The US market has experienced a 28% increase over the span of 10 months (from early October 2022 to July 2023), with a limited correction in August. However, the question remains: is a collapse likely to intensify?
Historical Recovery Spurts
Since 2000, there have been only four instances of more significant recovery spurts within a 10-month period: a 40% increase in January 2004, a 65% increase in December 2009, a 33% increase in April 2011, and a 68% increase in January 2011. Additionally, there was a similar situation with a 27% increase in October 2019.
In all previous episodes, intense market recovery has taken place in an environment of extremely loose monetary policy from the Fed, accompanied by clear signals of economic recovery and robust corporate financial performance. However, in contrast to history, the current market rally is occurring during a period of aggressive tightening by the Federal Open Market Committee (FOMC), a stagnant economy, a low household savings rate, and declining business profits and margins.
Adding to this, there is a notably skewed composition of risk factors that potentially lead to a crisis due to accumulating bad debts at weak links in the chain, as well as rising debt servicing costs for all borrowers. These factors further diminish household savings and business margins, affecting the ability to repurchase shares, including through buybacks.
Current Market Rally
Preliminary estimates for 2023 suggest that businesses' free cash flow might decrease by 20 - 25% relative to 2021 due to increased capital expenditures (largely due to inflation) and lower operating cash flow. Consequently, the capacity for buybacks without borrowing is diminishing, and historically, corporate buybacks have been the primary means for U.S. companies to repurchase shares.
The market's growth has unfolded alongside clear indications of an economy slowing down and entering stagflation, along with unacceptable medium-term risks associated with mounting debt and corporate deterioration. These risks are primarily tied to tight financial conditions and the economy's integral overleveraging.
The liquidity balance sheet is deteriorating as the entire stock of excess liquidity has essentially been depleted over the past three years, both due to inflation and financial instrument allocation.
Formulated Narratives
Since October 2022, the Western investment community has formulated four narratives to explain the market's ascent (in hindsight):
- Between October and December 2022, the narrative was that "It's not all bad." Expectations of an economic collapse and debt crisis from February to September 2022 were deemed excessive, and the economy has indeed proven to be resilient.
- From January to May 2023, the narrative focused on "AI will save the world." The hype surrounding generative AI models fostered expectations that AI would address unemployment, enhance economic productivity, improve business margins, and resolve various challenges.
- The narrative in March and April 2023 was that "We don't have to worry about the banks' problems anymore." The belief was that the Federal Reserve and other central banks would inject as much liquidity as required into the system, and the Primary Dealer Group would buy back assets, given their substantial free liquidity.
- From April to August 2023, the narrative emerged that "Don't care about Fed rates." The concern over interest rates diminished, as the economy's resilience suggested that rates could vary widely, and if needed, adjustments would be made to tackle any issues. There was even an expectation of declining rates.
- The only narrative holding validity is the notion that "it's not all bad," but why is this the case? This has been explained in detail here, outlining the lag in the impact of the Federal Reserve's tight quantitative easing (QE) on the economy and financial markets. More overt negative effects are expected to manifest over a 12 - 15 month timeframe, with the starting point not being March 2022 (when MPC tightening commenced), but rather September 2022, when rates became restrictive.
Conclusion
The recent surge in the U.S. market, with an impressive 28% increase in 10 months, has garnered significant attention and curiosity. This meteoric rise has prompted comparisons to historical recovery periods, highlighting the uniqueness of the current market upswing. However, as the market faces a range of challenging circumstances, the question of whether this rise will be sustainable or lead to a crash remains paramount.
History teaches us that past economic recoveries have been characterized by loose monetary policy, strong economic recovery and strong financial performance of companies. In contrast, the current scenario is characterized by tightening monetary policy by the Federal Open Market Committee (FOMC), a stagnant economy, declining corporate profits and a difficult debt situation. Risk factors are markedly skewed, increasing the likelihood of a crisis caused by the accumulation of bad debts and rising debt servicing costs.