A Visual Guide to Navigating Down Markets
Today, markets are facing headwinds due to the impact of capital misallocation to overpriced securities over the last decade.
A Visual Guide to Navigating Down Markets
Today, markets are facing headwinds due to the impact of capital misallocation to overpriced securities over the last decade. High inflation and rising interest rates have highlighted this misallocation.
Amid market uncertainty, the above infographic from New York Life Investments provides investors with insights to prepare for down markets and shifting economic conditions.
Market Valuations in Context
To start, let’s look at market valuations.
Roughly a year before the market began to turn, the price-to-earnings (P/E) ratio of the S&P 500 Index reached 38 in late 2020—nearly double its 10-year average of 20.3. The P/E ratio is a common valuation measure for equities. This metric shows investors how much they would pay for $1 of earnings.
This suggests that stocks were pricier than long-term averages, hitting steep valuations unhinged from their underlying fundamentals. Ultra-low interest rates likely bolstered valuations, encouraging investors to invest their money in equities versus cash or government bonds, which were at historic lows.
As interest rates increased and inflation rose higher, the P/E ratio of the S&P 500 Index fell to 20.8 in April 2022, closer to its longer-term average.
With this in mind, let’s look at the underlying fundamentals and key sectors that may position investors for strength amid a changing macroeconomic environment.
1. Focus on Fundamentals
When interest rates are rising and inflation is high, fundamentals relating to cash flow become more important:
Earnings Growth
Dividends
Return on Invested Capital (ROIC)
ROIC is a profitability measure that shows how much a company earns on its invested capital, such as debt and equity.
Historically, improving fundamentals have been a leading indicator of sector performance over the intermediate-term. Along with this, S&P 500 Index dividends have surpassed inflation over the last two decades. In fact, between 2000 and 2021, dividends paid out increased from $140 billion to $512 billion, or about 3.7 times.
Not only that, dividends have historically been far less volatile than stocks. Since 1957, stock prices have been more than two times as volatile as their dividend cash flows.
2. Trouble Can Become Opportunity
Consumer sentiment is hovering near historical lows.
The good news is this may be a silver lining for the consumer discretionary sector, which has historically outperformed when sentiment sinks to this level.
Consumer discretionary stocks cover non-essential items such as restaurants, hotels, and automobiles.
Given historical patterns, the consumer discretionary sector may be poised to accelerate over the next 12 months.
3. Value in Favor
Given high inflation and interest rates on the rise, it may present an opportunity for a value investment approach.
Value stocks are considered underpriced compared to the broader market and are often inflation-sensitive. In the last year, value stocks have outperformed growth by over 20 percentage points.
On a sector-level, materials, financials, and communication services are valued below their average P/E ratio, along with the following sectors:
Although the tech sector has seen declines in 2022, the sector’s P/E ratio (22.5) is above its 5-year average (21.7) with 9.8% earnings growth year-to-date.
Market Scenarios
With the S&P 500 Index experiencing its worst first half since 1970, let’s look at the different scenarios going forward into 2023.
The below table shows the worst case, base case, and best case scenarios for S&P 500 Index price returns during bear markets, based on data from 1953 to 2020.
Historical data shows that on average, the S&P 500 Index has returned 16% one year after the start of a recession.
The following key factors will likely influence market developments:
Inflation
Consumer Spending
Unemployment Levels
Interest Rates
Corporate Earnings Growth
So far, the S&P 500 Index has recovered 7% from its June lows as of early September. A similar trend is seen in the NASDAQ Composite Index—an index significantly weighted in tech stocks— which has recovered 8% over roughly the same time frame.
Keeping a Clear Focus During Down Markets
As investors navigate down markets, rebalancing to suit their risk profile can be an important part of the process.
It is also important to remember that markets are cyclical. For this reason, staying invested, diversified, and disciplined are critical for keeping long-term strategic goals in mind.