Has a long and painful journey to the bottom in equities just begun?
Head of Equity Strategy
Summary: S&P 500 is down 18% and we are 95 trading sessions into the current drawdown. Investors basing their decisions today on the experience of the past 12 years would argue that now is the time to buy equities, but unfortunately the past 12 years are worthless for the decision making today. The two drawdowns of the 1970s and one post the dot-com bubble are more aligned with the current dynamics and based on these three drawdowns investors are in for more pain and for much longer than most expect will happen.
History suggests the current drawdown could be long and brutal
The current drawdown feels brutal with Nasdaq 100 down 28% and S&P 500 down 17% since their respective peaks. We are 95 days into the current drawdown in S&P 500 and a drawdown that is currently the 15th largest since 1928. As we wrote the other day, many strategists and investors are talking more about buying the dip in technology and downplaying inflation, than looking at the hard reality; the world has hit a physical limit with a galloping energy crisis and a global food crisis that is only to get worse.
Many argue that drawdowns are short and that equities will quickly come back, but this type of thinking is misguided as it is mostly driven by the drawdown structure since 2010 which has been an outlier in the greater history of capital markets. The longest drawdown since 2010 was the period 2015-05-22 to 2016-07-11 which took 286 trading sessions. The current drawdown is the 4th largest since 2010 and the average number of days to the trough of the 10% or worse drawdowns since 2010 (there are seven of those) is 76 days, so if we apply the post financial crisis years as our baseline of course investors should buy the dip and the sunset is near. Unfortunately these samples are the wrong ones to apply.
If we look at the 30 largest drawdowns since 1928 in the S&P 500 there is a striking pattern. Either a drawdown reaches its trough fast or it takes a long time. The middle ground seems to be small. The total length of a drawdown, that is the combined length of first going to trough and then a full recovery to the past peak, is a function of the drawdown depth itself but also the length to the trough. Instead of naively applying the same weight on all historic samples some should have a higher weight as they are more relevant for the current regime.
We would argue that the drawdown after the dot-com bubble has similarities to the current drawdown due to above average equity valuation we reached this time in the MSCI World. The two other drawdowns during the early 1970s and late 1970s have similarities to the current inflation shock, supply constraints, and commodity crisis that we observe today. These three drawdowns had trading sessions to trough of 360 to 637 days (1.5 to 2.5 years before reaching the bottom) and a full length of 820 to 1898 days, that is around 3 to 7.5 years. In other words, the painful reality is that we might have just started on a very long journey into the unknown and something that looks very different than our past 12 years of experience.
The VIX forward curve as we have recently described is still relatively flat and is not suggesting panic or capitulation mode in US equities, so the worst is likely to come. The best investors can do is to think about balance. What will work during these times? Blend equities with short-term bonds, inflation-linked bonds, real estate, and then within themes get exposure to commodities, logistics, defence, cyber security, semiconductors, India, and renewable energy. The only thing investors must not do is to base decisions on their experience over the past 12 years.
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