• Investment Management

A Bump in the Road... or the End of the Road?

Bull market corrections follow a consistent pattern—a dip, rally, retest and recovery—and this period of volatility may be no different says Investment Management’s Andrew Slimmon.

Markets are invariably unpredictable, but two things remain constant: First, investor sentiment is often prone to wild swings. Second, barring significant changes in secular trends, economic growth or company fundamentals, markets have eventually returned to their historic averages, usually referred to as reversion to the mean.

In fact, mean reversion is a major factor behind this year’s equity market behavior. On an average year, the market experiences at least one 10% drawdown. Given that last year had no such correction, it should come as no surprise that this year has dealt investors a double decline. 

 

Annual Returns and Max Drawdowns for S&P 500

Source: Factset, Bloomberg, Morgan Stanley & Co. Research as of September 28, 2018. Note: Price return used. Drawdown is the peak-to-trough decline during a specific period. *See Risk Considerations and Disclosures below.

Likewise, following the strength of returns last year, it would not be unusual for the market to have a pause.  History has shown that such sell-offs are not only normal, against a healthy economic backdrop, they can fuel further upside, and bull markets tend to move in fits and starts.

 

Bull Markets Do Not Move in a Linear Fashion: Is 2018 a Pause Year?

Source: Bloomberg. *See Risk Considerations and Disclosures below

Here are six things to keep in mind:

Bull Market Corrections Typically Follow a “W”

The return of volatility is a predominant theme for 2018, to be sure. Yet, when the dust settles, we'll likely hear about a lot of knee-jerk reactions that weren't well-timed. The reason: Bull market corrections have tended to follow a “W” pattern, in which an initial decline is followed by a rally, and then a second decline, or retest, before the market marches higher. We saw this in 2010, in 2011 and in early 2018.

The upshot: It's often during the retest that people hit the panic button, as evidenced by significant outflows. Assuming this correction follows a “W,” indexes may drop again, as the market further flushes out.

 

Bull Corrections Typically Follow a "W" Path

Source: Bloomberg. *See Risk Considerations and Disclosures below.

Bear Markets Have Been Born Out of Recessions

While it would be great to be able to accurately predict and time these smaller corrections, most investors are better off rolling over these bumps in the road rather than trying to go around them. It's the real corrections — as in 20% or more — that require rerouting, and most of these are the result of an economic recession. In the last 85 years, the S&P 500 has dropped 20% or more 16 times — and 13 of those preceded economic recessions.

The upshot: Given the continued strength in key fundamentals, including corporate earnings, we don’t think an economic recession is imminent.

Yield Curve Suggests Gains Ahead

There is no perfect crystal ball for predicting an economic recession, but the yield curve has historically been a key indicator. Typically, short-term rates are lower than long-term rates, which stands to reason. In periods leading up to an economic recession, the yield curve tends to flatten to zero well in advance of the slowdown.

The upshot: While the yield curve has come down recently, it is by no means flashing economic recession yet. What's more, the initial inversion of the yield curve tends to precede market peaks by a full two years, during which time U.S. stocks have climbed an average of 40%.

 

Yield Curve Is Not Suggesting a Recession Next Year

Initial Inversion Stock Market Peak Time Difference S&P 500 Gain from Inversion to Peak
8/17/1978 11/28/1980 834 days 51.57%
12/14/1988 7/16/1990 579 days 41.46%
4/24/1998 9/1/2000 861 days 41.60%
12/27/2005 10/9/2007 651 days 28.80%
Average 731 days 40.86%
Source: Bloomberg. *See Risk Considerations and Disclosures below

Hit Ratios Are High Following a Drop

Late October marked the 10th time in more than four decades that the S&P 500 fell at least 10% at a time when economic recession was not in sight. In all but one of those selloffs (1987), the market went on to offer significant upside in the following six months.

The upshot: In the year after every 10% correction not tied to economic recession, the median return was 15.8%. Excluding 1987, the one-year median return is 20.6%.

Value Tends to Offer Most Upside

Until recently, momentum stocks led the market to the point of extreme. In September, relative price-to-book valuations for the best-performing stocks in the Russell 1000 were near their all-time highs. Value, meanwhile, has been cheap, with the cheapest 100 stocks in the benchmark trading one standard deviation lower than their historical level. 

As an example, a Morgan Stanley colleague who covers U.S. large- cap banks for Morgan’s Stanley’s Research team, notes that, just as in 1Q 2016, banking stocks are baking-in the same trough valuations when the market feared a near-term recession, yet one did not occur. “Further, half of all large-cap bank stocks are priced even lower than trough multiples hit in the 2001 recession,” she notes.1

The upshot: Following the late October sell-off, relative valuations for value stocks dipped to February 2016 levels. While such slides have historically continued when linked to economic recession, value can offer tremendous upside against a hearty economic backdrop.

 

Ex-Recession, Value Offers Opportunity
(Less than zero mean less expensive relative to history)

Source: Factset. Value spread as defined by the valuation differential between the cheapest decile of the Russell 1000 versus that of the market average. Valuation is based upon price-to-book, price-to-earnings, and price-to-free cash in terms of standard deviation. *See Risk Considerations and Disclosures below.

International Stocks Could Return to Favor

Only a year ago, investors were eagerly shopping overseas — leading the MSCI ACWI Ex US Index to a 27% total return in 2017. This year has been a different story, with the rest of the world lagging the U.S. by the largest margin we've seen in 20 years.2

Yet, extreme divergences tend to reverse quickly. Going back to 1988, there have been six periods in which the rest of the world underperformed the U.S. market significantly. In all cases, there have been reversions to the mean — with particularly profound results for emerging markets. In the 12 months following all of these dips, emerging-market returns have more than doubled those of the S&P 500.3

The upshot: Notably, a U.S. market sell-off typically sparks even greater declines in overseas markets, but that didn’t occur with the latest correction. This may be a signal that investor sentiment about other markets is shifting. It may be time for investors to give emerging markets a closer look.

Adapted from the recent webcast “Market Volatility: A Bump in the Road, Not the End of the Road." For more information, ask your Morgan Stanley representative or visit Morgan Stanley Investment Management. Plus, more Ideas from Morgan Stanley’s thought leaders.

Footnotes

1 Betsy Graseck, Morgan Stanley Large Cap Banks, November 1, 2018
2 Source: Bloomberg
3 Source: Bloomberg

Risk Considerations

There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. In general, equities securities’ values also fluctuate in response to activities specific to a company. Stocks of small-and medium-capitalization companies entail special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. Investments in foreign markets entail special risks such as currency, political, economic, market and liquidity risks. Illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility.


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