To The Moon

More money has probably been lost in timing the stock market than in corrections in the stock market. That seems to be the case again this year. After a tough 2022 investment year and a difficult December, investors were cautious early in the year and, in fact, they still are, given all the cash on the sidelines. The vast majority of economists predicted a recession. That recession did not materialize and, despite the banking crisis and the hassle surrounding the debt ceiling, the likelihood of it has clearly diminished. However, the stock market is carried by only a few companies that are benefiting from the hype in artificial intelligence. Now, the impact of artificial intelligence on the stock market and economy is at least as big as the Internet or the iPhone, nor is it something limited to ten companies at most. Regardless, this hype will broaden.

Even for the second half, many investors are cautious. Oddly enough, all these crises are reassuring, as a healthy bull market climbs a wall of fear. And plenty of worries remain. The banking crisis has not been resolved so long as interest rates are not cut they could flare up again at any time. There is talk of a robust El Niño this year that could possibly cause us to shoot through the 1.5 degrees agreed upon in Paris at a much faster rate, with negative consequences for food supply, among other things. Then 2023 may be the year of disinflation, but due to base effects, it is possible that in the fall inflation will stabilize at a significantly higher level. That depends, among other things, on energy and food prices. That is part of the inflation rate that does not belong to core inflation, but which are basic necessities on the basis of which many workers in the tight labour market still demand higher wages. The unions are not as powerful as they were in the 1970s, but they are certainly succeeding in Europe in getting higher wages anyway. Possibly they are helped in this by the power of social media, while companies fear their reputation much more than before. This also has to do with the greater role claimed by the government; a good relationship with the government is more important than ever. For corporate profits, inflation is not a curse, but a blessing, given higher margins. That does mean that disinflation is then a risk to corporate profits. For example, in the past 12 months, the prices of some hardware have fallen harder than at any time in history. What about energy prices? Since Saudi Arabia unilaterally introduced production cuts in mid-April, oil prices have fallen 20 percent. Even much faster, during the same period, natural gas prices fell, which are now much lower than they were before Russia's invasion of Ukraine. How's that for European inflation in August? A year ago, natural gas prices were more than 10 times higher. At the same time, long-term energy shortages rather than surpluses are threatened by the underinvestment of recent years and the forced energy transition. Furthermore, there are always geopolitical concerns, such as the war in Ukraine and the tense relationship between the United States and China.

In the long run, equities follow the underlying earnings trend, and after good first-quarter numbers, valuations for this year and next year are up. There are roughly two scenarios for the future. In the first scenario, the economy has a soft landing and central bankers have managed to get inflation under control without a recession. This has succeeded once before and that was in 1995, the only soft landing in history. Only now inflation is coming from a much higher level and if central bankers manage to control inflation after a corona pandemic and a war on the European continent, they will soon be seen by the market as miracle doctors. Interest rates and risk premiums can then come down, and in this new reality, the combination of an Uber-Goldilocks with an AI-Hype can take us back to the stock market years of the late 1990s.

In the second scenario, there is stagflation. Inflation remains too high despite the recession. Not a good scenario, but one that the market has implicitly partly priced in. Of course, in such a scenario, corporate profits fall. The relationship between profits and stock prices is linear, but between interest rates and stock prices is exponential. This offers compensation, especially with interest rates still low from a historical perspective in such a subsequent recession. Furthermore, a distinction must be made between an inflationary recession and a deflationary recession. The dot-com recession and the Great Financial Crisis created a clear fear of deflation. Such price declines of 50 percent go down well between the ears and are now fueled by the narrative of the "bubble of everything," but that is exaggerated given the large differences in valuation. It takes much more effort in such a deflationary recession to stabilize the economy. If a recession comes now, it will be more of a home-and-home recession, typically leading to a stock price drop of no more than 30 percent, but not a depression-like recession with also a much greater effect on corporate earnings. But the once-high probability of this stagflation scenario has clearly diminished in recent months and the low probability of a soft landing has clearly increased. Then the sequel may resemble the second half of the 1990s, when Greenspan kicked off an unprecedented rally in December 1996 after his speech on "irrational exuberance. Then Greenspan caused the birth of Goldilocks by smoothing out the cycle; now the same Fed may top this with an Uber-Goldilocks. Statistically, this is not surprising. A bad stock market year is usually followed by a good stock market year, and the third year of the presidential cycle is usually also the best year.