Drawdown Drawdown Drawdown

Drawdown lessons: Look at market dynamics and ignore the economy

Equities 7 minutes to read
PG
Peter Garnry

Head of Equity Strategy

Summary:  The US equity market is in a bear market despite strong economic activity confusing many investors. The reason for this is that the equity market is initially responding to tighter financial conditions causing the cost of capital to go up which then compresses equity valuations. The 1973-1974 drawdown also started with strong economic activity levels for almost a year while the equity market fell until the economy eventually fell into a recession succumbing to inflationary pressures. Could this drawdown cycle be similar to the 1973-1974 drawdown cycle?


Is the current drawdown a replay of the 1973-1974 drawdown?

This Monday we wrote an equity note on historical drawdowns in the S&P 500 and the importance of putting weight on the right historical samples for guiding investment decisions in the current drawdown. Our conclusion is that the past 12 years drawdown dynamics are the wrong ones to emphasize relative to the dot-com bubble drawdown and the two drawdowns during the early 1970s. Seen in that light, the worst might be ahead of us and the current drawdown could extend much longer than what most market participants are currently expecting.

Something we have alluded to in our daily Saxo Market Call podcast this week is that the US economy is still strong, something JPMorgan Chase CEO Jamie Dimon also emphasized yesterday, and that we highlighted in yesterday’s equity note. This might be a confusing element for many investors. Why is the equity market panicking when the economy is so strong relative to past trend growth? The simple answer is that financial conditions have tightening at a record pace and inside that process increased the cost of capital causing equity valuations to compress.

If we look at the 10 drawdowns since 1968 with a maximum drawdown of more than 10% then we observe the striking feature that in four of those 10 drawdowns the US economy was actually growing above trend growth in the entire period to the trough of the drawdown cycle. The period with the highest economic growth during a significant period of selloff is the 1983-1984 drawdown of a little more than 10%; here the economy did well, but equities were repriced following a strong 1982-1983 period as financial conditions came down, but around a 300 basis points move in the US 10-year yield from the summer of 1983 to the summer of 1984 changed equity valuations and took equities down. However, the economy was strong enough to absorb these higher interest rates.

We have talked a lot about the 1973-1974 drawdown because of the similarity in terms of explosion in inflation from low levels and the similarity of an energy crisis (this time a broad-based commodity crisis). If look at the entire 1973-1974 drawdown to the trough then it was during a time of strong economic growth in the US. As the table below shows, the CFNAIMA3 (3-month average in the Chicago Fed National Activity Index – a Fed measure of economic activity) was positive for 12 months while the S&P 500 was in a drawdown. It was not until one year into the drawdown cycle that the economy finally decelerated and eventually went into a recession. The current drawdown has similar characteristics with the US economy being strong four months into the drawdown, but as we are arguing the tighter financial conditions and the Fed’s inflation battle will kill demand eventually and thus a replay of 1973-74 could likely play out over the next year.

Source: Bloomberg and Saxo Group
Source: Bloomberg and Saxo Group
Disclaimer

Saxo Capital Markets (Australia) Limited prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments.Saxo Capital Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

Saxo Capital Markets (Australia) Limited
Suite 1, Level 14, 9 Castlereagh St
Sydney NSW 2000
Australia

Contact Saxo

Select region

Australia
Australia

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Limited ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide, Product Disclosure Statement and Target Market Determination to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation. The Target Market Determination should assist you in determining whether any of the products or services we offer are likely to be consistent with your objectives, financial situation and needs.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.

Please click here to view our full disclaimer.