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SPECIAL FEATURE

Hunting not the bear, but the market bottom

UBP’s chief investment officer, private banking, Norman Villamin argues this is not a bear market just yet

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Are we on the cusp of a new bear market? Not yet.

Looking back to the end of World War II, the US market has experienced 11 bear markets. Seven of the eleven bear markets observed have occurred in the context of a US recession. The economic data, as well as earnings and market dynamics, all appear consistent with a mini-cycle in the US economy - characterised by a decelerating manufacturing sector but with firm consumer/employment markets - rather than marking the approach of an economic recession.

Admittedly, however, the S&P 500 has seen four bear markets outside of a recession, though only one of those having occurred after 1970 - the stock market crash of 1987.

Interestingly, despite limited data, anecdotal descriptions provided by the Federal Reserve Bank of Richmond suggest that these pre-1970 bear markets were in the context of minicycles not supported by countercyclical Fed policy. So with US markets sitting 7 per cent lower than their 2018 highs, history suggests that a passive Federal Reserve in the face of sharply declining markets is a necessary condition for a bear market outside of an economic recession.

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Five potential triggers for a market bottom

TRIGGER 1: FED TONE MOVES TO NEUTRAL

The September communication from the Fed suggested a hawkish tone that was viewed by markets as a headwind to gains, contributing to recent, sharp market declines. However, set against the broader financial backdrop in the US economy, with the October declines in markets, US financial conditions returned to neutral from loose. In response, recent speeches by members of the US central bank have seen a shift in tone - from hawkish in September to more balanced currently, laying the groundwork for a more durable bottom in markets are neutral to tight financial conditions.

TRIGGER 2: VALUATIONS

2018 has seen S&P 500 P/E multiples decline persistently. Indeed, with forward P/Es for the US benchmark reaching close to 20 times earnings at their peak in January 2018, valuations began the year at near 30-year highs excluding the technology bubble of 1999-2000.

Investors will remember that in early 2016, the US economy experienced a growth scare as energy companies triggered concerns about defaults in a key sector important for US capital spending and economic recovery since 2008. Similarly, coming out of the tech bubble, which drove a US capital spending boom and economic growth in the late 1990s, the ensuing bust spurred only a mild US recession. In both situations, S&P 500 P/Es bottomed near 15 times earnings, approximately 5-6 per cent below their current levels. So, in the absence of any developing signs of an economic recession, declines to much below 15 times earnings in the S&P 500 should begin to tilt risk-reward in favour of investors.

TRIGGER 3: EXCESSIVE FEAR

With the CBOE SPX Volatility Index (VIX), a market "fear gauge", having peaked at 24 and currently at 19, it is still well above the 11-12 levels seen as recently as September. However, it has yet to spike above the 30 level that marked lows in the S&P 500 in early 2016 (during the US growth scare) as well as in early 2018. Admittedly, in 2010-12, as the eurozone sovereign crisis developed, the VIX Index spiked well through the 30 level to as high as 45 before triggering the bottom (coinciding with an easing of policy from the Federal Reserve and the ECB).

Therefore, without evidence of a systemic crisis, a spike in the market's "fear gauge" to above 30 could provide signals of a market bottom. Real concerns about a hawkish Fed in 2019 have clearly contributed to the weakness in October while rising geopolitical worries have likewise weighed on markets. As a result, signs of stability on key geopolitical axes would undoubtedly be helpful at removing the prospect of a non-domestic crisis from triggering a further de-rating in the S&P 500.

TRIGGER 4: TARIFF RELIEF OR PRO-CYCLICAL POLICY ACTION FROM CHINA

The slowdown in the Chinese economy, continued weakening of its currency, combined with further tariff rises scheduled for January 2019 on exports to the US, raise fears of a disorderly unwinding of the high leverage within China's economy. Though Chinese policymakers have reluctantly eased policy to support its slowing economy, a more proactive easing of domestic policy, probably via further cuts in domestic reserve requirements, would move to calm fears of a more dramatic slowing in Chinese demand that might weaken already frail emerging economies.

Should relief from escalating US tariffs not come from the end-November G-20 meeting between US President Trump and Chinese President Xi Jinping, China will be facing Q4 GDP growth slowing towards the critical 6 per cent level even before the next round of US tariffs are levied on January 1, 2019. As a result, pressure may begin to build on China to pivot towards a more pre-emptive policy agenda to stabilise and accelerate growth in early 2019.

TRIGGER 5: ITALIAN YIELDS REACHING 4 PER CENT

On the continent, the confrontation between Italy and the European Union has weighed on Italian assets, but has not yet resulted in broader contagion across the euro area. However, we still see little political motivation for either the Italian coalition government or the EU to compromise on their positions so early in the budget negotiations.

The combination of Italian 10-year yields at 3.6 per cent and the end of ECB net bond purchases in the new year should increase pressure meaningfully towards a negotiated solution, especially should yields rise towards the critical 4 per cent level that may trigger capital concerns among Italian banks.

All that being said, this analysis is penned just ahead of the G20 meeting. It would be most prudent to say that if the geopolitical climate reaches a new chill, the triggers would need to be recalibrated to reflect the ever evolving realities of the current investing landscape. Geopolitics today represents a risk that is stubbornly difficult to price.