Does a bear market really matter?

After a sustained sell-off last week, the S&P 500 has flirted with bear market levels (defined as 20% drawdown from its early Jan peak) but has so far kept its head above water.

But why do investors care? 2 reasons:

1.    The magnitude is significant: a 20% drawdown is a significant drop

2.    A bear market is a psychological trigger that could lead to further sell-offs.

On the last point, it’s worth looking into history for guidance. In scenarios where we’ve had a bear market and a recession, markets have dropped by 37% on average. Where we experienced a bear market and no recession, markets have dropped a lesser amount of 24%.

Our view is we won’t see a recession this year, so history gives comfort we may be closer to the bottom of the market. 

To give more colour and inject some optimism, here are 3 charts on sector dynamics, inflation and earnings that give clues on the market's future direction.

1.  Sector Dynamics: S&P 500 is tech-skewed and not representative of an ideal allocation

Over the past years, the index has become tech heavy and more vulnerable to higher rates. Nasdaq (purple) down almost 30%.

If you equal weight S&P 500 (blue) - i.e. moderate the tech skew - US stocks are down a more moderate 13%.

Why is this important? Stock and sector allocation matter right now and we think that value stocks will outperform growth in the current environment. A more balanced allocation to different sectors has outperformed and should continue to do so over the coming months.

2.  Inflation: US Inflation surprises are coming down

Markets dislike surprises, especially on inflation. But US inflation surprises (difference between expected and actual inflation) are falling and this is good. Why?

The stock market is a complex system reflecting future economic outcomes. It's based on projections, forecasts and sentiment.

So volatility increases when surprises occur.

Inflation has been one such surprise, rising in the US (yellow), Europe (blue) and UK (green).

Good news is US forecasters are finally assuming sufficiently high inflation in their models - yellow line trending down. Lowering the chances of nasty surprises.

Still not great for the consumer but lower US inflation surprises reduces risk of market shocks going forward.

Just need Europe and UK to follow suit.

3.  Earnings: Still strong

Corporate earnings are still strong even though stock prices and valuations have tumbled. 2 thoughts:

1. Historic PE ratios are now approaching 2020-lows. Driven by (still) strong earnings and obviously poor sentiment in markets. Denominator is high (earnings) while Numerator is low (price) - basic maths.

2. The forward outlook is the key focus of markets, with investors expecting earnings to come down. 

By this chart alone, one could argue valuations are approaching a bottom. But the macro variables (how sticky inflation ends up being and the central bank response) are uncertain.

Both are proving difficult to communicate and predict well. Hence, the volatility.