The global equity market slid for a seventh consecutive week with the MSCI AC World Index falling 1.2%. In the United States, the tech-heavy NASDAQ dropped 3.8% while the S&P 500 closed the week 3.1% lower. Markets overseas performed better with European stocks climbing 0.9% and Japanese stocks rising 1.19%. Emerging market stocks jumped 3.1% as the MSCI China index surged 4.5%. The nominal 10-year U.S. Treasury yield continued to retreat – falling another 13-basis-points to 2.78%.
U.S. stocks are pricing in a future slowing in the economy. This is not surprising given that the Federal Reserve is literally telling investors that it intends to slow the economy in order to combat inflation. The well-used motto, “Don’t Fight the Fed” seems an apt description…particularly when it is still punching (tightening monetary policy).
However, we feel confident that much of this drawdown is likely behind us. Excluding the Tech Bubble and Global Financial Crisis, past S&P 500 drawdowns around periods of U.S. recessions have been around 24.0%. Traditional signs of capitulation have yet to be reached, but financial markets appear to be getting ever closer.
The next Weekly Market Update will be published June 6, 2022. We hope everyone enjoys their Memorial Day holiday!
Are We There Yet?
If the Federal Reserve did not have investors’ attention, it likely does now with the S&P 500 briefly dipping into bear market last Friday before staging a late-day rally (a bear market is defined as a sell-off that is over 20%). Traditionally, bear markets are accompanied by a recession. In this case, equity markets are already pricing in a slight-to-modest contraction in the U.S. economy even though second quarter real GDP is tracking at about 2.4% and the unemployment rate sits at just 3.6% (see figures 1-2). A “hard landing” for the economy does not yet appear to be priced in.
The reason U.S. stocks are pricing in a slowdown in the economy is because the Federal Reserve is essentially telling investors that it intends to weaken the economy by tightening financial conditions in order to combat elevated inflation. This was confirmed last week when Fed Chair Powell said that “This is not a time for nuanced readings of inflation. We need to see inflation coming down in a convincing way. Until we do, we’ll keep going.”1. This commitment has left investors wondering just how far the Fed will go and how deep will the stock market sell-off end up being?
We completely acknowledge that we don’t know the exact answer to that question (and would argue that no one does). To say differently would be dishonest in our opinion, but we can use historical patterns around previous recessions and signs of investor capitulation (when investors have decided to stop trying to recapture lost gains as a result of falling stock prices) as a potential guide.
When we look at recessions since 1945, the S&P 500 has experienced an average drawdown of 28.4%. Though that average is skewed by several “mega” sell-offs like the Tech Bubble of 2000-2001 and the Global Financial Crisis of 2008-2009, when stocks sold-off by an average of 53.0%. Technically, that type of sell-off should be considered the absolute floor (see figure 3). However, that would put the index back at March 2020 levels, which was the height of the COVID-19 pandemic when unemployment shot up to 14.7%% and the S&P 500 was trading around 2,250. That doesn’t make sense to us.
|Periods of U.S. Recession||S&P 500 Drawdowns||S&P 500 Returns After Trough|
|Economic Peak||Economic Trough||Months of Contraction||S&P 500 Peak||S&P 500 Trough||% Decline||12 Months||18 Months||24 Months||Second Year Gain/Loss|
|Average Duration:||10 Months||Average (Decline / Gain):||-28.4%||37.9%||42.3%||49.1%||11.3%|
|Excluding the Tech Bubble
and Global Financial Crisis:
If we exclude the “mega” sell-offs of the Tech Bubble and the Global Financial Crisis, which seem like inappropriate comparisons, the bulk of recessions since 1945 saw an average drawdown of 24.0%. That would leave the S&P 500 around a level of 3,650. Again, we don’t know when the market sell-off will end, but that level would line up with historical patterns and potentially signal that a U.S. recession in 2023 or 2024 has been largely priced in. Though we wouldn’t be all the that surprised if the market finds a bottom above that level should economic data hold up and the Federal Reserve eventually communicate that it may pause in September to reassess the economic outlook.
What Should Investors Watch for Signs of Capitulation?
There are several potential capitulation indicators, but the Chicago Board of Exchanges Volatility Index (VIX) stands out as a relatively easy one to follow. In 1998, 2002, 2009, and 2020, the VIX jumped to above 40 before market volatility faded substantially (see figure 4). Again, we don’t think those periods are the best comparisons to today’s environment with less signs of economic excess currently (consumer debt levels are not at extreme levels, the banking system is well-capitalized, and many large technology companies have substantial earnings and strong balance sheets), but a more substantial spike in the VIX may be a sign of investor capitulation.
Another common metric that is often watched is the percentage of stocks that are trading below their 200-day moving average. Traditionally, capitulation has been reached once 80% to 90% of the New York Stock Exchange (NYSE) is trading below its 200-day moving average. Right now, 75% of the NYSE is trading below, which could mean that we still have a bit further to go if economic data and corporate profits start to weaken more materially (see figure 5).
Is There Any Good News?
We could argue that there are a couple of reasons to be optimistic: 1) the positive correlation between stocks and bonds appears to be breaking down and 2) the recoveries that follow bear markets tend to be lengthy and substantial. For most of this year, stock and bond returns have been falling in unison with stocks declining as bond yields rise. The result was weakened portfolio diversification. However, that correlation has broken down over past few weeks with the 10-year U.S. Treasury yield dropping from about 3.13% on May 6th to 2.86% currently. That means that bonds have once again been working as a safe-haven and are providing some portfolio diversification (see figure 6).
More important than this recent breakdown is the potential for the recovery to be lengthy and substantial. Going back to 1932, the average bear market recovery has lasted well over 600 days and returned an average of 102.1% from trough to peak (see figure 7). This is why we frequently remind investors that “time in the market is more important than timing the market.”
To bring home this point, consider that when the NASDAQ bottomed out after the Global Financial Crisis, very few investors felt confident about the future and yet it proved to be a wise entry point for long-term investors (see figure 8). We continue to encourage investors to not lose focus of their long-term goals because of volatility over the near-term.
|Trough||Peak||Trough to Peak %||Number of Days|
|Average # of Days||686|
|Stock Market Index||Date of Last
from Record High
|Percent Change from Global Financial Crisis Bottom
(March 9, 2009 to May 23, 2022)
|Dow Jones Industrial Average||1/4/2021||-13.4%||386.9%|
What Should U.S. Investors Watch in the Week Ahead?
Investors will get a fresh read on new home sales, which are expected to fall by about 1.7%, we will get the May Federal Open Market Committee meeting minutes, and the April personal consumption expenditure (or PCE) deflator index, which is an inflation metric that the Fed watches closely. The consensus is expecting the PCE deflator to drop from 6.6% year-on-year to 6.2%. That will be released on Friday and might end up being the key event of the week.
|Index||Weekly Chg change in percent||YTDyear to date change in percent||12 Months12 month change in percent||Div. Yield division yield in percent|
|Instrument||Weekly Chgchange||YTDyear to date||12 Months12 month change||Level|
|10-Year Treasury Yield (%)||-13 bps||127.1 bps||115 bps||2.78%|
|Index||Weekly Chg change in percent||YTD year to date in percent||12 Months||Div. Yield division yield in percent|
The Week Ahead
|5/24||10:00||New Home Sales||AprApril||750k thousand||763k thousand|
|5/25||8:30||Durable Goods Orders||Apr PApril||0.6%||1.1%|
|5/25||14:00||FOMC federal open market committee Meeting Minutes||5/4/2022||-- n/a||-- n/a|
|5/27||8:30||Advance Goods Trade Balance||AprApril||-$114.8b billion||-$125.3b billion|
|5/27||8:30||Real Personal Spending||AprApril||0.7%||0.2%|
|5/27||8:30||Retail Inventories MoMMonth over Month||AprApril||2.0%||2.0%|
|5/27||8:30||PCE personal consumption expenditures Deflator YoY year on year||AprApril||6.2%||6.6%|
|5/27||8:30||PCE personal consumption expenditures Core Deflator YoY year on year||AprApril||4.9%||5.2%|
|5/27||10:00||U. of Mich.University of Michigan Sentiment||May F||59.1||59.1|