Eyes on the Bear – Alex Cathcart

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Key points:

• Global equities entered a bear market;

• This liquidation was a little faster than normal, but is not unusual;

• The improvement in equity valuations caused by strong earnings growth and falling prices is unprecedented for fifty years;

• We believe the next leg of the bear market will be fueled by downward pressure on corporate earnings as a recession sets in over the next twelve months.

• Given this, we are significantly underweight global equities in our portfolios;

• There is still a reasonable chance (although less than 50%) that there will be no recession, in which case equity markets should rise strongly from here.

The US stock market has now entered its third bear market (more than 20% sell-off) in less than four years – the fastest hat trick in at least 120 years. Global equity markets were under pressure throughout the year, primarily due to persistent inflation and the resulting tightening of monetary policy by central banks globally. Equity markets took a hit from rising discount rates as long-term interest rates rose and began to price in the risk that a tightening of monetary policy would ultimately lead to a recession. In this month’s Insight, we take an in-depth look at bear markets and their drivers.

A history of bear markets

There have been 21 bear markets in the United States since 1900 – one every five to six years on average. The average total liquidation is about 35% over a period of about a year and a quarter. There have only been three U.S. market declines greater than 40% since the 1950s: the 1970s recession, the tech bubble, and the financial crisis. There were many major sales between 1900 and the Great Depression, but comparisons this far back in time are not as helpful as those with more modern episodes. In 1915, there were only twelve companies in the Dow Jones index, economic policy-making was very different, and the market structure was archaic compared to today.

Compared to previous bear markets, there really isn’t anything particularly special about the current episode (see below, in red). The pace is a little faster than average, although the 2018, Covid, Great Depression and Black Monday pullbacks were all significantly faster. With the market down just over 20%, the sell-off so far is below average – but of course it may not be over.

Source: Refinitiv DataStream, Drummond Capital Partners. Data from 1900 to 1950 are the Dow Jones industrial monthly average. 1950 – 1963 is the daily Dow Jones Industrial Average. Post 1963 is the S&P500 index.

Market return factors

If the current correction is relatively “normal” overall, what about the underlying drivers? Below, we break down historical stock market returns into dividends, earnings growth and valuations:

In times of severe equity market weakness, it is common for valuations to compress while earnings remain healthy. Then, long after that point, and often after stock markets have begun their recovery, profits fall. However, if equities rally, this is more than offset by rising valuations. Significant and prolonged declines and recessions, such as the financial crisis, face falling earnings and valuations. Dividends contribute significantly to long-term returns, but from year to year they have a negligible impact.

In 2022, the first half of this pattern has taken place. Of particular interest is the extent of the compression in valuations, the largest in fifty years. As the US stock market sold off, it was largely protected by very impressive earnings growth. This earnings growth (and market fall) has taken the US market’s trailing PE from a peak of around 35 times earnings in April 2021 to around 21 times today. This has kept the valuation gap between the equity market and the bond market relatively stable, despite the biggest increase in bond yields for many decades.

It is therefore possible to argue that the current decline fully reflects the valuation adjustment driven by higher bond yields. Compared to bonds, US equity valuations are fundamentally stable:

Are the markets continuing to fall?

With markets already down more than 20% and valuations having improved significantly in absolute terms, what’s next? Mechanically, any further correction must take the form of lower valuations, dilution (equity issuance) or lower earnings.

A correction in valuations could come from higher interest rates or heightened concerns about the risk of recession. As mentioned in previous notes, we believe that the rise in long-term interest rates (spot rates will continue to rise) has largely run its course. A continued multiple squeeze driven by recession fears is certainly possible, but the fall that has already taken place is quite extreme. The rolling PE ratio of US equities fell by around 40%, the same magnitude as during the tech bubble and the financial crisis. The only bigger drop was in the 1970s with a 62% correction. Although inflation played a key role in both episodes, we do not expect a decade of extremely high inflation ahead, so this comparison may not be the most valid comparator.

Dilution is common in times of economic and financial stress, especially when companies cannot access debt financing markets or the cost of such debt is prohibitive. In the short term at least, that doesn’t seem particularly likely. Earnings remain healthy and wholesale stock issuance is more of a last resort tool for companies.

This leaves gains. Earnings growth is largely a function of economic growth and profit margins. Profit margins for U.S.-listed companies are incredibly high right now, raising fears that a normalization could mean a sharp drop in profits. However, our analysis shows that much of the structural increase is due to lower corporate tax rates. One of the ways we assess earnings growth prospects is through our capital market framework, which takes into account the impact of margins and economic growth. Below, we show the output of our earnings growth models for the end-of-cycle scenario (the most likely scenario in our 2022 strategic asset allocation review).

Source: Refinitiv DataStream, Drummond Capital Partners
Source: Refinitiv DataStream, Drummond Capital Partners

In this scenario, we are modeling a relatively small decline in earnings in major markets. However, this small decline follows the post-Covid period of extremely high earnings growth, which could increase the impact on market sentiment. The slight decline in income reflects the assumption of a minor recession, similar in magnitude to that of the 1990s. This scenario assumes a minor economic contraction, as corporate and household balance sheets in the United States are very healthy ( household debt to GDP in the United States is around 2003 levels and corporate debt to GDP is around the post-1990s average), and there are no excesses or imbalances in the financial system (outside of crypto, which is irrelevant from a system-wide perspective). We also assume in this scenario that interest rate increases are in line with current market prices and that the minor recession is sufficient to bring inflation under control.

Given that valuation compression has largely occurred (barring an unlikely scenario of significant increases in inflation) and dilution is not likely at this stage, in the medium term earnings will be critical to the next phase of the stock market downturn. Although not a guaranteed outcome, a recession in the next year is more likely than not by our estimate. Central banks are determined to bring down inflation and this has historically been accompanied by slower economic growth, often leading to a recession. A forecast of slower growth is also supported by our growth barometers, all now in negative territory:

Source: Refinitiv DataStream, Drummond Capital Partners
Source: Refinitiv DataStream, Drummond Capital Partners

This recession would cause the earnings contraction necessary to bring the current bear market into the territory of the average market decline, around 35%, or 10% to 15% less than today.

Portfolio positioning

In line with this outlook, our portfolios are currently underweight growth assets, very underweight global equities and overweight government bonds. The risk of this positioning would be a significant bearish rally, which is certainly possible given the pattern of market declines shown in the first chart of this preview. Markets tend not to go down in a straight line. Otherwise, if global central banks manage to rein in inflation while avoiding a recession in the second half of this year, the current starting point for stock market valuations, combined with policy easing, would present a very attractive entry point. for equity market investors. Any loosening of central bank policy would likely be the catalyst for a significant market rally.

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