The current environment is similar to several previous periods where market weakness and substantial P/E compression occurred against a backdrop of economic and earnings strength. Historically, these periods have been followed by solid stock rebounds.
- Given a mostly healthy ClearBridge Recession Risk Dashboard, we expect current market turmoil will be relatively short, and not reach the severity that typically coincides with a recessionary market crash.
- We believe a great deal of negative news is now priced into the market, which should allow for positive surprises relative to expectations.
- The current environment is similar to several previous periods where market weakness and substantial P/E compression occurred against a backdrop of economic and earnings strength. Historically, these periods have been followed by solid stock rebounds.
First, we must define what constitutes a market crash. At ClearBridge, we define market crashes as drawdowns of 20% (or more) that last longer than one year. By contrast, we define other large selloffs (15% or more) that last less than one year as pullbacks. This added dimension of time is an important one as many investors may be able to ride out the shorter-term turmoil of a pullback but will feel the impacts of a market crash on their portfolio much more severely. Through this lens, it becomes clear that market crashes and recessions typically go hand in hand. Market crashes typically last three times longer and experience drawdowns 2.3 times more severe as compared with pullbacks. Most importantly, market crashes are 2.5 times more likely to coincide with recessions, historically.
S&P 500 Market Crashes vs. Pullbacks
Checking Key Indicators
ClearBridge Recession Risk Dashboard
While it can be hard to pinpoint the level at which equities find a bottom, it is important to view non-recessionary pullbacks through three dimensions: price, time and sentiment. While several sentiment surveys have ticked down recently, they remain at elevated levels broadly speaking. Overall, we believe we may be close to an inflection point.
Impact on Valuations
Third Greatest Decline in P/Es in Past 40 Years
Perspective from History
In 1984, earnings growth was 21%, real GDP was roughly 7%, P/E multiples contracted by two turns, and the market finished +2% for the year. Similarly, in 1994, earnings growth was 19%, real GDP was 4%, P/E multiples came in three turns and the market was down 1.5%. Importantly, after each of these years of lowered expectations and derating, the market bounced back, experiencing a 26% return in 1985 and a 35% gain in 1995. In our view, the key component to these bounce-backs was the lack of a recession in the year following the resetting of expectations.
The current environment also has several similarities to a more recent historical period, 2015-16. Falling crude oil, a hawkish Fed, U.S. dollar strength and Chinese weakness all contributed to a bout of market volatility in late 2015 and early 2016. Despite these negatives, the U.S. avoided a recession, Chinese stimulus took effect and a hard landing was avoided, the Fed slowed its pace of interest rate hikes and the greenback steadied. 2016 and 2017 both experienced solid returns for global equities, with double-digit returns for the S&P 500 in each year.
While several fears today echo those of late 2015, we are already starting to see some of the stabilizing mechanisms from early 2016 emerge. First, oil prices may have found support following the OPEC decision to cut supply. Second, Chinese authorities have performed over 50 different easing moves in the past six months which are starting to translate into green shoots in areas like infrastructure, total social financing and services PMI data. Although further Chinese stimulus may ultimately be needed, a rebound in Chinese activity could once again be an important driver for the global economy and a catalyst for a sharp rebound in global equities.
Recognizing the Risks
Tariffs are likely to remain in the headlines over the next several months as negotiations between the U.S. and China continue. While these headlines can rattle investors, the ultimate impact is likely to remain manageable for both the economy and individual companies. Most businesses are likely to utilize a combination of supply chain reorganization (substitution of suppliers) and price increases to offset much of the impact of higher input costs from tariffs. By passing along the cost of the tariff to a mix of suppliers and consumers, business should be able to preserve margins.
Fiscal Stimulus > Trade Concerns
A final investor fear is that the market cannot rally further as the economy slows and earnings growth cools. Although there is little question that GDP growth will decline after this year’s strong run, the economy is likely to still operate in the mid-to-low 2% range. Importantly, there is a difference between a slowdown off tough comparisons (with upside from tax reform) and a rollover ahead of a recession. Historically, peak earnings growth does not necessarily mean the end of the economic or market cycle. In fact, peak earnings growth has preceded recessions by over three years on average and the S&P 500 has seen an average return of approximately 40% over such periods.
Peak Earnings A Reason to Sell?
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