Jon Krakauer’s book “Into Thin Air” chronicles one of the deadliest years on Mount Everest, when 12 mountaineers died trying to reach the summit without proper regard for the risks. Everest’s peak is 3,000 feet above the start of the “death zone,” the altitude at which oxygen pressure is insufficient to sustain human life for an extended period. Many fatalities in high-altitude mountaineering occur in the death zone, either directly through loss of vital functions, or indirectly from bad decisions made under stress.
This is a good analogy for where equity investors find themselves today, and where they’ve been many times over the past decade. Either by choice or out of necessity, investors have followed stock prices to dizzying heights as liquidity (the market equivalent of bottled oxygen) allows them to keep climbing. But the oxygen eventually runs out and those who ignore the risks get hurt. Developments over the last few months show how the market got here, and what could be coming next.
This most recent ascent began in October from a much safer place of lower valuations: a price/earnings ratio of 15x, compared to today’s 18.6x, and an equity risk premium of 270 basis points above U.S. Treasuries, compared to today’s 155. The ascent was based on a reasonable narrative that China’s long-awaited reopening was finally about to begin and could provide an offset to the slowing U.S. economy. As a result, this rally was led by more economically sensitive stocks like global industrials, financials and China equities, and it made sense to go along for that stage of the climb.
By December, however, the air started to get thin again with the P/E back to 18x and the equity risk premium down to 225 basis points—indicating that it was time to head back to base camp, by positioning portfolios more defensively.
With the turn of the new year, many investors decided to make another summit attempt, taking an even more dangerous route with the most speculative stocks leading the way. This time, the narrative was that the Fed was finally going to pause its rate hikes at its early February meeting, and even begin cutting rates by the second half of the year as inflation continued to decline.
It was like a shot of oxygen. Investors began to move more quickly and energetically, talking more confidently about a soft landing for the U.S. economy. As stock prices have reached even higher levels, there is now talk of a “no landing” scenario, in which the U.S. economy never slows down. These are the tricks that the death zone plays — we have now reached a P/E ratio and equity risk premium that put us in the thinnest air of the entire liquidity-driven secular bull market that began back in 2009.
Meanwhile, interest rates are likely to keep increasing, with inflation turning back up and a Fed pause now off the table. In fact, additional rate hikes have been priced into market expectations, with the terminal rate expected to reach 5.25%.
Bottom line: The bear market rally that began in October from reasonable prices and low expectations has gone too far, based on an anticipated Fed pause and pivot that aren’t coming anytime soon. Moreover, despite the economic improvements indicated by a strong labor market and resilient consumer spending, the earnings recession has a long way to go.
As the Fed is tightening, financial conditions are continuing to loosen thanks to the liquidity provided by other central banks, China’s reopening and a weaker U.S. dollar. Since October, the global money supply has increased by a staggering $6 trillion, providing the supplemental oxygen investors need to survive in the death zone, and tricking them into thinking they are safer than they really are.
