#equitymarkets have started the new year with a bang and some investors are wondering whether the bottom may be already in. If history is any guide the likely answer is “not”. As pointed out in these posts, valuation (https://bit.ly/3CRg3cM, https://bit.ly/3H6Za05) and sentiment (https://bit.ly/3QFKxUS ,https://bit.ly/3ZHPnF1) levels have yet to reach values typically associated with market bottoms. More importantly, economic fundamentals make the most compelling argument that more declines are ahead.

Anxious about the worst inflation in forty years, the Fed embarked last March on the fastest interest rates hiking on record. In addition to rising rates, the central bank also pared down USD liquidity by some 16%. The bulk of the effects of such tightening, however, are typically delayed and it will take several months to fully be reflected on the economy. Hence the wide expectation of a downturn sometimes in H2 2023/H1 2024.

There have been 10 recessions since 1955 and each and every time the S&P 500 registered both a compression of PE multiples and a drawdown of the index (see chart). The average PE compression and drawdown were 26.0% and 31.5% respectively. Using these parameters, the index is likely to resume its decline and make new lows. Such a scenario may even be too benign if considered that, since 1929, in 80% of recessions the S&P had a 20+% drawdown in excess of the drawdown registered in the 12 preceding months. In plain English; since the max drawdown this cycle has been 25%, a recession-driven decline by or before the end of the year, may bring the index negative some 45+% from the Jan 2022 ATH. Bear in mind that, out of the 26 past bear markets, the average decline was 36%.

2022 has been a difficult year and it is only natural that market participants start 2023 with a bullish bias. After all, for the best part of the last two decades, “buying the dip” has always paid off. Yet the world has changed and the causes behind ever-rising asset prices are now gone into reverse. The four Ds of “debt”, “deglobalization” “demography” and “decarbonization” require an entirely novel approach to portfolio allocation and risk management. Caveat Lucrator.

Disclosure: Not investment advice. Do your own research. Hold all assets mentioned. Twitter @pietroventani for more timely comments and updates

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