When warning over the weekend that there has been a regime change in equity markets and that instead of buying the dip investors should sell the rip, Goldman’s co-head of equity trading Brian Levine countered the traditional response that despite the “technical selloff”, investor psychology remains intact with the following:
I’ve heard many “write-off’ this correction as being technical in nature. Well, yes, that was the trigger, but if you’re hanging your hat on that, you’re missing the bigger picture. The market had effectively quadrupled over the past 9 years. Why? Obviously numerous variables contribute, but it would be hard to dispute that unprecedented, globally coordinated easy monetary policy was your primary driver to force investors out on the risk curve. Sure, rates have been gradually rising the past few years, which the stock market has easily digested, but there’s always a threshold that sparks a seminal change. And I don’t think it was a coincidence that the S&P topped out on the very same day 10-year yields made 4-year highs (a week ago Monday the 29th)….and rates have backed up a further 15 bps to 2.8% currently. The fact that bonds couldn’t rally in the equity selloff is evidence of a regime change in the multi-year equity bull market.
In other words, Goldman no longer believes that one should “ignore the selloff because fundamentals remain strong.”
Adding to this overnight, SocGen’s Andrew Lapthorne writes that “fundamentals are nearly always strong when the market starts to sell-off.” And, as the strategist adds “when markets correct, the standard retort is that in the long-term it pays to stay invested and that the fundamentals remain strong and supportive.”
To determine the validity of this statement, SocGen looked at prior corrections in the S&P 500 to see how fundamentals looked at the point when the market turned. What Lapthorne found using data since 1985, is that at the point when the S&P 500 dropped 10% or more, on average the US ISM index was at 51.6 (indicating economic expansion), trailing EPS growth was on average running at 7% and forward growth expectations were at 11%.
The point being that at the top, economic fundamentals always look strong and this is why interest rates are going up. It is interest rates, not growth, that is the concern.
Lapthorne then shifts focus, and echoes an analysis conducted by Goldman’s David Kostin last Friday…
… namely how long it takes to recover from your index price loss.
Here, the mild corrections in 1998 and 1999 took under 90 trading days to get back to the initial index level. This compares to the 2000 and 2007 corrections which took over 1800 and 1400 days respectively to recover the prior price level.
In such long draw down periods, the compounding dividend takes on added performance, as in total return terms although you made no money in price terms from 2000 to 2007, at least you made 12.5% via the dividend. Another good reason to avoid dividend cuts.
Finally, looking at the composition of the selloff, SocGen notes that so far we have seen very little in the way of fundamental stock price discrimination. Specifically, during the worst day of selling, we saw some of the lowest ever cross sectional stock dispersion for a down market of such magnitude.
“In brief it looks like investors were selling markets, not stocks, a fact also reflected in the initial outperformance of small-caps versus large-caps.”
To Lapthorne, the next market phase is key: do markets simply shrug off the sell-off and resume business as usual, or do they start differentiating?
We’ve clearly been arguing for a while now that holding balance sheet risk in an era of rising interest rates and higher market volatility has limited upside but significant downside. That view has only become reinforced by the recent market turbulence.
So far today, they are once again “simply shrugging it off”, and judging by the wholesale rip in stocks just as fundamentals were ignored on the downside, so they will be forgotten on the rebound.