Market

These Are The Dangers That The Stock Market Is Facing Right Now

The S&P 500 stumbled in September, losing close to 5%. This appeared to be a bad omen for October, a month that in the past delivered very nasty surprises. But it wasn’t. The market recovered all the September losses and is now at a new record high. Initial 3Q corporate earnings that beat expectations were the fuel. But a closer examination suggests that not all is as well as stock prices seem to say. Here’s why.

There were a few reasons why September was a bad month for stocks: high inflation numbers, rising interest rates and a worsening supply-chain crunch. Congressional shenanigans that could have ended in disaster also contributed to market jitters but, as expected, there were not enough extremists in Congress to torpedo a vote that raised the debt ceiling and prevented the U.S. from defaulting on its obligations.

Those conditions persist: neither rates nor inflation have come down and supply-chain woes are not only resolved but possibly worse. While Congress did not inflict much damage, a new round of drama is scheduled for December, when the current debt-ceiling extension expires. The only bright spot is that 3Q corporate results are, so far, stellar. This is especially true for profit margins, which are just shy of the previous two quarters but still higher than at any point prior to 2021, according to Factset.

Very strong consumer demand is behind this strength, which in turn is due to pent-up demand from the lockdown days, out of which consumers emerged ready to spend. The savings accumulated during that period and various rounds of cash injections (rent subsidies, extra unemployment benefits, PPP loans, etc.) further fattened people’s wallets and lubricated spending. But, as spending went on and cash stimulus ended, savings have declined and are likely to fall further.

Sales are less robust than they may appear. Consumers have not been able to find all the goods and services they want at a price they like: cars are hard to come by, appliance delivery timelines are long and not all hotels and restaurants have been fully staffed. As a result, when cars or hotel rooms are available their prices are much higher than before the pandemic, causing sales to fall. This is not immediately apparent in retail sales numbers, which are measured in dollars. But goods that are measured in units (such as cars, homes, or gallons or gas) all show a significant decline in sales. Recent data releases show, for example, that although the dollar amount of vehicle sales rose by 7% Y/Y, the number of units sold slumped by 25% Y/Y.  

This suggests that economic conditions are less healthy than they look at first glance. If the reason for outsized business profits were that productivity had improved, it would be reasonable to expect even better corporate results in future quarters. Instead, they seem to show that some businesses have the power to charge far higher prices because of strong demand backed by high savings and months of restrained spending – an opportunity that seems unlikely to last much longer.

As various fiscal stimulus programs designed to put cash in people’s pockets come to an end, savings accounts balances decline and the Federal Reserve gets ready to scale back its own monetary injections, it is fair to ask whether businesses will be able to continue to extract high margins from their customers. Profits may disappoint in future quarters if sales volumes remain compromised, stimulus-padded savings deplete further and consumers grow increasingly reluctant to pay inflated prices. Upcoming retail sales numbers and developments on the supply chain front will be the key issues to monitor.

In addition, stock prices appear to be high from a historical perspective. While strong corporate numbers provide a strong reason for stocks to be in the upper regions of their long-term range, the chart above suggests that the supportive conditions themselves may be running at historically (and temporarily) high levels. On the other hand, it would be unwise to interpret the chart above as a reason to sell. After a similar incursion above the historical range in 1996, the S&P 500 went on to rally another 100% before peaking in 2000 – and suffering a brutal bear market in the two years that followed.

In sum, even though there is no indication that a crash is imminent, risks seem to be increasing. This is not to say that stocks cannot become considerably more stretched, as in the late 1990s, but that would make a subsequent correction deeper and more likely. The best case (other than for all the problems to vanish away) would be that the market stalls and prices become trapped in a range for a few quarters. That would reduce downside risks significantly. It also means that the double-digit equity returns we all came to expect will become harder to come by.

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