Sizing up this Bear Market: Some Observations
Given the turn that recent events have taken, I have chosen to write a post listing a few salient features of this bear market.
The SPX peaked on February 19th. It was down 13% by February 28th. Over the weekend of March 7/8th, the oil price collapsed, and the SPX ended March 9th 7.6% down. The SPX was down 9.5% on Thursday 12th and up 9.3% on Friday 13th, rebounding after Trump’s address. But Monday 16th saw another 12% decline. By March 20th, the SPX is down 32% from its peak. The 12% daily move is a 13-sigma event and the two 9% moves are 10 sigma events. We have had in a month more sigma events than in the entire decade. Sigma events tend to cluster around each other’s.
The pace of this bear market is unprecedented. Two external shocks, COVID-19 and Oil price collapse hit in a month.
Yet, similarities with previous bear markets exist. Factors are behaving as one would expect, with Quality outperforming and Value underperforming.
Exhibit 1: Factors performance as per Koyfin, up to 03/20/20
But the valuation spreads have expanded dramatically in a very short period. According to Empirical Research, valuation spreads as measured by top quintile vs average sit at 4.5 Standard deviations in the US, and around that level in much of the developed markets. This suggests potential for heavy factor rotation sometime in June/July when PMIs bottom and COVID sees resolution. In August, ahead of the brutal September rotation, these spreads were around 2SD.
Exhibit 2: Valuation spreads as measured by Empirical Research
I am also seeing relatively clear evidence of forced selling. Indexes of HF owned stocks that I track have underperformed. Anecdotally, I saw it this week with NXPI US, which was down 19% on Wednesday and up 18% the following day. Another place to look for evidence of this is in correlations across asset classes. Last week we saw high levels of intra-day correlations of the SPX and Gold, or between SPX and US 10y yield (negative).
Where do we go from here?
We know very little. But here is what we know. A Pandemic is unprecedented and the long-lasting consequences of it on the economy are hard to foresee; besides they largely depend on how governments answer. There is little traditional monetary policy can do.
Purely from a base rate perspective, the bear market has more downside from here. Valuations are not as low as during the GFC in absolute terms. The SPX stands at 15x Trailing earnings, and expectations are for 13% growth in the next 12m. Assuming earnings decline 20% instead, a severe downturn, places the SPX on 19x. It bottomed at 11x in November ’08 and March ’09. Trailing EPS shrunk by 56% between early ’08 and late ’09 (see chart below from Bloomberg). At the same time, the earnings yield vs US 10y yield is at levels last seen during the GFC. So that suggests equities are for sale now.
Finally, we should expect a massive sector rotation around the bottom of this bear market; that could happen in the Summer.
Comments welcomed…
