What goes down, must go up – and next year, no less. At the very least, that’s the confidence that will justify this year’s status as the second-best year on record for inflows into stock-focused exchange-traded funds.
Even as equities suffered their worst performance since the 2008 financial crisis with a fifth plunge for US blue chips, investors have poured $510bn into equity ETFs, according to Bank of America data. The biggest flows have been directed to giant index trackers and passive funds that invest in large-cap stocks that have led to losses this year.
Bulls have a point because stocks average a 20 percent gain in the 12 months after hitting the bottom of a bear market, according to brokerage LPL Financial. LPL added that, at almost a year old, the current bear market is longer than the average since the second world war of 11 months. There are also only four occasions that the S&P 500 has suffered back-to-back calendar year losses in a history stretching back nearly a century.
But at the risk of spoiling the events at the end of the year, what if 2023 marks the fifth unlucky and this is not yet the bottom?
In an interview on the All-in podcast, Tesla founder Elon Musk reflected last week on the potential for “mass panic” among investors. He warned listeners not to use stocks as collateral for loans in volatile markets and advised them to keep cash.
“You can get some extreme things that happen in the market going down,” added the businessman as he predicted his “best guess” of storms in the next 18 months. It must be easy to get gloomy when your company’s stock has fallen by more than two-thirds in a year and you’re facing a $44bn bill for the controversial Twitter takeover.
Still, Musk is far from the only one jittery about the outlook, especially since central bankers have made it clear they will continue to fight inflation with higher interest rates despite forecasts of – at best – an economic slowdown.
There is a lot of focus this year on the potential for blow-up in the world of securities, one of heavy borrowers fell as rates rise, or because some corner is generally suspected of suddenly gums up the system more, as happened to UK gilts, or the government. bond, in September, brought down the country’s prime minister in the process. But the shaky stock market has also caused its own pain.
The uncertainty is reflected in the spread of analysts’ forecasts for 2023. A Reuters poll of 41 forecasts at the end of November showed the average expectation of the S&P ended at 4,200, about 3 percent above the level at that time, and is expected to rise. a tenth of the current rate. But the poll also recorded a forecast that was almost 20 percent on either side.
While classic measures of expected volatility like the Vix index aren’t flashing red right now, others point to a more shaky environment. Earlier this week, the S&P 500 had seen an all-time record 16 Fridays this year that closed at least 1 percent lower, according to a count kept by Bespoke Investment Group. It has also enjoyed a 15-week closing where it has gained the most – a frequency not reached since the irrational exuberance of 1999.
Friday is important because it sets the mood for the week ahead, prevents big weekend events, and because it is usually a day for profit and risk reduction, not for making bold bets.
History also serves as a reminder that it can take a long time for the equity market to recover from the attacks it experienced this year. If the doomsters are right, then the bleak scenario might look like a dotcom.
After the bubble burst, it took seven years for the S&P 500 to regain and then surpass its boom highs. Just getting to the bottom also took some time — the S&P’s 49 percent slide from peak to trough took two and a half years as the hype wore off on tech stock valuations.
How close are current market conditions to that time? The cyclically-adjusted price/earnings ratio popularized by Robert Shiller of Yale University is one valuable benchmark. The measure is the average income adjusted for inflation over a 10-year period to smooth the economic cycle.
The current Barclays Cape ratio for US stocks of 29, based on the MSCI index, is below the peak of 47 in the dotcom bubble frenzy and has fallen from a peak of 39 a year ago. However, it is still above the long-term average for the indicator of about 16. It is also still above the level of 25 on January 1, 2008 before the financial crisis caused the S&P 500’s annual decline of 38 percent.
Optimistic ETF proponents may have been right, of course. Ending the war in Ukraine or reopening a smooth post-pandemic Chinese economy could dramatically improve the outlook. However, it’s worth considering the worst-case scenario – not least because the biggest ETF inflows are in 2021, and the bets aren’t good yet.
jennifer.hughes@ft.com