Turning points in the economic cycle bring emotion. The market quickly reverses the trend of forecasts – extrapolating optimism on economic recovery, though often with few data points. Academic studies have documented how expectations are driven by behavioural factors, and the bias that creeps into investment.
For example, research has shown that 52-week share price highs are a key anchor for analysts’ forecast targets. It ranks alongside current year growth as a factor. Higher past share prices anchor analysts to higher target prices, and so to less accurate forecasts. It is a distortion with an adverse impact, particularly as markets climb. Price anchoring is a bias that retail investors are considered particularly vulnerable to, but the evidence shows it is pervasive in the world of institutional investing.
Even as UK second-line stocks are rebounding sharply, this year brings added uncertainty about the risk that the rules might change. Like fashions, recoveries repeat but often with subtle changes. Analysts are often slow to recognise a different world, driving new winners. Corporate profit margins are near an all-time high at a time when government finances are under pressure. Adding to the pressures of a cost of living crisis, are the politics of increasingly pro-labour policies. This time, it may have less impact on inflation than it does on profits. In many areas skilled labour remains scarce and productivity in hybrid working is still in question. Can analysts factor-in this potential disconnect between economic recovery and returns to shareholders?
The bounce is being welcomed by some technology and private equity investors. Fund managers are typically skilled storytellers. Many managers are tempted to extrapolate the sentiment improvement from last September’s nadir as bringing validation of investment approach. But these are areas where the recovery might look very different.
Many private equity businesses have reacted to the drought in new finance by conserving cash. Most have tried to push the runway from their existing resources out to 18 months or more, in the hope that by then funding might be less penal. But conserving cash has brought risky change to business models, as investment in growth is shut off and existing customers lose the value proposition that once attracted them.
Customers of challenger banks will recognise this pattern. Charges are being increased rapidly, with benefits cut back. While private equity valuations of the businesses have been cut, is there really any purpose in a loss-making neo-bank that increasingly just looks like the old incumbents it once aimed to disrupt? Across fintech, and in many other technology sectors, this pattern of failed disruption is being repeated.
And even in the major US technology firms, investors should question whether the competitive position is unravelling. Tesla and Twitter might be examples. Can businesses grow just by cost-cutting? It looks as though many businesses must now cut costs and prices, with profits squeezed between cost-conscious customers and higher taxes. The shallower than expected recession in Western economies does not mean that the world is set for a normal recovery. In the upturn, businesses may see more of the austerity that is currently faced by governments and consumers. Profit margins look an easy target.
The current disconnect between a rebounding stockmarket and soggy corporate reporting may be misplaced optimism. It seems only a minority of companies have yet capitulated on their margin expectations, and many unrealistically behave as if they have real pricing power. In a world of constrained labour, more capital investment will likely be needed to improve productivity.
The challenges of 2022 have not disappeared, but may weigh on the recovery. There is emotion in a relief rally and investors should recognise the challenging nature of the recovery that we face.
A version of this article was published in Citywire on 8.2.2023.