Bear market rallies and the Silicon Valley survival guide
Head of Equity Strategy
Summary: In today's equity update we go back again and look at the 15 largest drawdowns in S&P 500 since 1928. We take a look at the number of 5% and 10% rebounds and the time spent during the drawdown in a rebound stage. We find that deep drawdowns have historically had many rebounds and as such investors today should be careful of not thinking the drawdown is done because of the latest rebound in US equities.
Bear market rallies are a natural phenomenon
Market sentiment shifted on Thursday breaking higher above previous highs and Friday’s better than expected PCE core inflation data for April adding fresh energy to the rally taking the Nasdaq 100 futures above the 18 May high ending a seven week period of declines. This morning, Nasdaq 100 futures are extending the rally with the 13,000 level as the next natural gravitational point for the market to test. While the rebound feels good it is not unusual to have bear market rallies (see discussion below) and investors should not forget that the underlying commodity and supply chain dynamics will continue to underpin pressures on inflation and interest rates.
We have recently been writing about drawdowns in S&P 500 with the first note Has a long and painful journey to the bottom in equities just begun?, timing the bottom for now in the S&P 500 using close prices, we looked at the historical drawdowns in the S&P 500 and argued which one to put more weight on when forecasting the length and depth of the current drawdown. In our other note Drawdown lessons: Look at market dynamics and ignore the economy we looked at how some drawdowns have been initiated during strong economic activity levels for up to 12 months. Today, we want to explore the concept of bear market rallies using the 15 largest drawdowns in the S&P 500 since 1928 and which includes the current drawdown (the 15th largest drawdown).
The current drawdown in the S&P 500 started on 4 January and had its first 10% rebound from a current low during the period 8 March to 29 March, before dropping to a new low. The current rebound since 19 May is 6.6% as of Friday’s close and thus under our definition of 10% rebound, not a real bear market rally yet, but that could be the case this week. How often do we see a 10% rally from a current low during an extensive drawdown?
As the table below shows, 10% rebounds are rare outside the four worst drawdowns of history. The 36% drawdown from December 1968 to May 1970 was dramatic in the sense that there was no 10% rebound during its journey to the bottom; that’s quite brutal for any investor. But look at the dot-com drawdown. Here we observe four events of a 10% rebound on its path to a 49% drawdown. The intensity measure in the table shows the number of trading days in percentage of the number of trading days from the start of the drawdown to the trough in which the index was up more than 10% from the current low at that point in time. During the dot-com drawdown the market was spending 42% of its time in a state where it was up more than 10% from the current low in the index; this state can be viewed as the hope phase when investors are hoping we have seen the bottom. The higher this measure the more painful the drawdown will likely be felt by investors.
We have argued in our recent notes on drawdowns that the drawdowns of the 1970s and the dot-com bubble are the best period to study in order to assess the current drawdown because of the combination of supply-side driven inflation and elevated equity valuations. These drawdowns had multiple rebounds, periods of relieve, before going lower again, so today’s investors must be extremely careful of not being fooled by a short-term rebound. We have also calculated the 5% rebounds during the same 15 drawdowns to give a bit more granular detail level. Again, it is not usual to have multiple 5% rebounds before reaching a severely lower bottom.
Sequoia Capital says adaptability is everything for survival
As a stark contrast to the current rebound in US equities and in particularly technology stocks Benchmark Capital and Sequoia Capital have lately put out presentations to the founders of the companies they have funded. In these presentations the two venture capital firms talk about the current crisis in technology and what these venture capital funded firms should do. Keep in mind that Benchmark and Sequoia are both old enough to have lived through the dot-com bubble. The Sequoia Capital presentation can be found here.
The short summary of Sequoia Capital’s presentation is this. It will not be a V-shaped recovery, but rather a long one. Capital is now expensive and companies that are burning capital the most will do the worst. The interest rate change must be respected and that new mortgage is now 67% more expensive than just six months ago. It is all about adaptability, meaning that it is not the strongest but the most intelligent that will survive, which includes preserving capital. Companies must be ready to shred R&D and marketing (this fits very well with the Snap outlook cut from last week). Presentation is quoting Ayrton Senna “You cannot overtake 15 cars when it is sunny, but you can when it’s raining”, which means that big opportunities will arise as well. Confronting the reality of a crash is the hardest step and you prevent the company from spinning into a negative cycle.
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