“At first sight things do not look encouraging”, reads Goldman’s initial assessment of the prospects for a bear market in equities following the October rout.
Since October 29, the S&P has seen its fair share of sizable rallies. Specifically, the index has posted >1% gains in four separate sessions since the October 29 nadir and there are a variety of factors that argue for a squeeze higher into year end. Between expected re-risking from systematic investors, buybacks and forced buying from hedge funds and asset managers who low-ticked their exposure the session before the best two-day rally since February (on October 30/31), more than a few analysts see scope for a tactical move higher into the end of 2018.
After that, though, it’s a different story. Persistent tightening of financial conditions, decelerating global growth, the overhang from trade frictions, expectations that margins (and earnings) have peaked in the U.S. and the fading fiscal impulse stateside all argue for caution.
The question, then, is whether whatever gains stocks manage to log from here constitute a head fake on the way to a sharper drawdown.
As Goldman reminds you in the noted cited here at the outset, “we often see slightly higher volatility and a peak followed by a correction, and then another peak around the top of a bull market.” In 2018, there have now been two corrections and we’re in the middle of a second bounce.
“There is nearly always a bounce after the initial decline, providing investors with another opportunity to reduce risks if there are sufficient signals at the time to suggest a further decline is likely”, Goldman goes on to write, in an update to their “Bear Necessities” series, before highlighting a chart they’ve used in the past, which shows “the profile of the average bear market starting in the post-war period.”
While each bear market is of course unique, the bank notes that “the common factor in all cases is that, with the exception of 1998, a correction and bounce can be clearly observed.” The implication, obviously, is that what we’ve witnessed in 2018 are two instances of investors perceiving an opportunity to buy the proverbial dip lacking any fundamental reason (e.g., a sharp downturn in the economic data) to believe that the drawdown will be anything other than fleeting.
Goldman goes on to update their Bull/Bear Indicator. We’ve been over this before in these pages, most recently in September, when the indicator was sitting at 75%, a 49-year high. Here’s a short history of this indicator, excerpted from a March post:
Back in September 2017, Goldman built themselves a bull/bear indicator that rolls up several variables in an effort to effectively divine something about the risk of imminent turning points. Ultimately, they “discovered” that “many bull market peaks were associated with a combination of conditions based on 5 factors”:
- the labor market,
- growth momentum,
- term structure of the yield curve and
There’s nothing particularly novel about their approach, but then again, there’s nothing particularly novel about anyone’s approach to trying to time markets and/or identify peaks because to the extent you actually discovered something that was truly unique and/or infallible, no one would know about it because you’d just build an algo based on it, hit “go”, and retire to the Swiss Alps.
And here are the latest readings on those five factors:
Goldman goes on to remind you that “historically, when the Indicator rises above 60% it is a good signal to investors to turn cautious, or at the very least recognize that a correction followed by a rally is more likely to be followed by a bear market than when these indicators are low.” Currently, the indicator is still extremely elevated, at 73%.
What does history say about the market following elevated readings? Well, readings around current levels are historically consistent with equity returns of 0 over the next year. Spelled out: Zero.
Goldman takes this forward-looking approach a step further. To wit:
In Exhibit 10 we show the maximum drawdown over the following 2 years conditional on the starting point of our Bear Market Risk Indicator (the vertical orange lines show what the indicator would be using the US Shiller P/E as the valuation variable or the simple P/E ratio). At the current level of our Indicator, the maximum drawdown has been about 15% historically.
It’s not all doom and gloom though. Goldman proceeds to reiterate their points from September’s update in which they suggested that a prolonged stretch of low returns is more likely than an outright bear market. Those factors include i) structural forces weighing on inflation and thereby allowing DM central banks to avoid tightening policy too dramatically, ii) the idea that while valuations and the labor market are pretty stretched, the other components of the indicator aren’t so lofty, iii) low macro volatility, and iv) the onboarding of financial imbalances to central bank balance sheets (as opposed to private sector leverage).
The bank also observes that the Shiller P/E is one of the variables skewing the Bull/Bear indicator, but forward multiples have come in materially of late (see figure below). Goldman does admit that the reasoning is “a bit circular.” That is, if de-rating is the result of the market pricing in decelerating earnings and earnings do indeed decelerate, well then any newfound “cheapness” is not actually “cheapness” or, as Goldman puts it, “could be an illusion”.
The bottom line is that in the absence of a recession, a bear market is unlikely. While Goldman is keen to note the deteriorating growth/inflation mix (i.e., the slow death of “Goldilocks”), they also contend that “market moves seem to have overshot the existing macro data, suggesting that further growth deterioration has been priced in to some extent.”
So you can take comfort in all of the above, or not. It’s up to you.
There’s also an entire section of the note which details why the market is more vulnerable now than in the past. Maybe I’ll get to that later, but suffice to say it’s the usual suspects (hint: the fragility inherent in modern market structure).