- Bearish sentiments surrounding hawkish Fed and stagflation fears triggered selldown in risk assets
- The selldown is driven predominantly by valuation contraction
- Data analysis going back to 1927 suggests attractive risk-reward in deploying funds to risk assets
- Corporate fundamentals (earnings) have remained resilient
- Quality stocks are expected to outperform during times of heightened volatility
Food for thought – history suggests positive 12-month returns for risk assets after acute correction. Global equities teetered on the edge of a bear market this year on overwhelming bearish sentiment relating to the hawkish Fed and stagflation fears. “Long duration” sectors, particularly those relating to Technology, bore the brunt of the selldown as concerns mounted on how rising bond yields will impact the valuations of growth equities. But, given the magnitude of the correction, it is now worth taking a step back to re-assess the risk-reward of putting fresh funds to work.
Using the US equity market as a proxy in our analysis, we look at how risk assets tend to perform in the subsequent 12 months after an acute correction. On a year-to-date basis, the S&P 500 has corrected 13.3% in January to May 2022. Looking through historical data dating back to 1927, there were only five other occasions where the S&P 500 registered higher magnitude of losses during the first five months of the year and this took place in 1931, 1932, 1940, 1962, and 1970. The key observations are:
- The S&P 500 fell 23.8% on average during those occasions, with the minimum correction at -15.1% and the maximum at -45.0%. In contrast, the selloff this year is comparably less intense at -13.3%.
- In the subsequent 12 months, the S&P 500 has rallied 20.0% on average after the correction (with positive returns on four out of the five occasions).
Taking our analysis one step further, we dissect the market corrections into the following components: (a) Price-to-Earnings (P/E) ratio and (2) Earnings. The purpose of this step is to ascertain if the selldown is predominantly driven by investors’ sentiments and expectations (proxied by valuation) or actual fundamentals (proxied by earnings).
As only data going back to 1954 are available for this purpose, our findings below are based on observations made for 1962 and 1970. Our key findings are:
- P/E valuations for S&P 500 contracted by 13.7% on average during those occasions, a level that is slightly lower than the current P/E contraction of 16.0%.
- Corporate earnings fell 3.3% on average for those occasions. In contrast, earnings gained 3.2% in the course of the current selldown.
Risk-reward looking attractive; Time to deploy a portion of your excess cash holdings in risk assets. Using history as a guide, it is evident that partial deployment of excess cash in risk assets looks compelling at this juncture. As opposed to trying to “time” for a market trough, a more relevant question investors should ask oneself is: “Where would my investments be in 12 months’ time?”. Our analysis has established the following views:
- After a sharp selldown at the start of the year, markets have historically rallied 20% on average over the next 12 months.
- This year’s selldown is driven predominantly by the recalibration in investors’ sentiments/expectations which results in valuation multiples contraction. Corporate fundamentals (notably, earnings), however, have remained resilient and this augurs well for the outlook.
Go for Quality Plays in times of heightened volatility. Market volatility is expected to stay elevated as the Russia-Ukraine crisis and high inflation persists. Using the S&P 500 Quality as a proxy, quality stocks have performed the broader markets in times of heightened volatility, and this time shall be no different.
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