Global equity markets experienced a rapid and bruising sell-off this week. In the U.S., we are nearing the intraday lows for the S&P 500 from June, while many stocks are making new lows.

Below we look to answer critical questions for this market and provide perspective on how strategic investors can approach this volatility.

Why Are Equity Markets Selling Off?

Why are equity markets selling off?

• Markets are waking up to the harsh reality of a world of very tight monetary policy, led by the Fed and compounded by other central banks around the world.
• Global central banks are now fighting a singular war against inflation, meaning other concerns like employment, growth, and even market stability are being put on the back burner
• Whistling past the graveyard: US equity markets had been overly cool and calm in recent weeks, ignoring the message that the bond market was sending
  • The bond market selling off, meaning yields were rising, was signaling that inflation was going to remain more persistent, and, thus, require central banks to remain more restrictive than what had been expected during the summer risk rally
  • The march higher in yields to new cycle highs (the US 10 Year Treasury up to 3.7%, and US 2 Year Treasury to 4.2%[1]) was not being mirrored by a fall in stocks to June lows or new cycle lows.
  • This divergence closed rapidly in recent days
  • Further, the deeper inversion of the yield curve (short yields moving increasingly higher than long yields) was signaling growing likelihood of a recession due to the tightness of today’s monetary policy
  • Remember, the Fed has expressed willingness to have a period of economic “pain” in order to control inflation[1]

[1] Bloomberg, as of 9/23/22 

How Deep Will the Correction in Equities Go?

• Waking up to a world of tighter policy for longer means two things for equities:
  • Lower earnings: S&P 500 EPS growth of 8% for 2023[1] may be too high given how tight the Fed is and how much lower US growth is likely to be as a result of this tight policy
    • Estimates likely need to be revised downwards towards flat at best and even lower in a recessionary environment
    • Current EPS for 2023 is at $243, flat with 2021 would $223, and a mild recession is could generate EPS closer to $200 (a decline of-10% from current 2022 estimates)[2]
  • Lower valuations: liquidity and rates drive valuations (PE ratios); today’s valuations at just slightly below average at ~16x[3] are still too high given the level of rates and how tight liquidity is
    • Further, as EPS estimates get cut to reality, these valuations will look even less attractive
    • Assuming a moderate recessionary 10% decline in earnings next year to $200, today’s market is at an expensive 18x; this valuation would be justifiable if the Fed pivoted to easing, but they say they will not be pivoting soon due to inflation
  • All in, we believe this suggests equity markets likely have not seen their fundamental bottom yet
• A retest of the June lows is likely in the near term, and it looks increasingly like we overshoot that level given the rising risk of recession (necessitating lower EPS and valuations)
• ~3,600 is an important support level for markets
  • Long run support since the recovery from the Great Financial Crisis is the 200 Week Moving Average (the S&P 500 tested it in 2011, 2016, 2018, and 2020)
  • But we note that the world is a different place than in each of those corrections: the Fed pivoted each time in response to support markets because inflation was benign; that is not the case today
• A liquidity event could also push us through the important 3,600 support level for the S&P 500
  • The UK bond and currency market today is a startling sign of brewing liquidity issues, along with pronounced and rapid weakness in other currencies versus the USD, mainly in Asia
  • China economic challenges (property, COVID Zero), Eurozone energy crisis, and a potential emerging market (EM) debt/funding crisis ($12T of USD denominated foreign issued debt[4]) are key watch items

Thankfully, the Fed has liquidity supporting facilities in place like dollar swap lines and reverse repurchase agreements available to foreign central banks, potentially helping to stave off a global liquidity crisis (like we saw in 2008 and for a brief moment in 2020)

[1] Bloomberg, 9/23/22
[2] Bloomberg, 9/23/22
[3] Bloomberg, 9/23/22
[4] Bloomberg, 8/31/22

Should We Be Scared?

• As the Hitchhiker’s Guide to the Galaxy says on its front cover: DON’T PANIC
  • Yes, there will likely be real economic pain in the future: unemployment will go up, bankruptcies will happen, growth will slow
  • This is the result of very tight policy
• We are now down ~25% from the all-time high over 9 months for the S&P 500[1], just shy of the average duration and magnitude of a typical recessionary bear market
  • We believe this bear has the potential to last longer and go deeper than average given the high valuation starting point, the degree of policy tightening, and how the Fed is constrained by high inflation today
• We do think the equity market is at risk of making new lows given the headwinds described above
• We believe now is the time to start thinking strategically, not just tactically

[1] Bloomberg, 9/23/22

What Should We Do?

• We believe we need to prepare ourselves to begin to be strategic buyers as we retest the June lows
  • If you have cash available, it may be appropriate to start systematically adding small portions on big down days
  • This may be a good time to start dollar cost averaging
• This is not calling the ultimate low, this is not trying to perfectly time the market bottom, this is not a tactical call, and this is not a pushing the chips “all in” moment
• Instead, this is about looking out 2+ years and seeing value and potential, acknowledging that forward returns after major market corrections are typically better than average
• When that capitulation moment comes, we do not want to be scared, we want to be prepared
  • The way to avoid fear in the later, scarier portions of a bear market is to have a plan in place beforehand to take advantage of weakness
• Markets like Friday’s is when fear starts to take hold, and when fear takes hold mistakes and overshoots happen

Also, We Could Be Wrong in Our Cautious Tone!

• If we are wrong about being cautious, markets have been weak enough YTD that returns could be strong in the near term if better data emerges
• This is not our base case, but we need to remain open to be surprised to the upside
• Factors like inflation falling much faster than expected and allowing the Fed to dial back its hawkishness, could be the drivers that surprise the market to the upside
• Be careful: do not conflate a counter trend, relief rally with a trend change!
  • Our stance is still not to chase rallies, but we will judge each rally as they come
  • Every bear has relief rallies as markets get oversold in the near term
  • The challenge is determining a trap from the early stages of a new bull
  • We watch for a true turn in liquidity to tell us that the new bull has started; liquidity will turn when the Fed turns

Where Should Strategic Buying Be Focused?

• What led in the last cycle (expensive tech, hyper growth, speculation) may not lead the next cycle given a very different macro backdrop (higher rates, higher inflation, tighter labor markets)
  • We believe Tech/Growth is still at risk with valuations that are far too high for the interest rate and liquidity environment
  • If we have to sell for any reason (liquidity needs), look to the most expensive names as the market will eventually “shoot the generals”
  • We think this means a Value tilt is warranted (with a quality overlay being imperative), while equal weight indices could outperform cap weighted indices that retain high tech/communications/mega-cap exposure
• We stay focused on US Quality stocks and managers
  • Quality stocks are names that you can potentially buy at discounts today and own through the next cycle in order to compound value in a tax efficient way
  • Quality will lag in the initial recovery (the junkiest names that barely survived have the biggest rebounds, but those names are often trades not investments), but Quality names are those you don’t have to sell going into the next downcycle
• We believe it is too early to step into higher risk areas like emerging markets (EM) and small caps
  • For small caps: these names outperform in the first phases of a market recovery, once the Fed has started injecting liquidity; if you are too early in the small cap trade you risk having to ride out higher occurrences of business failures and funding problems
  • For EM: you must wait on a breakdown in the USD to go overweight (OW) EM; every period of sustained EM outperformance has occurred alongside a major bear market in the USD; eventually this parabolic move in the USD will snap, allowing for an OW to EM, but not yet

Today’s Market Mood

• One reason we have been so cautious through this correction and unwilling to call the end of the bear has been the persistence of bullish equity positioning by individual investors
• We have been surprised by the resilience of many US retail investors through this bear market:
  • Investor allocations to equities is only -5% from its pandemic-bubble peak to ~65%; in deep bear markets (2000 tech bust, GFC) this allocation fell to 45% and below[1]
  • Investors are still “buying the dip” with notable inflows into equities throughout 2022
  • This positioning and buying has occurred despite poor sentiment surveys
  • This is good reminder to “watch what investors do, not what they say”
• But we think this resolute bullish positioning may change in this correction
  • When the market suffers a quick drop to prior lows after a powerful rally (when many thought the worst was over), it is usually when despair and fear start to set in
  • We see potential for some investors to “throw in the towel” on equities and finally start selling, mostly now that they have competition from safe assets, like 2 Year treasuries yielding over 4%
• There is a silver lining in this: the more investors give up on equities in the near term and the lower equity allocations go, the higher forward returns are
  • The wall of worry is painful when it is getting built in bear markets, but climbing the wall of worry is a key source of better returns in bull markets

[1] American Association for Individual Investors (AAII), 9/15/22