is a leveraged play on the price, but in practice the link between miners’ shares and the underlying commodity price is loose. A small holding of both metals, via a fund, could be considered a good approach.

By Tom Stevenson, investment director.

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Tom Stevenson

If we were playing golf, we’d be taking a break at the Halfway House. So, as we head towards the end of June, it’s time to sit down with a metaphorical cup of tea and a Mars bar to assess how the first few holes have gone and how we might approach the back nine.

The investment course has been kind to us so far in 2024. But there are some tricky holes ahead and achieving a decent score by the end of the year will require us to address three questions.

First up is the politics in this Year of the Election. There have already been some surprises (India, Mexico, France), and it’s all still to play for in the UK and in America. The vote that matters more is in the US. Question one, then, is who will win the US election and how will the market respond?

Neither candidate is popular. But it’s close and the fate of Presidents seeking re-election since Ronald Reagan has been heavily influenced by macro trends in the months leading up to the vote. Consumption growth, employment data, inflation and GDP are the indicators to watch.

It is worth remembering that elections affect sentiment in the short term, but, as we learned in 2016, they tell us less about the longer-run direction of the stock market.

This year was also expected to be the Year of the Interest Rate Pivot and I expect monetary policy to be a bigger driver than politics. While some countries or regions have started the process of cutting interest rates (the Eurozone is the most consequential so far), others have still not begun. The US is holding fire – and for good reason. The American economy remains stronger than expected at the start of 2024 and a cut in the cost of borrowing is hard to justify. The second key question is, therefore: will US interest rates start to fall this year and how far?

Interest rates likely to stay higher for longer than we hoped six months ago. It’s not clear where the neutral rate lies (not too hot, not too cold), but wherever the end point is it will take some time to get there. We are unlikely to get more than one rate cut in the US before the end of the year. Remember, the market was expecting six quarter point cuts at the start of 2024.

That might be better for share prices than it looks because the incentive to seek other homes for your money is less today than it was. Yes, you can expect to beat inflation with the income you can earn on a Treasury, or even cash. But the price you pay for that certainty of income is a lack of capital growth. And if inflation stays persistently higher than target, you will need some growth to keep your head above water in real terms.

Question three focuses on market leadership. Five stocks have accounted for 60% of the S&P 500 Index (Index)’s year to date return. Microsoft, Nvidia, Alphabet, Amazon and Meta have risen by a collective 45% and now comprise a quarter of the value of the whole Index. That’s been justified by earnings growth – up 84% in the first quarter, year on year, compared with 5% for the average stock in the US benchmark.

Profit forecasts for those five shares in 2024 have risen by 38% while those for the other 495 stocks in the Index have fallen. But the gap is forecast to narrow, according to Goldman Sachs. Next year the Fab Five will grow their earnings by 19% versus 11% for the average stock. In 2026 it’s 13% against 9%. This matters because the headline Index trades on 21 times expected earnings while the equal weighted index is valued at just 16 times. If the gap between the two narrows because the expensive market leaders get cheaper (rather than the rest of the market catching up with them) then the second half of 2024 could be hard work.

As we gather our thoughts in the Halfway House, we can look back on a positive start. The best performing stock markets in America and Japan have delivered between 15-20% in the first six months alone. The second tier – UK, Europe, emerging markets – have already secured a decent 6% or 7%. Even China is back in positive territory. Copper, oil and gold have all provided investors with a double-digit return. Even the laggards – property and government bonds – have not really lost you any money this year.

So, it’s been a tidy front nine. The investment equivalent of a couple of birdies and a string of pars. But, as any golfer will know, things can change dramatically at the turn. A change of leadership could alter the valuation arithmetic of the market. Higher-for-longer interest rates could be the sign of an economy in good health but also the precursor of a nasty slowdown. The aftermath of elections on either side of the Atlantic may be volatile. It’s not over until your card is signed and submitted.

By Tom Stevenson

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Tom Stevenson

Only a few weeks ago, a key question for investors was: ‘have I still got time to buy into the Magnificent 7?’ Fear of passing up the stellar returns delivered by America’s leading tech stocks was palpable. Now we’re all asking: ‘is it time to sell?’. Not fear of missing out, just plain old fear.

It’s not hard to see why the FOMO should have kicked in. In the five years to the recent peak in March, even the worst performer of the seven, Amazon, had nearly doubled an investor’s money. The best, Nvidia, had increased a well-timed investment 20-fold. Apple, Alphabet, Microsoft and Meta had trebled an investment made just before the pandemic. Tesla had turned $100 into $1000 over the same period.

Last year, these seven stocks more than doubled while the remaining 493 companies in the S&P 500 gained just 12.5%. The top seven companies delivered about 60% of the index’s 26% return for the year. And the fever continued through the first quarter of this year, as Nvidia added another 90% to the 240% it had chalked up in 2023. No wonder US technology funds took in more than US$5bn in the first two months of this year.

It’s just as easy to see why investors have now started to question their enthusiasm. Over the past month, only Alphabet has made any progress at all. The other six have all lost money for investors. Tesla and Nvidia have both shed more than 15% of their value in a few weeks. Tech stocks marched the US market up to the top of the hill. Now they are leading it down again.

When markets get frothy, I look out for the ‘tell’ – the sign that something is wrong. During the dot.com bubble my lightbulb moment was when a so-called incubator fund – essentially a pile of cash waiting to be invested in internet stocks – traded at a multiple of the money investors had put up.

When it costs you $5 to buy a dollar, you don’t have to be Warren Buffett to spot the red flag.

The tell this time around was when I heard that a highly regarded US fund manager had tweaked the position limits within his fund to allow him to buy more of the best-performing stocks. Active managers have struggled to keep up with the US market in recent years because they have not been able to hold enough of the handful of big shares required to match the market. That’s hard to accept when you are judged by your relative performance, but it is a poor reason to change the rules.

A second sign of potentially excessive exuberance is the coining of the magnificent moniker itself. We’ve been here before. Back in the early 1970s, a set of one-decision, buy-and-hold stocks was labelled the Nifty Fifty. These were high quality companies – the likes of Coca Cola and Xerox – which were growing their profits fast, supported by strong balance sheets and great brands. It was a difficult time for the US economy and investors craved the security these companies seemed to offer. Which all sounds very familiar.

The Nifty Fifty craze did not end well. But the parallels are not exact. We need to look at two things – how fast and sustainably the companies are growing, and how much investors are paying for a slice of the action. The two are related. It does not take too many years of above-average growth to justify even an apparently high valuation. Sometimes it is worth paying up.

This theory was tested to destruction by the Nifty Fifty. In 1972 the average stock in this group traded on a multiple of nearly 50 times the previous year’s earnings. That valuation was 2.5 times higher than that of the rest of the market. And it made the Nifty Fifty vulnerable when things turned down. The shares fell more than the rest of the S&P 500 in the 1974 market crash, and then they recovered more slowly.

This week, four of the Magnificent 7 will lift the lid on their latest quarterly profits. Ignoring Tesla (which arguably shouldn’t be in this AI-focused group anyway), the numbers from Meta, Microsoft and Alphabet are expected to be strong, perhaps 40% ahead of last year on average. I suspect they will be good enough to justify a valuation premium which is still modest by comparison with that enjoyed by the Nifty Fifty. The Magnificent 7’s performance in recent years is only partly about rising valuations. It has been justified by superior earnings growth too.

So, I don’t think the fundamentals are enough to derail the Super Six or whatever we end up calling them. What might, however, is the other big story in investment at the moment – the realisation by investors that interest rates are likely to stay higher for longer, in the US at least. The abandonment of the belief that interest rates would fall quickly from the middle of last year is particularly bad news for high-growth companies.

Much of their value derives from the profits they will earn in future years. These as-yet-unearned profits are worth less to an investor today if inflation and interest rates remain high. I might pay 80 cents for the promise of a dollar in ten years’ time if I expect inflation of 2% a year but only 60 cents if prices are forecast to rise at 5% a year. In both cases my real purchasing power will be the same a decade from now.

That’s the main reason that the Magnificent 7 have paused for breath. The growth is still there; these are great companies, with the benefit of size and first mover advantage. It’s just that the future is more uncertain than we thought. And, quite rightly, that reduces how much we will pay to jump aboard.

By Tom Stevenson, investment director

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Tom Stevenson

History does not repeat, but it rhymes. I was reminded of this truism recently when I compared the recent stock market performance of Nvidia with that of Cisco Systems in the two years leading up to the bursting of the dot.com bubble in 2000. The similarity of the two charts is striking.

In both cases, the share price trebled in a matter of a few months, then paused for breath for a few months more before turning left up the page as the fear of missing out sucked in the doubters. Nvidia had risen by more than 50 percent since the start of the year before this week’s wobble. Both companies’ shares increased seven-fold in less than two years. Nvidia remains close to its all-time high, and what happens next is one of the most important questions in investment right now.

In the case of Cisco, however, we have the benefit of hindsight. We now know that in the two years after its share price peaked it fell all the way back to where it started. Between March 2000 and September 2001, Cisco’s shares tumbled from US$78 to US$11, a loss of 86pc for anyone who had bought at the peak. It has taken a generation for enough of those who lived through the bursting of the last bubble to retire and make way for a new group of converts.

The echoes of 1999 are all around us, although there are some important differences too. The similarities include a narrow market leadership – the so-called Magnificent Seven group of leading tech shares that includes Nvidia accounts for around half of the S&P 500’s gains so far in 2024. Collectively, the companies represent a quarter of the value of the US stock market. The market 25 years ago was similarly dominated by a handful of internet-related stocks, including Cisco.

Then as now, investors fixated on the power of the new. In the late 1990s it was the internet that was going to change everything. Today it is artificial intelligence (AI). In both periods, valuations of companies expected to benefit from the perceived paradigm shift diverged from those of the also-rans operating in the ‘old economy’. It is very likely that in due course today’s AI bubble will go the same way as 1999’s technology, media and telecoms (TMT) boom. But waiting for that to happen will be hard. Watching from the side lines could be quite as painful as missing out on the final stages of the dot.com bubble.

A bubble is a speculative frenzy, usually driven by the promise of an economic and financial revolution, in which share prices massively exceed the underlying value of the companies that issued them. It is not just about overvaluation. It requires the abandonment of tried and tested fundamentals, a loss of reason. It is a mania that appears regularly but infrequently. A quarter of a century on, we are probably due one.

How does the current situation measure up on five key indicators of a nascent bubble? The first sign – the widespread adoption of a ‘new economy’ story – looks to be in place. The potential for AI to change the world is unproven but you would be hard pushed to find many people who don’t think it matters. Most of us are enthralled and scared by AI in equal measure.

Related to this revolution narrative is a generational divide that drives a wedge between old guys like me who ‘don’t get it’ and young believers who do. Many of us have already had a taste of this via heated dinner-table debates over the merits of investing in bitcoin. The mantra that ‘it’s different this time’ famously links the four most dangerous words in investment.

In order to justify the ‘now is different’ argument, true believers need to invalidate the valuation framework into which old-style sceptics retreat. The easiest way to do this is to invent a new set of metrics that fit the bullish case better. In the dot.com bubble, we were told to dispense with outdated measures like price-to-earnings ratios and look instead at price-to-clicks or ‘eyeballs’. I recently came across a new expression: ‘price to innovation’. Alarm bells quickly rang.

A fourth indicator that trouble is brewing is when prices continue to rise even when news flow turns negative. When investors become selectively deaf, you can be sure a bubble is inflating. The recent fourth quarter results announcements from the Magnificent Seven were a mixed bag. Investors are choosing to see what they want to. Another potential red flag.

A final sign that we may be in a bubble is when investors, flush with their stock market gains, look for opportunities in other risky assets. Watch out for new asset classes to emerge, usually investments that offer no cash flows or asset backing but which rely on the ‘greater fool theory’ that someone else will pay an even higher price than you. The 1980s bubble in Japan was characterised by this contagion from stocks to property then impressionist art and golf club memberships.

Spotting a nascent bubble is one thing. Navigating it is another. The easiest, and most psychologically painful, approach is to stand back and let others enjoy the ride. Good luck with that. Resisting the temptation to join in the final stages of a bubble is near impossible.

I think that if we are in a bubble, it is still young. The valuation premium is well short of the level reached in 1999 or even in the early 1970s when the most popular shares were priced nearly twice as expensively as the rest of the pack. We are a long way off that today. Sentiment is not yet universally positive. When it becomes so, it will be time to worry. We’re not there yet.

By Tom Stevenson, investment director

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Tom Stevenson

Making predictions is hard, they say, especially when they are about the future. One of the many truisms attributed to baseball player and popular philosopher Yogi Berra, this pearl is front of mind for those of us on the hook for our market forecasts for the year ahead.

Guesswork about what the next 12 months holds is fun but it bears little relation to what investors actually do. As my old friend Jim Slater once said about the importance of acting on your convictions: ‘the difference is that I did it.’ Anyone can have an opinion about the future direction of markets, but whenever you make an investment, you have to do so without the benefit of hindsight.

That’s the context for the decision by my investment colleagues at Fidelity to dispense with the usual Outlook circus this year and instead indulge in some scenario analysis. Without the benefit of a crystal ball, thinking through possible outcomes and assigning probabilities to them is all an investor can do. Anything else is just putting your finger in the air.

This year feels like a particularly difficult time to make predictions. But, in reality, it always has been. Yes, there is uncertainty about the future path of inflation, about when and how quickly interest rates will start to fall again, how things will evolve in Ukraine and Gaza, or who will emerge victorious from the many elections that 2024 will bring. But we are always looking through fog at the start of a year, just as we are at every other point in the calendar.

Let’s start with what we know. We have lived through a couple of years in which central banks have raised the cost of borrowing at an unprecedented rate. The rapid tightening of monetary policy since the start of 2022 has been an experiment, the outcome of which will only become clear in the months ahead.

The first signs of the impact of rising interest rates are starting to show. Inflation has rolled over and, while it is higher than we would like it to be, it is heading back towards target. Related to that, economic growth is slowing, even if economies have been more resilient to the rising cost of borrowing than many people expected.

So, three of the likely scenarios for the year ahead are variations on a theme: a continued fall in inflation, a deceleration in economic growth and consequently lower interest rates. For completeness, there is a fourth possibility: that the economy just keeps growing, inflation stays high and so too does the cost of borrowing.

The scenario that the market is currently pricing as most likely is the ‘soft landing’. Achieving this would be a rare triumph for policy-makers – overcoming inflation without simultaneously pushing the economy into a recession. It doesn’t often happen this way, so investors are betting on those four most dangerous words: this time is different.

Navigating a path to a soft landing would be good news for investors but we only attach a 20pc probability to this. It would give a boost to the majority of shares which have not bounced back much since the market low in October 2022 and can still be bought on reasonable valuations. Government bonds would also look attractive because victory over inflation would allow central banks to start to reverse the last two years’ monetary tightening. At the same time riskier corporate bonds would benefit from an improving business outlook. Parts of the property sector, such as the logistics warehouses that support online shopping, could do well.

Even less likely, we think, but nonetheless possible, are the two extreme outcomes: a deep and painful ‘balance sheet recession’ that triggers widespread cutbacks in spending by both companies and households; and a so-called ‘no landing’ in which growth continues, inflation remains sticky and central banks push interest rates even higher for even longer. We think there’s just a one in ten chance of each of these.

The hard landing of a deep recession would be bad for most risk assets like shares and corporate bonds. Investors would need to seek out safe havens like the US dollar, gold and government bonds. Within the stock market, defensive sectors like utilities and healthcare would do relatively better but probably not well in absolute terms. The winners in a no-landing scenario would be mid-cap companies that would benefit from increased demand and which haven’t yet seen a recovery in valuations. Commodities could do well too.

Add up the percentages so far and you can see that the remaining outcome, a mild recession, comes with a 60pc probability. A cyclical recession is our base case. It would involve inflation remaining higher for longer before being dragged down by a moderate economic contraction followed by recovery at the end of next year or early in 2025.

Because the market is currently pricing a softer landing than this, earnings forecasts are probably a bit too high which means that investors should look at cheaper markets where more bad news is already expected. Europe and Japan fit the bill on this front. It’s probably not the best scenario for the UK, which has a weighting towards cyclical sectors like energy and mining and financials. As with the no-landing scenario, a mild recession might favour mid-cap stocks that have so far missed out on 2023’s ‘priced for perfection’ rally but are big enough to have some resilience during a downturn.

Setting out four probability-weighted scenarios runs the risk of sitting on the fence – on the one hand X, on the other Y. But it does have the merit of honesty. No-one knows what the future holds, and investors need to approach their task with an open mind and a willingness to alter long-held beliefs as the facts change. As Yogi Berra also said: when you come to a fork in the road, take it.

By Tom Stevenson, investment director

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Tom Stevenson

When the S&P 500 index closed above 4,292 on 8 June, it cleared a significant hurdle. It might look like an arbitrary number, but it marks the point at which the US benchmark can plausibly claim to have put last year’s stock market slump behind it. This was the moment when the US’s blue chips had risen by 20pc from last October’s low point of 3,577, and by doing so had met the traditional definition of a bull market.

The measurement of bull markets is more art than science. On plenty of occasions, markets have enjoyed a rally of 20pc or more before reverting to their previous downward path. The stock market bear is a wily beast and enjoys pulling wishful thinkers into its embrace with this kind of sucker’s rally. This time around there are more reasons than ever to question whether this is the start of a sustainable bull market or another false dawn.

The most important of these is the lack of breadth in the last six months’ recovery. The S&P 500 may have risen by 13pc since the beginning of the year but almost all of that gain can be attributed to the performance of a handful of the index’s biggest companies, almost exclusively technology stocks which have soared on the back of investors’ new-found enthusiasm for all things artificial intelligence (AI).

The S&P 500 is market capitalisation-weighted, which means that the larger a company is the more influence it has on the overall level of the index. It is a reasonable way of looking at the market but at times like these, when there is a big divergence between the performance of large and smaller companies, and the leadership is so narrowly focused, it can also be misleading.

Another way of looking at the index is to give each company in it an equal weight. If you do this, the performance of the five largest companies in the index (Apple, Microsoft, Amazon, Nvidia and Alphabet) is no more influential than that of the smallest constituents (Advance Auto Parts, Lincoln National, Newell Brands, News Corp and Dish Network).

Look at the US market through this equal-weighted lens and the performance year to date is not 13pc but just 3pc. Since the low point on 12 October 2022, the equal-weighted index has risen not by 21pc but 14pc. Impressive, but still a way short of that traditional bull market definition.

So, as the headline index, but not the wider market, moves into bull market territory, investors face two key questions. First, is the recovery since October the real McCoy or just another bear market rally? Second, if we are at the start of a sustainable bull market, what is the best way of playing it?

To answer the first question, you will need to address three subsidiaries: what’s happening to corporate earnings; where next for interest rates; and is the rally broadening out from those AI-focused tech stocks?

The earnings picture is slowly turning more positive. Not so long ago, the expectation was that the economy was heading towards a recession. And that, historically, has led to a double-digit decline in earnings. Today, the consensus is for a much more modest fall in profits, perhaps only 4pc in 2023. Better still, next year is expected to deliver an earnings rebound of as much as 10pc.

At the start of the year, only around a quarter of companies were seeing an improvement in their earnings forecasts. Today, half of them are. Less bad is the first stop on the journey to good and this so-called second derivative is clearly heading in the right direction.

The interest rate question also looks to have a broadly positive answer. This week’s improvement in the US inflation picture gave the Fed cover to put its monetary tightening program on hold. And while next month might have one more hike in store, that is likely to be it for this cycle. With rates likely to peak at 5.5pc in July, the gap between inflation expectations and the cost of borrowing is historically wide. Central banks tend to stop when they have reached today’s level of positive real, inflation-adjusted interest rates.

The third question, on the breadth of the recovery, is the clue to how best to play the next phase of the cycle. For the bull market to be really sustainable it will need to broaden out from the tech stock leadership that has been the defining characteristic of the past six months. And there are early signs that this is happening.

An index of stocks that retail investors favour, monitored by Goldman Sachs, is breaking out from its recent sideways trading channel. At the same time, more investors questioned by the American Association of Individual Investors are positive on the market’s prospects than are negative, a reversal of the recent trend.

One last hurdle remains. Typically, bear market rallies run out of steam at or below the point where they have retraced 50pc of their most recent fall. A rally that breaks through this barrier usually goes on to become a sustainable bull market. Here the evidence is mixed. The S&P 500 index has clawed back 63pc of what it lost in 2022. But the equal weighted index is only 39pc of the way there.

That suggests one of two things. Either this is a bear market rally that has overstayed its welcome and the technology leaders might be hardest hit in the correction. Or the bull really does have legs, and the rest of the market has some catching up to do.

By Tom Stevenson, investment director

The post Investors should beware another false dawn appeared first on AdviserVoice.

Tom Stevenson

Is now the moment to get back into emerging markets (EM)? Six months ago, you might have laughed at the suggestion. Russia might have been written down to zero in your EM fund and Xi Jinping looked to be doubling down on a seemingly irrational Covid containment policy. Things look very different today as China opens up and the developed world flirts with a re-run of the 2008 credit crunch. Russia remains a pariah, but the hit has been taken.

The performance of EMs has been to say the least volatile. The MSCI EM index, expressed in dollars, is pretty much exactly where it was ten years ago. Along the way, it has been a rollercoaster ride. The index lost more than a quarter of its value in 2015. By February of 2021 it had nearly doubled from its pandemic low point but by last October’s Chinese Congress it had given back almost all of those gains. Over the following three months it added nearly 25pc. And breathe.

For a decade, EMs have played second fiddle to the in-vogue, technology-driven US market. While the developing world’s stock markets have gone sideways, with plenty of sleepless nights along the way, the US has soared. By its peak at the start of last year, the S&P 500 had trebled since 2013. As the US benchmark tumbled in the first nine months of last year, the EM index followed suit, only more so.

So, EM can be exhausting. We know that. But over longer periods are you compensated for the ups and downs? Potentially yes, to an extent, if you have the emotional grit to stick with it. If you had invested at the end of 2000, you would likely have enjoyed almost exactly the same return from the MSCI emerging markets index as from the S&P 500. And yes, I’m picking my time horizon to suit my argument, but you get the picture.

Perhaps unsurprisingly many investors have taken the view that similar returns with more volatility is not a great trade-off. Global portfolio managers might be expected to have about 12pc of their money invested in emerging markets on the basis of their weighting in the All-World index, but they actually have about 9pc. If you consider that China’s weighting in the global indices is artificially low because of the historically limited access to its shares for overseas investors, then the underweight is even more pronounced.

So, are investors right to be wary? Or does the last decade’s underperformance set us up, as it has from time to time in the past, for an extended period of outperformance. Is the last six months’ return to favour a flash in the pan on the back of China’s Covid U-turn, or the start of something more significant?

The first thing to understand is what you are getting when you invest in an EM fund. One that sticks to the weightings of the various countries captured by the EM indices, will likely have around three quarters of its money invested in just four countries: China is about a third of the MSCI emerging market index, Taiwan represents another 15pc, South Korea and India both contribute about 12pc each. Brazil is the largest of the rest at just 5pc.

So, not many countries but already you can see that it is quite hard to generalise about the kind of exposure you are buying into. There’s obviously a big consumption story but the five countries here are at very different stages of their development. Most of them are big commodity importers, one relies on exports. There may be a play on demand in the developed world, especially in the technology sectors.

The case for investing in EMs has three timescales. The long-term argument is one we are all familiar with. They account for: 70pc of the world’s population and half of its land mass; 40pc of its economic output; and 60pc of its growth. The difference between the growth rates in the emerging and developed worlds may have narrowed but it is still meaningful and sustainable. The low hanging fruit of moving large populations from rural subsistence to urban consumption may have been harvested but the transition from low to middle and higher incomes is ongoing with potential opportunities in sectors that target that growing middle class such as consumer finance, for example.

The second medium-term timescale reflects the transition from the post financial crisis era of US exceptionalism in which the expansion of America’s technology sector allowed Wall Street to flourish while the rest of the world struggled with sluggish growth. With profit margins at unsustainably high levels, sky-high debts and a weakening currency, the US looks to be running out of road versus an emerging world with more sustainable borrowings, healthier current accounts, further advanced in its inflation-fighting monetary cycle and with better demographics.

And then there’s the short-term case, which has two principal drivers: the re-opening of China and the yawning gap between stock market valuations in the US and in emerging markets. The recent rally in response to the improving backdrop in China has barely made a dent in the differential between emerging markets on around 12 times expected earnings (even accounting for India’s much higher rating) and the US on 18.

This, in my view, leaves just two questions. How to invest and how much?

By Tom Stevenson, investment director.

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Tom Stevenson

For a couple of reasons, the recent publication of the Credit Suisse Global Investment Returns Yearbook had me thinking about my kids. The first is personal. The report’s launch was hosted as usual by the bank’s research director who I first met after the birth of our daughters nearly 30 years ago. That’s only around a quarter of the 123 years now covered by this unmatched guide to the financial markets, but it’s long enough to have seen a few ups and downs and for both of us to have gained a few grey hairs.

The second reason is that one of the report’s focuses this year is on what we might expect from financial markets in the future. When your children reach their twenties and pick up the work and investment baton from you, it is natural to wonder how their experience of the markets will compare with your own. And seeing the markets through their fresh eyes puts those past three decades into perspective.

One of the key themes of the report is the importance of taking a long-term view. After a year in which bonds and shares delivered extremely poor returns it’s all the more important to see the recent volatility in context. The long run rewards for embracing the risks of investment have been spectacular, but there have been long periods when it has not felt that way.

Just US$1 invested in the US stock market at the dawn of the 20th century would have grown to be worth over US$70,000 by the end of last year. Even after an adjustment for inflation (which is the only meaningful way to look at investment returns) that dollar would have grown to be worth US$2,000. But after the Wall Street crash in 1929, shares lost 79pc of their value in real terms by 1932 and it was not until 1945 that they had regained their previous high.

In the UK, we have experienced our own more recent wilderness years since the bursting of the dot.com bubble in 2000. As recently as last October, the FTSE 100 was trading below its peak level on New Year’s Eve 1999.

A long-term perspective is not just important for an understanding of the equity market. In bonds too, even 40 years can be an aberration. Between 1982 and 2021, bonds delivered an annualised return of around 6pc, not far behind shares, but this was an exceptional golden age fuelled by victory over inflation and the beneficial impact of globalisation. In the previous 80 years from 1900 bonds lost money for investors in real terms. Last year, they did so again, dramatically, falling by more than 30pc after accounting for inflation.

So, when my children complain that we have had it easy, I’d counter that it’s not quite so black and white. Yes, we enjoyed the equity market’s golden period in the 1980s and 1990s (and as for housing, well that’s another story). But the first two decades of the 21st century have been more of a challenge. Two bear markets in which shares have halved, a global financial crisis and a pandemic gave us something to think about along the way.

What does the future hold for the next generation of investors just starting out today?

According to the yearbook’s authors, Professors Paul Marsh and Elroy Dimson and Dr Mike Staunton, they should probably expect slightly lower returns than their parents enjoyed and significantly less than their grandparents did starting out in the 1950s and 1960s.

The difference between the 6.7pc inflation-adjusted return from shares since 1950 and the 4pc predicted from here may not sound enormous but compounded up over a lifetime of investing, it will make a big difference. The gap between the 2.9pc delivered by bonds over that period and the 1.5pc that’s expected going forward will be even more significant.

The fact is that the stars were aligned in the second half of the 20th century as far as investors were concerned. Just as the first half of that turbulent century was far more catastrophic than anyone might have predicted in 1900, the second 50 years were far better than would have seemed possible as our young parents picked through the wreckage of two world wars and a Depression.

Some of the exceptional returns in that period were simply compensation for taking on the risk of investing in businesses that can and sometimes do go bust or simply disappoint. But others were one-off non-repeatable gains such as the relentless drop in interest rates over four decades and the progressive upward re-rating of share valuations over time.

Perhaps the most important takeaway from the report’s forward projections is the importance of dividends to the total returns that investors should expect from the stock market. In the short run, everyone focuses on capital gains or losses. Over a year or two they are likely to be the main driver of performance. But in the long run it is the re-investment of dividends that makes all the difference. One of the key reasons to expect poorer returns in the future is that dividend yields are lower today, with the exception of the out of favour UK market.

Thinking about my kids’ investing futures in the context of this subdued forecast, I’m reminded of the serenity prayer: accept what you can’t change and focus courageously on what you can. So, that the future turns out a bit better than they fear. And if it doesn’t, then at least the Millennials and Gen Z-ers in my family are doing the right thing: starting earlier than I did, saving what they can, taking sensible risks, diversifying away their mistakes and sticking at it.

By Tom Stevenson, investment director (The views are his own.)

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Tom Stevenson

Like everyone else, I’ve been surprised by the market’s rally since its October low. Not so much that it happened, but when it arrived. I expected the market to turn higher in the middle of the year about the time it was clear that inflation was on a sustainable downward path and interest rates had peaked. I know that the market likes to pre-empt recovery, but investors seem to have turned up to this party before the invitations had even been printed.

The US stock market has risen by 15pc over the past three months as investors have looked through gloomy economic forecasts for 2023 to an anticipated recovery in 2024. Last week, the FTSE 100 hit a new all-time high. The markets are making some heroic assumptions about how far interest rates will go and how quickly they will come back down again. Investors have decided to accept optimistic earnings forecasts, put their faith in a soft landing and ignore central bank warnings that their job is not yet done.

It remains a tantalising possibility that the market has simply seen something that the rest of us have not. This week Goldman Sachs said it thought there was now only a 25pc chance of a US recession this year, less than half the consensus view. Europe, which looked like it was heading for an inevitable contraction, now looks like it has dodged the bullet too. In the UK, the first cut of fourth quarter GDP may show that a technical recession has been postponed, for now at least.

And halfway through the fourth quarter earnings season, it also looks possible that the downturn in corporate profits this year could be subdued. Most companies are beating estimates, even if the bar is getting lower as analysts become more realistic about the outlook. Last week’s jobs data in the US showed that the labour market, if not every other corner of the economy, is remarkably resilient.

All this competing and sometimes contradictory information makes predicting the bottom of a bear market even harder than it always is. Forecasting turning points is notoriously difficult. Even with the benefit of hindsight, it took Russell Napier 300 pages to analyse the factors that caused the market to turn higher after the four biggest bear markets of the 20th century. His excellent book, Anatomy of the Bear, written about 20 years ago, is well worth a read if you can find a copy.

If anything, the big turning points are easier to spot than a mid-cycle changes of direction, which is what we are dealing with today. They have some common characteristics, such as a widespread mood of pessimism, extremely low valuations and a preference for safe assets like cash. That’s not where we find ourselves now. Deciding where the market goes from here is more nuanced.

One of the reasons why we tend to discourage people from trying to read the market cycles ups and downs is that it often is ‘different this time’. In every single market cycle that I have looked at, the relationship between the state of the economy, corporate earnings, valuations and the overall level of the market is subtly different. The sands are always shifting.

The basic framework looks something like this. First earnings and valuations rise together in a bull market. Then investors start to worry about a downturn and valuations fall even as earnings continue to grow. This is what happened last year. Sometimes you then get a period when valuations continue to drop as earnings also turn lower – a painful double whammy. Finally, there is light at the end of the tunnel and the market changes direction even though profits are still declining. The new bull market has begun.

If it were always this simple, we’d all be rich. Unfortunately, there are many variables. The depth of the earnings downturn, or whether it even happens, is one. How far ahead of the turn in the real economy the market changes direction is another. How deep the retrenchment in valuations is one more.

The early 1970s bear market may provide an interesting parallel with today. Then the market fell while earnings were still buoyant as central banks tightened policy in the face of worrying levels of inflation. Then the economy went into recession, earnings started to fall, interest rates stopped rising – and the bear market ended. Just when everything looked terrible, it was the time to buy again.

The reason I am concerned about the rally since October is not that the template from 50 years ago doesn’t fit but the fact that we haven’t yet reached that moment of peak gloom. Recession remains a possibility not a certainty, earnings are still flattish not really falling, and the US Federal Reserve seems happy to let the market rise without further comment.

We may not be at peak gloom, but we may be at peak Goldilocks. The market is convinced rightly or wrongly that central banks will pivot to easier policy just in time to avoid a recession and forestall a serious downturn in earnings. If that is how things pan out then Mr Powell will have achieved what most of his predecessors failed to, a genuinely soft landing.

Maybe he will, but we won’t know for a few months yet. And, in the meantime, I would expect the market to bounce around, revisiting the October low perhaps once or twice again. That’s OK. In fact, for anyone looking to build their investments, a prolonged period of consolidation before a renewed bull market begin may be a welcome opportunity to invest at a sensible price.

By Tom Stevenson, investment director,

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