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Traders work on the floor of the New York Stock Exchange on Sept. 9.BRENDAN MCDERMID/Reuters

Well, that was fun wasn’t it? After two and a half years of coronavirus, war and surging-then-falling stock prices, we are now back to pretty much where we started.

In nominal terms, Canadian and U.S. stock prices hover roughly 10 per cent above where they stood on New Year’s Day, 2020, before plague, inflating prices and Vladimir Putin knocked the world for a loop. Adjust for inflation and stocks are actually a hair cheaper in real terms than they were before this lunacy started.

One way to view this round trip is as a sign that the madness has been shaken out of the market and sanity has been restored after the excesses of the pandemic era. There is a lot to be said for this happy view. When investors can collect dividend yields of around 6 per cent a year on blue-chip Canadian companies like BCE Inc. BCE-T, Bank of Nova Scotia BNS-T and TC Energy Corp. TRP-T, it seems clear the market is offering some decent value.

But that may be missing an equally important point. While stocks certainly look a lot more reasonably valued than they did at the start of the year, their fall from the heights of giddiness doesn’t ensure they are now free of problems. Those problems include the lingering impact of the pandemic as well as the uncertain situation in Ukraine. The biggest issue of all, though, is rising interest rates.

Governments, corporations and households are struggling to adjust to a new regime. For more than a decade after the financial crisis, the smart thing to do for policy makers, executives and consumers was to take advantage of rock-bottom interest rates in a low inflation environment and load up on debt. Now, with inflation ripping and central banks competing to push up interest rates, taking on large amounts of debt is suddenly looking like a much riskier proposition.

The ramifications of this abrupt shift are just beginning to work their way through the system.

Rising mortgage rates in Canada and the United States have pushed real estate markets in both countries into the deep freeze. Soaring bond yields and better savings rates have put pressure on share prices by offering an increasingly enticing alternative to risky equities.

Meanwhile, surging U.S. interest rates have attracted a swarm of investors and helped to propel the U.S. dollar to a two-decade high against other major currencies.

The U.S dollar’s relentless rise puts enormous pressure on other countries to follow suit with rate hikes of their own. Otherwise, their currencies will cheapen even further against the greenback. And that would mean they would have pay even more in local-currency terms for goods and commodities priced in U.S. dollars.

On the brink of a global recession, hopes dim for a soft landing for Canada’s economy

This mass move to higher rates could have unintended consequences. Central banks “risk acting too forcefully,” Maurice Obstfeld, a former chief economist at the International Monetary Fund, warned in a recent note. “By simultaneously raising interest rates, they amplify each other’s policy impact and, if this feedback loop isn’t taken into account, could drive the global economy into recession.”

In this uncertain environment, it takes a brave person to attempt to put a value on stocks. Fortunately, Aswath Damodaran, a professor of finance at New York University and expert on valuation, rose to the challenge this week. He outlined the key variables in an enlightening blog post and arrived at a fair value estimate of 3,516 for the U.S.-focused S&P 500 – just slightly below its current level around 3,610.

This is somewhat reassuring, but Prof. Damodaran stresses that his estimate hinges on several unknowable factors – how badly corporate earnings will be hit by any future recession, how high interest rates will have to go and how much of a premium investors will demand to offset the risk of holding stocks. Nudge any of these factors just a bit and you arrive at very different estimates of fair value – some much higher, some much lower.

The key takeaway for investors may be that stocks are far cheaper than they were but are still not undeniably cheap. Look, for instance, at the ratio of stock prices to company revenues. In the U.S., this price-to-sales ratio has plunged from pandemic highs, but is still at one of its highest levels in the past 20 years.

In Canada, valuations appear more reasonable. The problem here is the economic picture is darkening.

One of the classic ways to assess the broad economic outlook is to look at the gap between short-term interest rates (as measured by the two-year government bond) and long-term rates (as measured by the 10-year government bond). Long-term interest rates are typically higher than short-term rates. When this pattern inverts, it usually indicates a period of economic weakness ahead.

Right now, the Canadian yield curve is steeply inverted. This does not bode well for corporate earnings or stock prices.

Long-term investors may decide to overlook these immediate problems and start nibbling on the values that have emerged after stocks’ plunge this year. But the key word there is nibbling. Until interest rates stop rising, gorging does not seem like a great idea.

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