- Historically, US bear markets are rare outside of a US recession. However, a turn in markets will likely require some mix of the following:
- Valuations in the S&P 500 have only fallen below 15x forward earnings in the context of a recession or global crisis since 1990. At 15.7x earnings, a 5–6% fall in P/Es would signal overpricing of recession risk.
- To mitigate the prospect of a eurozone crisis, pressure to resolve the Italy–EU budgetary conflict would increase should Italian yields move to challenge 4%.
- Turning to China, signs of proactive rather than reactive policy stimulus would calm fears of a tariff-driven slowdown in Chinese growth.
- Strategically, hedge funds and capital-protected equity exposure remains valuable in the face of asymmetric risks facing investors in 2019.
Having spent much of the past six weeks on the road meeting clients in Europe, Asia and the Middle East and travelling in North America, we notice the pivot in sentiment from the optimism of September to the anxiety of October has been dramatic.
Our recent publication, P/E De-Rating in Progress (October 2018), set out to address the most common questions about why the recent sell-off has taken place. Given the persistence of the declines, many clients are now asking:
- “Are we in a new bear market?”
- “If not, “when will this sell-off end?”
Are we on the cusp of a new bear market? Not yet.
Looking back to the end of World War II, the US market has experienced 11 bear markets (declines of <20% peak to trough). Seven of the eleven bear markets observed have occurred in the context of a US recession.
UBP’s Recession Watch framework identifies few recessionary signs across manufacturing, consumption or credit conditions. Instead, as highlighted in our May 2018 report, Navigating the coming ‘Mini-Cycle’ in the US Economy, economic data, earnings and market dynamics all appear consistent with a mini-cycle in the US economy – characterised by a decelerating manufacturing sector but with firm consumer/employment markets – rather than marking the approach of an economic recession.
Admittedly, however, the S&P 500 has seen four bear markets outside of a recession, though only one of those having occurred after 1970 – the stock market crash of 1987.
Interestingly, despite limited data, anecdotal descriptions provided by the Federal Reserve Bank of Richmond suggest that these pre-1970 bear markets were in the context of mini-cycles not supported by countercyclical Fed policy.
So with US markets sitting 8% lower than their 2018 highs, history suggests that a passive Federal Reserve in the face of sharply declining markets is a necessary condition for a bear market outside of an economic recession.
Five potential triggers for a market bottom
As noted earlier, those bear markets which have occurred outside of a recession have tended to emerge against the backdrop of a mini-cycle in the US economy (which we believe we are in) and in the face of passive Fed policy.
Admittedly, recent communications suggest a hawkish tone that might be construed as passive Fed policy in the context of such recent, sharp market declines. However, set against the broader financial backdrop in the US economy, even with the October declines in markets, US financial conditions remain loose in a historical context. They are only moderately below the peaks seen in the economic expansion of the mid-1990s and mid-2000s.
- TRIGGER 1 – FED TONE TO NEUTRAL
- TRIGGER 2 - VALUATIONS
- TRIGGER 3 – EXCESSIVE FEAR
- TRIGGER 4 – PRO-CYCLICAL POLICY ACTION FROM CHINA
- TRIGGER 5 – ITALIAN YIELDS APPROACHING 4%
Group Chief Investment Officer
and Co-CEO Asset Management
Chief Investment Officer Private Banking
and Head of Asset Allocation
Deputy Head of Asset Allocation