After a difficult few months, the FTSE 100, the S&P 500, and the Nasdaq 100 have all gone up over the past week. So could this be the start of a stock market recovery?
Inflation
Inflation pushes down stock prices by threatening corporate profits. When inflation is high, businesses have to increase their prices in order to offset their own increased costs.
The trouble is, there’s no guarantee that customers will continue to buy a company’s goods and services at elevated prices. If they don’t, then profits – and shareholder returns – will be lower.
Inflation has been high in the UK and the US this year and the fall in share prices reflects the risk of a fall in corporate profits. Worse yet, the latest data indicates that the inflationary situation in both countries is getting worse.
Until I see evidence that inflation is starting to subside, I’ll be wary of the idea that this is the start of a stock market recovery.
Interest rates
Increasing interest rates are also bad for businesses. When interest rates are higher, consumers have less incentive to spend money. It also becomes harder for businesses to grow.
Rising interest rates make it more attractive for consumers to save their money. As a result, they become less likely to spend and this is reflected in share prices coming down.
Equally, higher interest rates make it difficult for companies to grow. Growth requires financing and one way in which it is financed is with debt.
Suppose that a company has a growth opportunity that it thinks will generate a 5% annual return. That opportunity is attractive when the interest on the debt needed to finance 1%, but less attractive when the debt incurs interest at 4%.
Increasing interest rates are one of the few things that central banks can do to try and combat inflation. With inflation rising, I’m anticipating further interest rate hikes and I’m expecting this to weigh on share prices.
What to do?
I don’t think that the recent increase in share prices is the start of a significant stock market recovery. But I think that this is a good thing for me as an investor.
My ambition as an investor is to buy shares in quality businesses at good prices. The best way to do this is to be greedy when others are fearful.
That’s much harder when shares are becoming more expensive. A stock market recovery would mean that I have to pay more for the shares I want to buy.
For example, I own shares of Games Workshop in my portfolio. The stock is currently 42% lower than it was 12 months ago.
I’d like to own more Games Workshop shares and I’d like to acquire them at these prices. If a stock market recovery pushes the share price back to where it was a year ago, it’ll cost me a lot more to build out my investment.
As such, I’m hoping that this isn’t the start of a stock market recovery. I’d like more opportunities to buy shares at lower prices. And since I think that inflation is going to get worse before it gets better, I think I’m going to get my way.