Investment markets are driven by two things. Sentiment is the driver that is unpredictable and can change very fast. Fundamentals is the driver that provides you with the true value over time. If we look at the past two years in the equity markets we can see that sentiment was the dominant force behind equity returns. Sentiment has two triggers: the first one is uncertainty, which has a very negative impact on the markets; and the other one is confirmation, which has a positive impact on markets.
In early 2020 Covid caused a lot of uncertainty, which dragged the markets down by more than 30% in a very short period of time. That negative sentiment was replaced by certainty that the government would do everything they could to protect us from disaster and the markets shot up. Unfortunately the way the governments across the world protected us from disaster was to shut down everything and replace productivity with artificially-created free money. With people sitting at home with a lot of money to spend, they started buying companies that benefitted from anything to do with e-commerce and technology, and sold everything to do with travel and leisure.
This combination of free money, low productivity and some dangerously elevated share prices encouraged two nasty things to start growing in the dark, namely inflation and a disregard for fundamentals. By the end of 2021, with the Federal Reserve in the USA ignoring the warning signs of hyperinflation by claiming that it would be transitory; and some shares trading at prices far exceeding their intrinsic values based on fundamentals; the markets were ripe for a catalyst to pop the bubble – and so 2022 gave us the war in the Ukraine.
Towards the end of 2021 we were becoming rather uncomfortable with the strength of the market in the USA, especially in the technology sector, and we expected some of the froth to blow away but we were not expecting a 20% decline. So what went wrong?
It is fair to say that two big events created a lot of uncertainty, causing sentiment to collapse. The first one was that the Federal Reserve in the USA confirmed that they had been wrong and that they would have to increase interest rates a lot to counter inflation; and the other one was how far the geopolitical turmoil caused by Russia would spread. If, for example, China had invaded Taiwan and the USA had retaliated, we would have been in a proper international economic meltdown.
The good news is that most companies in the USA are showing relatively good financial results, and although sentiment is still very negative regarding the extent of interest rate hikes in the US, positive fundamentals are singing a lullaby which will soon be calming the shattered nerves of those with the negative sentiments. We have to remember that our investments in shares will always fluctuate between too expensive and too cheap. As long as the average trend-line of these two extremes is upwards, we will be okay.