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

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research 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. To the extent that any content is construed as investment research, you must note and accept that the 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 under relevant laws.

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

Saxo Bank (Schweiz) AG
Beethovenstrasse 33
CH-8002
Zurich
Switzerland

Contact Saxo

Select region

Switzerland
Switzerland

All trading carries risk. Losses can exceed deposits on margin products. You should consider whether you understand how our products work and whether you can afford to take the high risk of losing your money. To help you understand the risks involved we have put together a general Risk Warning series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. The KIDs can be accessed within the trading platform. Please note that the full prospectus can be obtained free of charge from Saxo Bank (Switzerland) ltd. or the issuer.

This website can be accessed worldwide however the information on the website is related to Saxo Bank (Switzerland) Ltd. All clients will directly engage with Saxo Bank (Switzerland) Ltd. and all client agreements will be entered into with Saxo Bank (Switzerland) Ltd. and thus governed by Swiss Law.

The content of this website represents marketing material and has not been notified or submitted to any supervisory authority.

If you contact Saxo Bank (Switzerland) Ltd. or visit this website, you acknowledge and agree that any data that you transmit to Saxo Bank (Switzerland) Ltd., either through this website, by telephone or by any other means of communication (e.g. e-mail), may be collected or recorded and transferred to other Saxo Bank Group companies or third parties in Switzerland or abroad and may be stored or otherwise processed by them or Saxo Bank (Switzerland) Ltd. You release Saxo Bank (Switzerland) Ltd. from its obligations under Swiss banking and securities dealer secrecies and, to the extent permitted by law, data protection laws as well as other laws and obligations to protect privacy. Saxo Bank (Switzerland) Ltd. has implemented appropriate technical and organizational measures to protect data from unauthorized processing and disclosure and applies appropriate safeguards to guarantee adequate protection of such data.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc.