Why confidence is growing despite us entering the exhaustion stage of the bear market rally
The equity market is not the economy is a phrase that’s been repeated ad nauseam the past six months. However, there are aspects of the economy that matter more to the equity market than others, and it’s important investors distinguish between the two, or risk finding yourself down the wrong rabbit hole.
Philip Petursson, Chief Investment Strategist and Head of Capital Markets Research at Manulife Investment Management, said that employment and housing data are bright spots that partly explain why markets have surged back so strongly while the economy as a whole grapples with the impact of COVID-19.
Petursson said that Google Trends can be a great source to uncover or verify trends that aid economic and market analysis. For example, the search trend “how to file for unemployment” that reached its peak in March has been steadily declining. It’s not back to the pre-COVID level (2% of the peak search activity) but it is at levels that are encouraging for continued improvements (6% of peak).
With housing – one of Manulife’s recessionary indicators is the decline of housing starts – search activity for “buying a house” was at its highest in five years and housing starts have recovered right back to their pre-COVID levels.
“We’d suggest that while not all the economic data is trending in the right direction, some of the data that‘s most important to the equity markets is trending in the direction we want to see — including retail sales, durable goods orders, and purchasing managers’ indices, to name a few.” Petursson said.
“We’d compare the evaluation of the current economic conditions to that of a roller coaster ride. A market strategist and an economist exit a roller coaster. The economist is green and holding his stomach; the market strategist is smiling. Whether it was a good ride or not depends on who you ask.”
He added that while the aggregate of economic data may suggest a sluggish recovery, prone to a reversal of trend, the economic data that’s most important to equity markets, the data that has historically correlated strongly with earnings growth, continues to trend in the right direction.
“Despite our more modest outlook to equity market returns over the next year, our confidence is greater than it was three or six months ago,” he said. “That’s not to say there won’t be bumps along the way. Over the next couple of months, we fully expect continued volatility as investors project their political views on the markets. History would show that this is to be expected. In fact, it would be uncharacteristic if we didn’t see volatility leading up to the election. But with an improving outlook, to volatility as to the long winter in front of us, we say, ‘embrace it’.”
Q3 featured a show of strength from equity markets in July and August, while September fell back, which is a seasonal norm. The S&P 500 Index gained 8.47% (USD) during the quarter, on a price-return basis after giving back 3.92% in September.
Peturrson explained how, since 1950, September has produced a negative return 52% of the time, with an average return of -0.43%.
He said: “If we were going to see volatility in the equity markets after a 60% gain in the S&P 500 Index off the March 23 low, September was as close to a sure thing as we could get. However, knowing that September tends to fall on the more volatile side, and with a better understanding of where we were in the economic recovery, our attitude towards any market weakness was to embrace it. We say the same for October, as since 1952, October holds the title as the worst-performing month of the year in election years.”
The strategist has previously talked about how the equity market will follow that of the three stages of General Adaptation Syndrome – the alarm stage, the resistance stage, and the exhaustion stage, which occurs once market P/E multiples have reached their peak.
While we never know we’ve hit the peak until well after the fact, investors are starting to see more signs of an impending earnings recovery. Global purchasing managers’ indices continue to improve on a month-over-month basis and one of Petursson’s favourite charts, the South Korean Exports YOY (year-over-year), has recently turned positive. He believes we are now entering exhaustion.
He said: “If we’ve emerged into the third stage of this bear market cycle, then the next two years are going to deliver closer-to-average returns as we move into an earnings recovery. It only stands to reason to expect that future equity returns will be somewhat more average following such an impressive rally against a backdrop of a modest economic recovery. It isn’t a reason to sell equities, merely a reset of return expectations.
“In our mid-year outlook, we set expectations for the S&P 500 Index to return 5 to 15% through to the end of 2021, with risk to the upside. Since June 30, the S&P 500 Index has gained 8.5% through quarter end. We believe the market is entering the exhaustion stage and, therefore, Index return expectations over the next couple of years are likely to be much closer to average (upper single digits), with risks remaining to the upside on the potential for an accelerated economic recovery.”