Originally published at Value Penguin

An uncountable number of things affect the global stock market. In just the last 24 months, oil price has declined from over $100 to around $30 per barrel, and henceforth has bounced back to about $40 recently. Central banks in Japan, Sweden and Switzerland lowered their interest rates to the negative territory in an effort to keep their economies afloat with monetary stimulus. The UK has shocked the world with its vote to leave the Europe Union. Amongst this turmoil, major indices all over the world have declined meaningfully in the last 12 months, with one exception: S&P 500 continues to rise and is trading at its all-time high. This leaves many to ask one question: what will happen to the global stock market going forward?

It’s practically impossible to predict how the stock market will behave; if you can, you should probably be a billionaire already. For the vast majority of people, it’s advisable to refrain from making bets on the stock market while trying to predict how the market will move. However, it’s one thing to not bet on market sentiment, and it’s a whole different thing to ignore market environment entirely. When you can’t know where you are headed, it’s important to know where you are situated so you can prepare yourself for a range of possibilities. Understanding what has been happening and where things stand currently is useful in preparing for the future, however it turns out to be.

Basic Concepts

Every financial product, including stocks and bonds, is meant to represent some investment return given some amount of risk. For instance, short-term US treasuries (also referred to as monetary market) are regarded as one of the safest assets in the world, and hence typically carry a very low return for its investors. Private equity and venture capital, on the other hand, are regarded as two of the riskiest assets in the world, and investors demand an extremely high potential return to buy such assets. This characteristic of financial products is collectively described with a chart called the risk curve depicted below. No money is free, and high return is wed at the hip with high risk.

Global Stock Market

[drizzle]Typically, an asset is “cheap” if it offers a high return on investment compared to the risk it contains. For example, a bond from Company A that yields 6% could be perceived as being cheap if all other corporate bonds from companies with similar caliber as Company A only offer 4%. A stock’s cheapness is measured by a metric called Price/Earnings Ratio (“PE Ratio”), which is calculated by dividing the stock’s price by its earnings per share metric. A PE Ratio is essentially an inverse of interest rate that allows comparison between a stock and a bond. For instance, a stock that has a PE Ratio of 10x offers 10% (1/10) return to the investor, which is higher than interest rates offered by most investment grade bonds.

What has been happening so far?

Since the global financial crisis of 2008, nearly every single central bank in the world has been implementing a policy called “quantitative easing” or “monetary stimulus” to calm the market and aid in economic recovery. Quantitative easing (or “QE”) and monetary stimulus refer to measures taken by central banks to lower interest rates by printing money. The hope of such a strategy is that low interest rates will help some companies and consumers pay down their debt, while incentivising others to borrow money to fund new projects that could increase employment (and hence income & consumption). It was supposed to buy time until governments figure out ways to stimulate their economies with fiscal policies like upgrading infrastructures to create jobs and boost financial health of their people.

One of the biggest side effects of such strategy was the massive influx of capital into the stock market, also referred to as equities. Because of low interest rates, bond investors were suddenly left with bonds that provided insufficient returns they required. To look for better yields, they moved their money out of bond market and into the stock market that offered higher potential returns but with higher amount of risk compared to bonds. This influx of capital increased competition for stocks, and investors found themselves demanding even lower return on stocks than they had previously. This behaviour pattern spread, and hedge funds that typically only invested in equities began to make venture capital investments that were previously regarded as too risky, in turn creating an unprecedented number of startups valued above $1bn called “unicorns.” This series of pattern resulted in a new risk curve that is lower and flatter than typical, implying investors have gotten much laxer with their standards and have begun to accept lower return for a given amount of risk.

Global Stock Market

In the meantime, although central banks have tried to buy time for more meaningful solutions for the crisis that happened in 2008, just about the only thing any government has ever done in the last 7-8 years is mostly printing money without meaningful actions to increase productivity or income. US and Europe have been (and continue to be) handcuffed by their own internal political conflicts. Japan’s Abenomics has yet to create any fruitful results. And China is struggling to contain its immense pile of bank loans that seemed to have gone nowhere but to companies seemingly incapable of paying their money back. Eight years have passed and almost nothing has changed.

So what is happening now?

In light of this backdrop, the recent volatilities in the global stock markets seem to make more sense. The global economy has been walking on thin ice since the last crisis in 2008, and central banks are out of ammunition because they can’t lower interest rate anymore. Meanwhile, political unrests add to oil to the fire, creating a lot of uncertainties in the market. Little wonder most of the major indices in the world are down in the last 12 months.

% Chg Since 12 Months Ago 2007 Peak
S&P 500 4% 40%
Hang Seng -9% -28%
Shanghai Composite -18% -50%
Nikkei 225 -19% -8%
FTSE 100 2% 1%
DAX -8% 29%

Something more interesting underlies the events that have been happening recently. Despite all the problems in the world, S&P 500 reached its historic high, almost 40% higher than its peak in 2007. When adjusting for currency fluctuations, S&P 500 has outperformed all other major indices massively in the last 12 months. This is in stark contrast to the rest of the world, which typically has fallen 10-20% in USD terms. It seems that there may be some level of capital flight happening into the US stock market from all over the world, helping to artificially prop up US equities. Is it really possible for the entire world to be on the verge of recession (if not already in one) while US only maintains a healthy economy?

% Chg Since (In USD Terms) 12 Months Ago 2007 Peak
S&P 500 4% 40%