Probability-based investment modelling for professional and institutional investors
It easy to be overwhelmed by the speed and quantity of information in a bear market. Investors need a clear focus on what matters and what doesn’t. In any bear market, there are about 10 sector pairs (out of 45) which really drive the performance of a regional equity portfolio and the rest don’t matter very much. These pairs vary from one bear market to the next but are relatively easy to identify. There is also another set of pairs, which may be significant in market cap terms, whose relative performance cannot be easily integrated with the rest of the portfolio. US sectors which feature heavily in this list in this bear market include Financials, Healthcare and Industrials. In Europe, they are Materials, Utilities and Financials.
There is a leadership vacuum in global equity markets. The US, the Eurozone and the UK all have serious issues to confront, ranging from valuation excess and monetary tightening to political uncertainty and energy rationing. Japan and Emerging Asia share some of these problems but are not as badly affected. One is a low return, risk reduction trade, while the other offers high risk and high reward. Both strategies have a place in a well-diversified global equity portfolio.
The percentage of companies in the S&P500 with no drawdown in their earnings estimates is declining and just about to drop below its median for the last 15 years. The percentage where there is a drawdown of more than 20% is about to start rising, but from a low level. We are still within normal ranges on both measures, but if they move out of this, the downside is significant and the recovery takes much longer than the decline. At the sector level, we cannot make sense of the relative rankings in several cases. In particular, we think the consensus is far too optimistic about the outlook for Industrials.
We have cut our reasonable worst-case estimate of where the S&P500 may bottom from 3,400 to 3,000. This follows on from our last note which argued that current consensus earnings were likely to drop by at least 15% before hitting their trough sometime in 2023. Our new target implies a forward pe ratio of about 15x, which is slightly lower than the median for this century. As consensus forecasts are reduced, we expect the earnings mix to move away from highly-valued sectors like Tech and Consumer Discretionary towards lowly-valued sectors like Energy and Materials. The other reason for our new target is that nobody has any profits from other investments which they can reinvest into equities. US 7-10 Treasuries are down by about 17% since the equity market peaked, compared with gains of about 10% at the equivalent stage of the bear markets in 2001 and 2008.
Bear markets can make the most rational of investment approaches look pretty stupid. Any concept of fair value based on consensus estimates can be downright dangerous. The typical delay between the peak in the index and the peak in estimates is more than 30 weeks, so we should not expect the consensus to start cutting until late August. The typical drawdown in 12-month forward estimates lasts between 115 and 170 weeks. So, the estimates you are using for 2022/23 may also be the numbers for 2025/26.
The huge monetary interventions during the pandemic in the US and other countries were designed to protect equities from a surge in economic and financial risk. They succeeded, but at the cost of distorting the normal relationship between risk and return: specifically, the excess volatility vs the excess return of equities vs bonds. This is now reverting back to normal. As the volatility of equities rises relative to the volatility of bonds – and this figure is well below its long-run average, let alone its potential peak – their return relative to bonds must decline. The only developed market which may escape the worst of this adjustment is Switzerland.
We think US equities as an asset class are going to struggle against US Treasuries over the next few weeks, partly because bonds have already priced in a lot of bad news, and partly because earnings estimates for 2022 and 2023 are too high. It may take investors some time to realise this, so positioning within equities or between equites and bonds may give rise to significant timing difficulties. However, our models are really clear about the relationship between Treasuries and some sectors, like Energy. There are at least four of these sectors now and this number could rise to eight. Investors may find that using this direct approach, comparing equities against Treasuries, rather than other equities, helps to clarify their thinking.
A recession in 2023 is not our central case, but investors ought to price the risk of it happening, in order to reduce the probability that it will. We would be surprised if the Federal Reserve were to raise rates seven times in 2022, mainly because that would automatically cause the consensus to reduce its forecasts for US growth in 2023. The Fed’s hawkishness in 2016 had a similar effect and we see early signs of this happening in two of our main models. Investment Grade has hit a five-year low in our US$ fixed income model. Investors are now concerned about credit quality for the first time in years. Industrials have just been downgraded to underweight in our US equity sector model, which nearly always indicates that investors are worried about the outlook for the real economy.
If investors decide to get out of the growth style in the US, there are several other strategies they can follow apart from US value: (1) low volatility in US equities; (2) growth in non-US equities; (3) low volatility in other US asset classes; (4) non-US value. The problem with the value style is that cheap stocks tend to stay cheap, unless there is a clear and obvious catalyst for them to outperform, like a massive earnings surprise (as in Energy) or a surge in corporate activity (which may happen in the UK). We think the most popular destination for flows out of US growth will be low volatility in US equities, into sectors such as Consumer Staples and, possibly, Utilities.