Market Bipolarity: Exuberance versus Exhaustion!
As we enter the last quarter of 2023, it has been a roller coaster of a year. We started the year with significant uncertainty about whether the surge in inflation seen in 2022 would persist as well as about whether the economy was headed into a recession. In the first half of the year, we had positive surprises on both fronts, as inflation dropped after than expected and the economy stayed resilient, allowing for a comeback on stocks, which I wrote about in a post in July 2023. That recovery notwithstanding, uncertainties about inflation and the economy remained unresolved, and those uncertainties became part of the market story in the third quarter of 2023. In July and the first half of August of 2023, it looked like the market consensus was solidifying around a soft-landing story, with no recession and inflation under control, but that narrative developed cracks in the second half of the quarter, with markets giving back gains. In this post, I will look at how markets did during the third quarter of 2023, and use that performance as the basis for examining risk capital’s presence (or absence) in markets.
The Markets in the Third Quarter
Coming off a year of rising rates in 2022, interest rates have continued to command center stage in 2023. While the rise in treasury rates has been less dramatic this year, rates have continued to rise across the term structure:
Finally. I looked at global equities, broken down by region of the world, and in US dollars, to allow for direct comparison:
India is the only region of the world to post positive returns, in US dollar terms, in the third quarter, and is the best performing market of the year, running just ahead of the US; note again that of the $5.2 trillion increase in value US equities, the seven companies that we listed earlier accounted for $3.7 billion. Latin America had a brutal third quarter, and is the worst performing region in the world, for the year-to-date, followed by China. If you are an equity investor, your portfolio standing at this point of 2023 and your returns for the year will be largely determined by whether you had any money invested in the “soaring seven” stocks, as well as the sector and regional skews in your investments.
Price of Risk
The drop in stock and bond prices in the third quarter of 2023 can partly be attributed to rising interest rates, but how much of that drop is due to the price of risk changing? Put simply, higher risk premiums translate into lower asset prices, and it is conceivable that political and macroeconomic factors have contributed to more risk in markets. To answer this question, I started with the corporate bond market, where default spreads capture the price of risk, and looked at the movement of default spreads across ratings classes in 2023:
In a post in the middle of 2022, I noted a dramatic shift in risk capital, i.e., the capital invested in the riskiest investments in every asset class – young, money-losing stocks in equities, high-yield bonds in the corporate bond market and seed capital, in venture capital. After a decade of excess, where risk capital was not just abundant, but overly so, risk capital retreated to the sidelines, creating ripple effects in private and public equity markets. In making that case, I drew on three metrics for measuring risk capital – the number of initial public offerings, the amount of venture capital investment and original issuances of high yield bonds, and I decided that it is time to revisit those metrics, to see if risk capital is finding its way back into markets.
With IPOs, there have been positive developments in recent weeks, with a few high-profile IPOs (Instacart, ARM and Klaviyo) hitting the market, suggesting a loosening up of risk capital. To get a broader perspective, though, I took a look a the number of IPOs, as well as proceeds raised, in 2023, with the intent of detecting shifts:
What now?
Entering the last quarter of 2023, it is striking how little the terrain has shifted over the last nine months. The two big uncertainties that I highlighted at the start of the year – whether inflation would persist or subside and whether there would be a recession – remain unresolved. If anything, the failed prognostications of economists and market gurus on both of these macro questions has left us with even less faith in their forecasts, and more adrift about what’s coming down the pike. On the economy, the consensus view at the start of 2023 was that we were heading into a recession, with the only questions being when it would kick in, and how deep it would be. One reason for market outperformance this year has been the performance of the economy, which has managed to not only avoid a recession but also deliver strong employment numbers:
It is true that if you squint at this graph long enough, you may see signs of slowing down, but there are few indicators of a recession. This data may explain why economists have become more optimistic about the future, over the course of 2023, as can be seen in their estimates of the probability of a recession:
The economists polled in this survey have reduced their likelihood of a recession from more than 60% to about 40%, with the steepest drop off occurring in the last two months.
On inflation, we started the year with the consensus view that inflation would come down, but only because of economic weakness. The positive surprise for markets in 2023 is that inflation has come down, without a recession yet in sight:
The drop off in inflation in the first half of 2023 was steep, both in actual numbers (CPI and PPI) and in expectations (from surveys of consumers and the treasury market). While the third quarter saw of leveling off in those gains, it is clear that inflation has dropped over the course of the year, albeit to levels that still remain about Fed targets. If you are one of those who argued that inflation was transitory, this year is not a vindication, since prices, even if they level off, will be about 20% higher than they were two years ago. There is work to be done on the inflation front, and declaring premature victory can be dangerous.
Valuing Equities
In response to what this means for the market, I have to start with a confession, which is that I am not a market timer, making it very unlikely that I will find the market to be mis-valued by a large magnitude. In keeping with a practice that I have used before (see my start-of-the year and mid-year valuations), I valued the S&P 500, given current market interest rates and consensus estimates of earnings for the future:
Download valuation spreadsheet |
Source: https://aswathdamodaran.blogspot.com/2023/10/market-bipolarit-exuberance-versus.html
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