Equity markets continue to struggle with the harsh new reality of slower growth and tighter Fed liquidity. This challenging combination means that both earnings estimates (from slower growth) and valuations (from tighter liquidity) are under pressure. Add on top of this a high inflation environment that both hurts earnings and prevents the Fed from stepping in to stabilize markets, and markets have been shaken.
Periods of market volatility always raise two questions: how much further down do we have to go and what actions should we take in response? Unfortunately, the former cannot be known with certainty and is outside of our control; however, the latter is within our control.
In short, we do see the possibility for further downside in major U.S. equity indices, but we think we have likely already experienced the majority of this correction. This means it is time to prepare for how to take advantage of this volatility.
Are We There Yet?
Even after today’s sharp sell-off, we still don’t see signs of a true capitulative flush in equity prices and positioning. We watch a host of technical and fundamental signals to determine when people are terrified, racing for the exits, selling indiscriminately, and paying egregious prices for downside protection. Though many of these signals are starting to near more significant levels, few have reached extremes consistent with prior major market lows. This doesn’t mean that we cannot have short term bounces (bear market rallies), but in order to see a major, sustainable low, we are looking for things to be “so bad they’re good.” We’re not quite there yet, but we are getting closer.
Next, we must appreciate that unlike prior corrections where the Fed stepped in to support markets in 2011, 2016, 2018, 2020, today’s high inflation is a constraint on the Fed and is likely to prevent it from calming markets in the very near term. Importantly, inflation was at or below the Fed’s 2% target in each of the corrections in the prior cycle. This allowed the Fed to pivot aggressively to dovishness in order to support markets and spur rallies.
Today, inflation is 4x the Fed’s target, and while year-over-year inflation metrics are likely near a peak (tough comps, easing durable goods inflation), at least in the next 3-5 months, we do not expect inflation to moderate quickly enough to allow the Fed to do a full dovish pivot. Further, the Fed remains well below its target for a neutral policy rate, which means this tightening cycle is just getting started. Note, if valuations and expectations continue to fall rapidly, it may not take a full dovish pivot to provide relief to beleaguered markets — another reason, to start preparing to take advantage of opportunities, even if there is more near-term downside.
The 200-Week In Play
So if we’re not “there yet”, where is “there”?
Here we look to the 200-week moving average, which has been a long-term level of support for the S&P 500 for the entirety of the last cycle (except for the short undershoot during the COVID sell-off). After the ~18% correction YTD, to correct down to that level today would imply another ~11% downside for the index. This would bring the total correction to a whopping -28% from the early 2022 all-time highs. Corrections of this magnitude are typically followed by robust forward returns over the next 12 months.
We can, of course, undershoot this level, as we did during the COVID melt-down, but this 200-week level — at about 3,480 — is where things get interesting and increasingly compelling.
A correction to this level would also bring us back to the pre-COVID high in early 2020. If we compare today’s estimates for 2022 GDP and earnings to the pre-COVID levels of 2019, nominal GDP is expected to be 16% higher in 2022 than 2019 and S&P 500 earnings are expected to be 45% higher in 2022 than 2019. Of course, these numbers are likely to move lower as growth slows and recession risks rise. Still, a return to pre-COVID levels in equities, despite a much larger economy and earnings base, would be compelling from a valuation perspective.
On the discussion of a recession, the odds are rising, but we would note that we do not see the set up for a major, systemic debt crisis that typically results in more protracted and pronounced equity market corrections (in the 50%+ magnitude).
What Should We Do?
First, we should not panic. Even if there is more downside in the near term, we must be measured and calculating about the actions we take within portfolios instead of emotional.
One of the biggest and frankly most common unforced errors a long-term investor can make is selling out of risk assets after a meaningful correction and then letting fear prevent them from becoming reinvested until markets have already recovered meaningfully. Sticking to a long-term, strategic asset allocation is the best way to prevent investors from committing this error and impeding progress towards long-term goals.
Second, even if we are not making large changes to our broad asset class exposures for the long-term, we have been aggressively migrating portfolios to quality all year. Our CEO, Rob Sechan, always says we have to “love what we own.” And we love quality. Quality is the ballast in the storm of economic volatility. Quality is found in companies that can navigate uncertainty, maintain fortress balance sheets, have powerful business models, and generate ample cash to be opportunistic in their own investments as prices become attractive. These crown jewel companies are getting sold in this market rout as well, and we are eager to pick them up at increasingly attractive prices.
As painful and startling as recent volatility is, and even as we expect it to continue, we must be ready to treat volatility as opportunity, even when it feels scary and wrong. If the great Roman philosopher Seneca is right that luck is when preparation meets opportunity, then let’s make sure we get lucky by being prepared for coming opportunity.
S&P 500 with 200-Week Moving Average
Source: NewEdge Wealth, Bloomberg, as of 5/18/2022
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