The recent equity market selloff has been nerve-racking and historic in terms of the severity and duration. From the closing high of the S&P 500 Index on February 19th to the closing low on March 23rd, the index declined 35% (a 99% annualized rate) in just 34 calendar days (24 trading sessions). Both of those are records. While some of the selling that took place is related to the usual unwinding of leveraged positioning/margin calls and spikes in cross asset volatility requiring broad reductions in gross risk exposure, there was a unique element to this experience. Jim Paulsen from the Leuthold Group pointed out that this was the first “Recession by Proclamation”, meaning that the U.S. government intentionally shutdown economic activity. This all but assures a hopefully temporary, but likely severe, recession. This likely contributed to the swift reduction in equity market values, as normally it takes a series of negative economic and corporate data releases before investors start to price in a recession as the base case.
There has been some discussion that based on how quickly the market declined, there could be a quick rebound as well. While possible, it would be unusual. Looking at the prior cyclical bear markets as defined by Ned Davis Research (see chart disclosure for definition of bear markets), the median duration from market top to bottom has been 358 days. Even looking at cyclical bear markets that take place within secular bull markets (like the current period), the median duration from market top to bottom has been 245 days. There are often multiple strong rallies and new lows reached on the way to the inevitable cycle bottom. The key takeaway from looking at history is that it will likely be several months before the equity market moves out of the current phase and into the next bull market.
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Copyright 2020 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.
The impact to the economy, labor market, and corporate profitability is still unknown as many of the indicators that will be affected by the measures taken to control the spread of the COVID-19 virus have not yet been released. The duration of that impact will be determined by how long the virus lasts, how people respond after the quarantines are lifted, the policy response to the people and businesses impacted by the quarantines, and the effectiveness of those policy responses. All of these things are almost impossible to predict and do not have a solid historical analog.
There are some key indicators that investors can monitor to see if equity markets are suggesting they are nearing a bottom. One is a reduction in the level and rate of change in cross asset class volatility, which we discussed in a prior post. Another is comparing equity index volume on positive and negative performing days. Historically, in order for the equity market to continue to have sustained positive returns, buying needs to be stronger than selling. The last indicator is the performance of corporate credit markets. We looked at the performance of investment grade and high yield corporate spreads during prior S&P 500 Index bear markets. In each of those periods, credit spreads reached their highest level on the same day that the S&P 500 reached a cycle low. The only exception was the 2007-2009 period, where credit spreads peaked three months prior to the S&P 500 bottoming.
Source: Yahoo Finance.
Source: ICE BofAML.
Source: ICE BofAML
There is a positive message for investors in all of this analysis. On the other side of the bear market there are a lot of attractive opportunities, and it does not require being fully invested at the absolute bottom of the market. Research firm Verdad looked at returns during crisis periods (defined as periods when high yield spreads are greater than 6.5%). The best performing returns over the next 12-24 months are in the lowest rated corporate credits. We corroborated this by looking at the forward returns from different starting spread levels. Current investment grade and high yield corporate credit spreads are in their cheapest valuation decile (highest spread level). This has historically led to the highest forward 3-12 month returns. There can be some volatility associated with getting to the market bottom, and research firm Richard Bernstein Advisors showed that investors do not need to be fully invested at the exact bottom. They looked at the returns earned from being fully invested in the S&P 500 six months prior to the end of each bear market and the 12 months after the bear market bottom (13 periods) and compared that to the returns earned from being in cash for the six months leading up to the bear market bottom and the first six months after the bottom and then being fully invested for the next six months (same 18 month period, different portfolios). The average and median returns are better for the investor that misses the bottom, and 100% of the 13 periods were positive after 18 months.
Source: Verdad Bond Database.
Source: Verdad Bond Database.
Source: RBA.
One of the most important things for investors to have in these environments is patience. Eventually the market will find a bottom, likely when the news and mood are the worst and after more time than investors had hoped for. Ned David Research showed that the S&P 500 Index has, on average, bottomed four months prior to the end of recessions. Once that bottom has been reached, investment returns will likely be higher than average for the next 12-24 month period.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Vice President, Investment Strategy
Boyd Watterson Asset Management, LLC
