The recent stock market recovery means that, in general, stocks are more expensive than they were a month ago. So will the stock market continue to recover or come crashing back down?
The truth is that nobody knows with certainty what the stock market will do in the next week or month. But I think that there are some things that give us a clue.
Economic data
The first thing that might indicate the direction of the stock market is economic data. Specifically, the possibility of a recession.
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Central banks have been raising interest rates to try and bring inflation under control. As interest rates rise, however, the possibility of a recession increases as economic activity slows.
In my view, a recession is likely to cause a fall in share prices as expectations of earnings decline. So I think that a recession is likely to stall a stock market recovery and bring the stock market down.
Central banks
I also think that central bank policy is important. Currently, both the Bank of England and the Federal Reserve have been raising interest rates to combat high inflation.
More importantly, central banks have been saying that they are prepared to do whatever it takes to bring inflation under control. In other words, they are prepared to raise rates quickly and by a lot.
If central banks change their outlook, then I think that share prices will continue to rise. I don’t think it matters whether this comes from inflation coming under control or central banks giving up.
A change in central bank policy is therefore the second thing that I’m looking for to try and figure out the direction of the stock market.
Capitulation
Lastly, I see the amount of money coming out of the stock market as important to the recovery. In particular, I’m looking at the amount of money coming out of the market from retail investors.
According to Bank of America, the last major stock market declines have been accompanied by significant outflows from retail investors. This time, however, investors have been staying the course.
If retail investors capitulate, then I expect stock prices to go lower. Since this hasn’t happened yet, I think there’s still a major threat to the stock market recovery.
How I’m investing
I think that where the stock market goes next will be the result of a number of factors that are very difficult to predict accurately. So how should I invest?
Without a strong view on where the stock market goes next, I’m following Warren Buffett’s advice. Instead of trying to buy stocks at their lowest prices, I’m aiming to buy stocks at prices that are low enough.
Right now, I’m looking at Diploma and The London Stock Exchange Group in the UK. In the US, I’m buying Meta Platforms and Disney.
I think that the cash that these businesses will produce is attractive compared to the price that I have to pay for them today. As such, I’m happy buying the stocks regardless of where the stock market goes next.
