Putting Pullbacks in Perspective
Market pullbacks can be unnerving. That is why investors should make a plan with their financial advisors that addresses pullbacks and is informed by historical perspective, not emotion.
Pullbacks & Bouncebacks
We can gain important perspective on market pullbacks by considering post-World War II declines in the S&P 500® Index. The majority of declines fall within the 5-10 percent range with an average recovery time of approximately one month, while declines between 10-20 percent have an average recovery period of approximately three months. Pullbacks within these ranges are not uncommon, occurring frequently during the normal market cycle. While they can be emotionally unnerving, they will not generally undermine a well-diversified portfolio and are not necessarily signals for panic. Even more severe pullbacks of 20-40 percent registered an average recovery period of only 15 months.
The Deeper the Stock Market Decline, the Longer the Recovery1
Declines in the S&P 500® (Since 12.31.1945)¹
||Number of Declines
||Average Decline %
||Average Length of Decline in Months
||Average Time to Recover in Months
In contrast, pullbacks of 40 percent or more, while occurring much less frequently, post an average recovery time of 58 months and can potentially compromise an investor’s financial plan. Pullbacks above 20 percent (including all pullbacks above 40 percent), which have registered the longest recovery periods, have been associated with economic recessions. When evaluating a market pullback, the probability of a recession is a key insight to consider when determining whether or not to reduce equity exposure.
While recessions are readily identifiable in hindsight, prospectively they can be difficult to spot. This makes access to reliable market analysis all the more important when determining the probability of a recession.
Where Are We Now?
(Guggenheim Investments provides its view of the current market environment - as of 11.2018)
It is difficult to ignore the preponderance of positive economic data in the United States. Financial conditions remain loose. On a net basis, more banks are easing standards on commercial and industrial loans to large- and medium-sized firms. Headline and core inflation have both accelerated, with the year-over-year change in the core personal consumption expenditures index now meeting the Fed’s 2 percent target. Finally, with third quarter U.S. economic growth coming in at 3.5 percent, the pace of job creation is above the level needed to keep the unemployment rate steady. The economy is firing on all cylinders, thanks in part to a temporary fiscal boost, belying the fact that we are in a period of tightening monetary policy. A few weeks after the strong jobs report, the Fed delivered its eighth rate hike in three years to close the third quarter of 2018 with a fed funds target of 2.00–2.25 percent.
The seeds of the next recession are sown during the height of economic prosperity, and this time is no different. For example, lending standards typically loosen late in the cycle, and we have seen high-risk companies take advantage of the opportunity to borrow more. In the leveraged loan market, 70 percent of new-issue institutional loan volume this year has been rated single-B, up from an average of 62 percent over the last five years. Most of that debt is being used to finance acquisitions (which include leveraged buyouts) at cycle-tight spreads. Meanwhile, the investment-grade corporate bond market’s seemingly insatiable appetite for BBB-rated debt will have predictable consequences given the history of negative ratings migration during downturns. We estimate that at least 40 percent of BBB-rated companies in the Bloomberg Barclays U.S. Corporate index carry debt loads greater than 4x EBITDA, which is above an average BB-rated company debt multiple. Today’s easy financial conditions encourage greed even as the data urge caution.
We believe the Fed will continue its quarterly hiking path until rates reach 3.50 percent by the end of 2019. Restrictive monetary policy will have consequences, particularly in leveraged credit borrowers’ income statements and balance sheets. For now, we expect that foreign investors will continue to see the United States as a haven of opportunity given strong economic growth and attractive yields, but at this point in the cycle it is better to err on the side of caution
Guggenheim’s Recession Dashboard and Recession Probability Model Point to the Next Recession in the First Half of 2020
The business cycle is one of the most important drivers of investment performance. It is therefore critical for investors to have a well-informed view on the business cycle so portfolio allocations can be adjusted accordingly. At this stage, with the current U.S. expansion showing signs of aging, our focus is on projecting the timing of the next downturn.
Guggenheim has developed several tools to guide this effort. The last several expansions have shown similar patterns leading up to a recession. We have created a Recession Dashboard of six indicators that have exhibited consistent cyclical behavior, and that can be tracked relatively well in real time. These six indicators include a measure of the unemployment gap, the stance of monetary policy, the shape of the yield curve, the Leading Economic Index, changes in aggregate weekly hours worked, and changes in consumer spending. In addition to our dashboard of recession indicators, we have also developed an integrated Recession Probability Model that attempts to predict the probability of a recession over six-, 12-, and 24-month horizons. Our methodology is explained in greater detail on our Forecasting the Next Recession page on www.guggenheiminvestments.com. 1
Taken together, our Recession Dashboard and our proprietary Recession Probability Model, point to the next recession beginning in the first half of 2020.
Naturally, there are substantial risks that our recession date could be too early or too late. Nevertheless, we believe that successful investing requires a roadmap, as with any other endeavor. Our investment team uses this roadmap to help guide our portfolio management decisions, in order to seek superior risk-adjusted performance over time and across cycles.
Near-Term Recession Risk Has Fallen, But Expected to Rise3
Model-Based Recession Probability
Interval Since Last Non-Recessionary Pullback
While there is a relationship between the days since the end of the last correction and the magnitude of pullback, as shown in the following chart, the majority of pullbacks during non-recessionary periods registered declines under 20 percent. As we discussed earlier, pullbacks falling within the 5–20 percent range historically experience recovery periods of one to four months. These are not periods typically associated with severe economic deterioration, and do not necessarily represent a signal to reduce equity exposure. As of the date of this analysis (11.5.2018), there had been 270 days since a non-recessionary pullback of greater than 10 percent.
Ex Recession S&P 500 Corrections (>10% Decline)4
Putting Pullbacks in Perspective
Pullbacks are often not a time to panic and should rather be used as a reason to analyze and assess. Under certain circumstances, it may even be the case that a pullback represents an attractive buying opportunity for certain portfolios. The benefit of gaining reliable market and economic perspective is essential in preparing for market pullbacks. Rather than act on emotion, it’s important to put these events in context to determine what they mean.
Working with your financial advisor, you may then better assess any potential impact on your portfolio and implement a proper course of action, if any is necessary, that is in line with your investment objectives.
To learn more, speak to your financial advisor, who has access to Guggenheim Investments’ timely insights and thought leadership.
1 Copyright 2018 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers, refer to www.ndr.com/vendorinfo.
2 Visit page at https://www.guggenheiminvestments.com/perspectives/macroeconomic-research/forecasting-the-next-recession
3 Hypothetical Illustration. The Recession Probability Model is a new model with no prior history of forecasting recessions. Its future accuracy cannot be guaranteed. Actual results may vary significantly from the results shown. This illustration is not representative of any Guggenheim Investments product. Source: Haver Analytics, Bloomberg, Guggenheim Investments. Data as of 6.30.2018. Shaded areas represent periods of recession.
4 Source: Guggenheim Investments. Data as of 8.3.2018
Any overviews herein are intended to be general in nature and do not constitute investment, tax, or legal advice.
This information is subject to change at any time, based on market and other conditions, and should not be construed as a recommendation of any specific security or strategy. There can be no assurance that any investment product will achieve its investment objective(s). There are risks associated with investing, including the entire loss of principal invested. Investing involves market risk. The investment return and principal value of any investment product will fluctuate with changes in market conditions.
Guggenheim Investments represents the investment management businesses of Guggenheim Partners, LLC. Securities offered through Guggenheim Funds Distributors, LLC. Guggenheim Funds Distributors, LLC is affiliated with Guggenheim Partners, LLC.
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