As interest rates climb and inflation shows signs of cooling — where are stocks in the market cycle? Equities markets usually have four phases, and right now stocks are in the “optimism” stage, according to our Chief Global Equity Market Strategist Peter Oppenheimer. He expects relatively low returns from here as stocks trade in a wide range.
Most cycles start with “despair” (a bear market) and are followed by “hope,” which is the strongest and shortest phase, where markets and valuations rise in anticipation of a recovery in profit growth, according to Goldman Sachs Research. Next there is usually a “growth” phase, where profits recover and grow but valuations fall back and returns moderate. The final phase, which Oppenheimer describes as “optimism,” is generally associated with increasing valuations even as interest rates rise.
“If we look at the history of equity markets, you do tend to get repeating patterns around business cycles — periods of expansion or contraction, recessions, and booms,” Oppenheimer says in an interview with Goldman Sachs Exchanges. “We've entered a bit more of what we call the ‘optimism’ phase, sort of later cycle, as valuations start to go up again despite, perhaps, rising interest rates.”
Market phases are easier to pinpoint in hindsight, but there are signs that this cycle is following the typical pattern.
Although the despair stage at the start of the pandemic was shorter than normal (only around one month), it was similar in magnitude to the average cycle, according to Goldman Sachs Research. The hope phase was in line with the average in terms of time (nine months) and annualized returns (at over 60%). The growth phase, despite its name, is typically associated with lower returns. This is because, while EPS are rising, it has often already been paid for during the hope period. This has been the case in the current cycle, which was also weaker than average because of the speed of interest rate rises. The optimism phase, which started in late 2022, has largely been in line with history, driven by higher valuations.
While the pattern of returns has been similar to the past — particularly in the despair and hope phases — our analysts have expected a “fat and flat” outcome, with relatively low returns while indexes oscillate in a wide trading range. They project returns will be constrained by the ongoing tug of war between rates and growth fears, the higher-than-average valuations (particularly in the U.S.), and a backdrop of weak earnings growth despite a likely soft landing. The S&P 500, for example, is at roughly the same level as a year ago. Japan and Europe are a little higher, but Asia is a little lower. Overall, the global equity index is broadly unchanged.
“The ‘fat and flat’ idea really comes from the context of some of these cycles having lower average returns with a wider trading range,” Oppenheimer says in our podcast. “And that's really a description of what we've seen in the last year.”
Stocks markets have rallied in recent weeks, leading to optimism that they could break out of their trading range, according to Goldman Sachs Research. Equity markets have gained — and volatility declined — as the U.S. resolved its standoff over the debt ceiling and deposit flight at American regional banks slows. Lower commodity prices have reduced the risk of inflation becoming more deeply entrenched. Investors’ recent focus on artificial intelligence, meanwhile, has fuelled a renewed enthusiasm for growth.
In combination, equity markets were rising despite pedestrian profit growth in most regions, and valuations have increased despite higher interest rates, even (and in some cases in particular) in the long-duration technology areas of the markets where profits may not occur until well into the future. These are all characteristics of the typical late-cycle optimism phase, according to Goldman Sachs Research.
“In the last few weeks in particular, volatility has come down in equity markets,” Oppenheimer says. “And that really reflects a sense that some of the worst tail risks have been moderating.”
Markets are also pricing in a lower likelihood of U.S. recession, moving closer to the outlook of our own economists who think recession risks have faded.
Another way of observing that is by looking at global cyclical stocks (that are more sensitive to economic growth) versus equities that are more defensive, and comparing that metric to the global purchasing managers’ index (PMI), according to Goldman Sachs Research. Even as the PMI survey data shows signs of softening, markets appear to be pricing in stronger growth moving forward.
Oppenheimer is less optimistic than stock markets seem to be. He argues that further upside is constrained by already high valuations and the prospects for interest rates to stay higher for longer than markets are pricing in. European Central Bank commentary has become more hawkish, while Federal Reserve Chair Jerome Powell recently emphasized the need for more monetary tightening. The Bank of England and Norway’s Norges Bank have surprised investors with larger than expected interest rate hikes. PMIs, meanwhile, continue to show signs of weakening, and that softness has spread from manufacturing to services.
Rising interest rates have been the key driver for bonds and stocks over the last year-and-a-half, Oppenheimer says on Exchanges. “We're getting closer to the end of that cycle. We don't think we're there yet, by the way — we think interest rates have a little further to rise.”
Stock market valuations also seem to be decoupling from real (accounting for inflation) interest rates. The S&P 500 price-to-earnings ratio has risen sharply of late despite an increase in real bond yields. That implies that either investors expect rapid rate cuts, or long-term growth expectations have gone up, or a combination of both. Oppenheimer thinks that optimism is premature: Our economists have argued that the market-implied path for inflation remains too optimistic and, by extension, the prospects for interest rate declines.
Even if the market is right about interest rate cuts happening earlier than our economists project, Oppenheimer points out that the reason for those rate cuts will be important. In recent market cycles, equity returns once rate cuts begin have depended on economic growth and market valuations. For now, in the absence of a recession, the urgency for central banks to cut interest rates is likely to be less than the market is pricing. And while Goldman Sachs Research doesn’t expect a recession, our economists’ outlook for growth remains subdued. The combination of high valuations and relatively slow profit growth implies a positive, albeit moderate, return for equities, Oppenheimer writes.
“Growth is really the central driver, and this year we've seen very little in the way of underlying profit growth,” Oppenheimer says. “What's going to be crucial…[are] expectations about whether we can avoid recession and what kind of economic and profit recovery we'll see over the next one or two years.”
Another concern is that a relatively small number of stocks have driven much of the returns this year. The 15 largest companies in the U.S. and Asia are responsible for much of the performance in those markets in 2023, according to Goldman Sachs Research. While Europe’s market breadth has been somewhat healthier, the performance of the median company has been very modest. Year to date (through June 27), the biggest 15 companies in the S&P 500 have gone up 34%, while the median company is up just 1%. On this basis, Japan has had the most impressive returns, with the median company rallying 11%.
Will the rest of the market catch up to the high-flying stocks, or will the market leaders come back to Earth? In Europe, where the market is rallying with narrow leadership, the subsequent 12-month returns for the aggregate index are positive 71% of the time (the unconditional average following rallies is 62%), according to our analysts. There have been signs recently that market breadth has started to improve, suggesting that greater confidence in growth is leading to a widening of optimism about non-tech parts of the market. But the narrow contribution of returns is still significant — particularly in the U.S., where gains have been driven by technology stocks.
Tech companies have rallied despite higher interest rates, which Oppenheimer says suggests investors are optimistic that AI could result in higher longer-term growth. He says this is also reflected in the way that U.S. technology valuations are moving ahead of those in other markets, for example pulling away from the valuations of the tech sector in Europe. Oppenheimer says AI is likely to benefit far more than just a handful of tech companies.
“As these technologies develop, just as we saw with the Internet, some of the big beneficiaries will probably be in companies that don't yet even exist, as the technology generates new opportunities for new entrants,” he says. “It has the opportunity of really raising productivity across economies. But to do that, some of the big winners will actually be in non-technology companies. Companies that are embracing AI to improve efficiencies and improve costs. And not all of those, of course, will be in the U.S.”
At the same time, comparing sectors across the U.S. and Europe on a price-to-book basis with their return on equity shows that most sectors are valued in line with expected profitability. The S&P 500 and Europe’s STOXX 600 are trading in line with expected returns, while technology stocks may be an exception.
“Over the medium term, we think that investors can get good returns in equities, but probably not as good as we've seen in the last decade or two,” Oppenheimer says.
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