Quick Bite: Market Mood Sours
Author: Paul Zwi
It is astonishing how quickly the market mood can sour – it’s like everyone is dancing at the party, getting a little drunk, and then suddenly your parents come home, switch the lights on bright and turn the music off.
Three weeks ago, everyone was still dancing. Now people are looking a bit sheepish and asking for a ride home. Bull markets are tremendous fun, but all good things come to an end, and perhaps that time has arrived.
During the past 3 weeks, the S&P 500 index has fallen 9% from its all-time high with more than half of the correction accounted for by the 14% rout in the share prices of the Magnificent 7 stocks (taking P/Es from 30x to 26x). In contrast, last year the Mag 7 stocks made up more than half of the 25% total return of the overall index.
The S&P 500 has experienced a median annual drawdown of 10% during the last 40 years.
Source: Goldman Sachs
The typical stock in the S&P 500 as represented by the equal-weight index (SPW) has declined by 6% during the past 3 weeks (P/E from 17x to 16x) and trades 8% below its all-time high reached at the end of November. The most likely causes of the market decline are the jump in policy uncertainty related to tariffs, concerns about the economic growth outlook, and perhaps a positioning unwind, especially among hedge funds. But once it starts, corrections are quite unpredictable.
Source: Goldman Sachs
While the catalyst seems to be the Trump tariffs, there were other undercurrents that were threatening to spoil the party. The global investment environment has changed in important ways over the past few months and so the narrative has shifted. As we’ve noted previously, market narratives really matter. We enjoyed the Pandemic Bounce-Back, then the AI Boom set alight by ChatGPT, then it was the Magnificent 7, Central Banks lowering rates, and finally a combination of the Trump Trade and US Exceptionalism.
Source: Goldman Sachs
The idea that the US is the only place where global investors can deploy capital was always fanciful – prices matter, and when China and Europe offer valuations well below their long term averages, and US stocks are well above theirs – well, it makes sense to buy cheap and sell expensive.
Chinese growth prospects look brighter, especially since the Chinese government is looking to boost domestic consumption and investment. As the Chinese growth outlook has improved, so have the returns on Chinese equities. Suddenly, Chinese equity markets are once again competing for the marginal dollar of global equity allocation.
And in Europe, the geopolitical shifts and the imminent change of government in Germany will result in European countries running more stimulative fiscal policies. This will tend to imply higher yields in Europe, as well as a stronger euro. In turn, this will encourage European savers to stay at home.
Back to valuations: stock prices on US equity markets – and on the US dollar – were very rich until a short while ago. Whatever measurement you use (price-to-earnings, price-to-cash-flow, price-to-sales, market-capitalization-to-GDP or market-cap-to-M2), in recent years US equity markets have become more of an outlier relative to other major equity markets. Trees don’t grow to the sky.
Source: Gavekal
The recent sharp increase in the Economic Policy Uncertainty Index has prompted many portfolio managers to think about the implications of a potential recession on the US equity market. Historically, the median peak-to-trough decline in S&P 500 earnings during 12 economic downturns since WWII is 13%. During recessions, the index level typically declines by 24% from its peak. Outside of a recession, history shows that S&P 500 drawdowns are usually good buying opportunities if the economy and earnings continue to grow. At this stage, we still regard that as a reasonable base case scenario.
Markets usually bottom only when investor positions have declined sharply and become depressed. That is not the case yet – so we may have further pain ahead.
Source: Goldman Sachs
Share market pullbacks are healthy and normal; in the absence of a recession a bear market may be avoided. Investors are advised to take a long term view and assess their investment objectives together with their professional advisers.
