In a late-night scrolling session, I came across a video of a guy saying that because of the cave dweller part of our brains, it’s much easier to assess risk than it is to assess opportunity.

While it may depend on your personality, in many ways, I personally found this true. Just like it’s easier to critique than to create, I tend to look at things through a lens of “How can this go wrong?” 

With that in mind, the recent market rally, which started after June 16th, has me thinking, did I wait too long worrying about what could go wrong? Is this one for real? Or is this like the stock market rallies we had in March and May?

We are now more than halfway through earnings season and have gotten a ton of evidence from corporate America on how things are going. So far, there seems to be two camps: 1) “It could’ve been worse” (Tech) or 2) “Oh wow, those are really good earnings, even though all signs pointed to that” (Travel and Energy). The surprise with the latter continues to, well, surprise me.

Last week, we also received some economic data and the last Fed meeting of the summer occurred. This week, we’ll get an update on the employment picture (July jobs data on August 5), which many hope will show some softening. Inflation is expected to have peaked, and many believe the next CPI inflation report on August 10 will show this. If both are true, it’s expected this will give the Fed some room to soften their message and slow their roll on interest rate hikes, which the market likes. Often in rising interest rate environments, when there is bad economic data, the market will like it, since it will further support lower inflation and fewer interest rate hikes. In short, bad is good.

So, could it be that we are at the end of the bear market and this rally sticks? Well, earnings expectations for US companies have finally started to come down (albeit a small amount of ~2%). And if the market has fully absorbed all potential Fed moves and US inflation, and the uptick in weekly claims we saw last week continues into the aforementioned July jobs report, it’s possible Jay Powell’s Jackson Hole address at the Fed’s annual conference in August or the Fed’s next meeting in September will be used to subtly shift the monetary message. Then, yes, perhaps we have seen the bottom for now.

BUT, then that little voice inside still quietly raises: valuations and global energy prices. 

Valuations are still in the average-to-expensive range for stocks. The 10-year average forward P/E ratio of the S&P 500 is 17.1x, which was in a lower interest rate environment than today. Assuming the consensus-expected 8% growth rate of S&P 500 corporate earnings for 2023 is even close to correct, this makes the valuation of 17.3x* at the current market level feel just ok, and a lower growth rate would mean that number is even bigger. The other concern is that energy supply and demand is volatile, given reserve releases, higher prices, and most importantly, Russia’s intentions. 

Expectations are so important in investing. I fear the market just really wants everything to be ok. So far, with earnings better-than-feared but still just ok, and economic data only starting to look slightly less strong, there is a decent chance the Fed will take a bit longer to care about growth over inflation. Though there are always risks with investing, I believe these are the main ones right now…

…or is that just my cave dweller brain only assessing risk again?

In the end, it's not easy to be perfectly right… that’s why the fundamental values of staying long-term focused and adding to investments over time, when appropriate, can serve most investors well.

*Forward Price/Earnings is a measure of valuation that shows how many multiples the price of stock is relative to its expected earnings. At this time, with the S&P 500 at the ~4100 level, divided by $237 expected earnings per share for the next 12 months = ~17.3x

Source: Factset Earnings Insights