It's Never a Straight Line

WED 25 MAY 2022

From our perch, the prevailing bias has become rather pessimistic on risk assets. That observation is evident in a range of sentiment and positioning data. As we noted last week there has also been a notable shift in consensus beliefs from inflation fear to growth. Over the past couple of weeks bonds have started to outperform in phases of equity weakness. Put another way, fixed income is behaving as a diversifier again for equities.

Over most of the regime over the past decade or more since the 2008 crisis, extremes in sentiment after a meaningful drawdown or 10% or so were typically “mean reversion” opportunities or in zero-hedge terms opportunities to BTFD (buy-the-dip). It is notable that sentiment on a range of indicators including the AAII Investor Survey is modestly above the lowest level since 2009 (chart 1).

However, the challenge for would be dip buyers in the current phase has been inflation and the major shift in the rate and liquidity environment. The good news is that most of the compression in equity valuation has been due to tighter monetary policy and with multiples back or below long term averages most of that process is largely complete (chart 2).

However, there are three negative points to note. First, valuation tends to overshoot to the downside (neutral or equilibrium is not a destination). Second, and as we noted last week, probable earnings downgrades from slower growth and profit margin compression still lie ahead even if the slowdown is moderate (chart 3). If there is a recession-like contraction in growth, current earnings forecasts and profit margin expectations are implausibly optimistic.

Third, valuation multiples are pro-cyclical or reflexive with earnings. The required risk premium tends to rise (valuation multiple tends to fall) in a profit recession. That also tends to reinforce the valuation overshoot, valuation multiple de-rating or widening in the equity risk premium (chart 4).

In conclusion, while there is reasonable odds of a tactical our counter trend bear market rally given pessimistic sentiment, positioning and beliefs, equities have probably not priced the likely downgrade to earnings and profit margins. Bear market rallies tend to be rapid and impulsive due to short covering (it is never a straight line). However, market conditions likely remain in a STFR (sell-the-rip) environment. The good news in this region is that Asia has de-rated down to trough valuation, trades at a near record discount to the United States and China has started to ease credit and liquidity (chart 5). The set up better for regional out performance, especially if the US dollar has peaked.