By Robert M. Almeida, Jr., Portfolio Manager and Global Investment Strategist, MFS Investment Management
Bear market rallies have often unfolded as investors anticipated lower rates which tended to push up valuations. But these rallies have typically proven short-lived because next comes the realization that the business cycle is ending and profits surprise to the downside.
Since mid-October 2022, risk assets such as the S&P 500, the NASDAQ Composite and the MSCI EAFE indices have generated mid-teens returns. Such rallies are not unusual and we think clients should consider being wary of this happening. In 2022, we saw three double-digit percentage rallies. The S&P 500 Index rallied about 11% in March of 2022 and jumped another 17% (from much lower levels) last summer. At its worst, the S&P 500 Index shed more than 25% from its early January 2022 highs to its low point in October and has now retraced about half those losses.
Recent episodes harken back to the punishing bear market of the early 2000s after the bursting of the Dotcom bubble. In 2001 and 2002, there were four rallies of between 19% and 21% within a two-year decline that saw a peak-to-trough drawdown of 49%. Similarly, during the global financial crisis, US blue chips rallied more than 24% in late 2008 only to decline a total of nearly 57% from the peak of the cycle in October 2007 to the trough in March of 2009. Looking back further, in the crash of 1929, the Dow Jones Industrial Average fell nearly 48% in two months. While stocks quickly retraced nearly half of those losses into 1930, they ultimately fell another 85% by mid-1932.
Why does this happen?
We believe, while the market is extremely efficient at discounting in the near-term, it’s less efficient over longer time periods. During many of the aforementioned bear market rallies, the market was focused on the latest data point, which was often falling inflation and falling interest rates in response to the ending of the business cycle. While rates aren’t being cut currently, we are experiencing disinflation and markets anticipate we could be nearing peak interest rates and forward interest rate curves imply that rates will begin to fall at the end 2023. Stated simply, markets are acting in anticipation of potential lower rates as lower rates push up valuations, which may lead to bear market rallies. But these rallies could prove short-lived because, typically, next comes the realization that the business cycle is ending and profits surprise to the downside.
It generally has taken between 12 and 24 months for the effects of tighter monetary policy to impact company fundamentals. For most of the economy, the transmission mechanism isn’t immediate, unlike in housing, for example, where the adjustment happens fast. Most companies have a combination of fixed and floating rate debt, and thus the impact of higher rates on corporate fundamentals happens further in the future than the market is willing to look during inflationary and monetary policy inflection points.
Markets are forward-looking, but not forward-looking enough
This isn’t a new phenomenon. In August 2008, earnings were estimated to fall in the mid-single digits. But the impact on profits from the sharp recession that started that fall after the collapse of Lehman Brothers was materially greater as earnings declined 50% from their peak.
And keep in mind, the current tightening cycle in developed markets began less than a year ago and still has a way to go. The pig is still going through the python, as it were. While every economic cycle is different, profits, on average, have fallen 23% over the last five recessions, according to data from Goldman Sachs. Maybe the drop will be larger this time because labor and capital costs won’t drop as much as in past episodes or maybe it will be less because the consumer and banks are healthy. I’m not sure which, but that’s not my focus. My attention is on how to seek better risk-adjusted outcomes for clients, which we believe will come from owning high-quality names with what we think offer lower downside profit risks than their benchmarks and peers.
Finally, we feel the market is brilliant in the short-term. But while it’s not focused on profits today, when it does shift, it will be fast. Then, investors will price in weakness before companies report it and we believe clients should consider being positioned for that. For that, we are ready.
MFS Investment Management or MFS refers to MFS Investment Management Canada Limited and MFS Institutional Advisors, Inc. MFS Investment Management Canada Limited is the sub-advisor to the Sun Life MFS Funds; SLGI Asset Management Inc. is the registered portfolio manager. MFS Investment Management Canada Limited and MFS Institutional Advisors, Inc. have entered into a sub-advisory agreement.
Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any mutual funds managed by SLGI Asset Management Inc. These views are subject to change at any time and are not to be considered as investment advice nor should they be considered a recommendation to buy or sell.
