Anatomy of an Upbeat Market
The US index, comprised of thirty bellwether stocks, experienced its best month since 1976. A bellwether stock tends to show market leadership just like a sheep leading its flock with a bellwether tied around its neck. Last month’s US equity returns were even more impressive, given that interest rates tied to economic activity also rose in October. In normal circumstances, the level of economic interest and the prices held on financial assets move in opposite directions. However, investors were able to see through the risks in October and decided that equities represented a strong buying opportunity.
The overall market for public ownership in corporations has benefited from better news. For one, public corporations started to publish third-quarter profits and guide investors on the economy’s strength. This quarter’s earnings data has come in strong, as consumers seem able and willing to pay higher prices. However, aggregate volumes of goods and services sold appear to be down, indicating that actual production is also lower, and profits are likely higher because of recent inflation. That trend may persist for a short time, but robust economic productivity will one day need to return to maintain stability. Next, the primary market for mergers, acquisitions, and new public offerings has suddenly heated up after a short period of dormancy. A couple of new deals have recently been announced worth billions of dollars. Fortunately, pricing in the primary markets can help reaffirm prices in the secondary markets for stocks and bonds. As a reminder, many of the commonly-used investments, such as index funds, come from the secondary market.
The structural component of the stock market has undergone quite a bit of change caused by new spending habits, higher borrowing costs, and other exogenous shocks. For example, the stock prices of companies with high-quality brands have been more robust than shares of companies that depend on ambitious growth. Therefore, money has recycled from one part of the market to another, helping shield investors from the worst scenarios. As a result of this cyclical rotation, the usual bearers at the top of the index have shrunk. For example, the top ten stocks in the US large-cap index previously occupied almost thirty cents of every invested dollar. That fraction has since fallen to twenty-five cents of every invested dollar. The result is reduced security-level concentrations, and more diversification, in the broader indexes.
These structural changes, and the bear market in general, have also helped to diversify investor risk from a sector perspective. Before the current bear market, investor returns depended more heavily on the success of stocks classified as either technology or communications companies in the broad large cap market. However, at the current time, energy has crept into the top ranks of investor wealth, and healthcare has increased its presence as well. As a result, investors that allocate similarly to the broad indexes are now generally receiving a more diversified mix of corporate profits on every investment dollar.
October made investors feel more upbeat about stocks, which is a good change of pace. However, even though it’s good to exercise optimism, risks still remain on the horizon. For instance, a European land war still rages with no end in sight. Thankfully, Russia has re-agreed to allow Ukrainian grain exports to pass into the Black Sea after Russia stepped up its attacks and propaganda against Ukraine. In addition, investors would like to know what’s next for the Chinese economy as zero-covid policy restrictions lock-down citizens and global supplies. Finally, inflation remains a global phenomenon that has put central banks in reactionary mode throughout most of the developed world.
But, against an uncertain backdrop, investors still found reasons to want the equity risk premiums that stocks offer. The equity risk premium represents the extra return over bonds that investors receive for holding risk when times are tough. Moreover, last month’s stock market gains seemed even more meaningful since interest rates rose globally. With all that said, it is important to remember that stocks are leading economic indicators and therefore may very well rebound ahead of a sustained economic recovery.
