Not time to press a negative view after 15% selloff

What happened

Sharply rising rates have weighed on capital markets. They come on the heels of a more hawkish Federal Reserve meeting, a flurry of rate hikes in overseas markets, and a large stimulus package in the U.K. that investors fear will be inflationary. Several international markets are making fresh lows for the year, while U.S. stocks are near year-to-date lows. The 2-year U.S. Treasury yield is now above 4%, having risen from 0.25% a year ago as the most aggressive global central bank tightening cycle in decades continues.

Our take

The regime is shifting. With the sharp rise in yields, the likelihood of a global recession only grows larger. This, along with the higher interest rates, is leading markets to revalue equities lower.

In August, we had been advocating to reduce equities in the 4200-4300 range for the S&P 500 and a continued focus on increasing quality in portfolios. In our view, the challenging macro environment is here to stay. This is not the time to be on offense.

However, it doesn’t make sense to pile on to the negativity in the short term and become even more defensive after a large selloff has already occurred.

• Extreme selling has already taken place—The S&P 500 is down about 15% over the past five weeks. This happened most recently in May of this year, coming out of the pandemic low in 2020, and before that around the U.S. debt downgrade in 2011.
• Bearishness is high, a positive from a contrarian perspective—The percentage of investors that hold a bearish view has climbed to 60.9%, the highest level since the March 2009 market bottom, according to the most recent survey from the American Association of Individual Investors (AAII). This is a positive from a contrarian standpoint in that it suggests low investor expectations.
• Stocks are oversold—The percentage of S&P 500 stocks above the 200-day moving average is now below 20%. This simply suggests selling is becoming indiscriminate. The last time we saw such broad-based selling was near the mid-June low which was followed by a 17% sharp, though relatively short-lived, rally.
• Probability of breaking June market low is rising which may provide flush out—The increased probability of breaking the June S&P 500 price low may be what it takes to invoke even deeper fear. Fear often leads to short-term bottoms. Importantly, as we saw in June, even if the market overshoots, snapbacks can be sharp and hard to time. 
• Market baking in median recession already but it could go further—The S&P 500 is currently trading down around 23%, close to the median market drawdown of 24% since 1950. The average recession drawdown is 29%. That would equate to roughly 3400 on the S&P 500, which is also close to the pre-pandemic peak in 2019. Of course, markets can overshoot the averages, but this provides some perspective.

While markets are likely to remain choppy and challenging near term, the good news is that the longer-term outlook – the next 5- to 10-year periods – becomes more positive.

Equity valuations have seen a sharp valuation reset and high quality fixed income is providing the most attractive yields in decades. Moreover, historically, buying stocks after they have been down 20% from record highs has been a good risk/reward proposition for longer-term investors, though the journey does not always offer a smooth path (see table on next page).

Following past instances, the S&P 500 has been higher three years later in eight out of nine cases with a solid average return of 29%. However, the short-term return outlook was more mixed and influenced greatly by whether the economy went into recession (such as 1973, 2001, and 2008).