For those wondering “how long” the US equity run can continue – this is a very insightful piece of analysis from our in-house team. ~ Brent Woyat
As the great and the good in the world of economics and policy-making gather for the joint IMF and World Bank annual meetings in Washington this weekend, you may think they would be in a congratulatory mood given the synchronized positive growth in the global economy. Ahead of the meetings, the latest IMF economic projections point to a pick-up in global economic growth to 3.6% for this year and 3.7% for next, from the 3.2% growth in 2016. Moreover, the current global economic acceleration is broad based with all major regions and countries projected to grow this and next year. There are no signs of this economic expansion coming to an early end.
Even though the macro back-drop keeps improving, we can’t help but notice the polarization of views about equity markets. Notably, the focus on market valuation, sentiment and whether or not an equity market correction is overdue given the strong rally since 2009. We highlighted in previous Strategy Notes that equities are not cheap anymore, but they are not prohibitively expensive either. Indeed, investor sentiment indicators seem evenly balanced between bullish and bearish, and net mutual fund and ETF flows this year have favoured bonds over equity – hardly a signal of complacency. So what of the possibility of a market correction? Well that would seem likely at some point, we’ll probably see a few before the peak of this cycle, but the possibility of a major bear market does seem remote right now.
That is, the bigger picture here is that most bear markets in the US have coincided with a US recession – at least when looking back over the past fifty years. We don’t see the excesses in the economy that indicate a recession is likely in the short term. Indeed, most recessions in the US have occurred as a result of an over tightening of interest rate policy by the central bank. At the moment, the US Federal Reserve is approaching policy normalization in a cautious manner. The other two major causes of a US recession have been the oil price hikes in the 1970s and a bursting of a credit bubble in 2007. Presently, we do not foresee the price of oil rising to such a level or a severe credit event which might cause a recession. In addition, the strong US and global purchasing managers surveys point to a continuation of the positive economic momentum in the near term.
Given the economic and market uncertainties, a dilemma for some investors is either to participate in what they view as an over-extended stock market or wait for a more opportune time to invest. We would highlight that it is difficult to pinpoint the top of the market and crucially, that most bear markets take time to manifest themselves. This presents opportunities for investors. Provided the next recession is more than three months away, typical returns over the next six months would be positive, based on our analysis of US equity market returns over the past 50 years.
Figure 1 highlights the 7 bear markets in the S&P 500 Index over the past fifty-five years. We have defined a bear market as a fall of more than 20% or more in the Index based on weekly data. Most bear markets have coincided with a recession with the exceptions of 1966 and 1987.
Figure 2 highlights that most bear markets take time to correct. On a median basis, bear markets last 18 months with the shortest being 7 months (excluding the 1987 bear market) and the longest 21 months. Moreover, while the eventual percentage drop in a bear market is substantial, they are often accompanied by volatility in the initial period and thus take time to develop.
Figure 3 highlights the median losses in the initial periods following the start of the bear markets. The median losses were -4.7% and -7.7% after three and six months respectively. Moreover, if we consider the returns including the three and six months prior to the start of the bear market, then the losses tend to be minimal. The median return was -1.9% for the period between the 3 month prior and 3 month after the start of the bear market. On the six month window either sides, the median return was actually positive at 1.6% over the period.
So what does all this mean for the investment decision today? Essentially we believe that investors should be positioned for growth in a well-diversified portfolio. In the words of the Communards, “don’t leave me this way.” It is too early to capitulate, based on our assessment of markets and the economic cycle.
Brent Woyat, Canaccord Genuity
