Bear market patterns: What investors should know about trend reversal

Stock markets will turn, even with all the economic news still being negative, except in two scenarios

In the midst of a bear market, which we are undoubtedly in today with every asset class except commodities in the red, it is common for the sell-side commentary to become ultra-bearish. This is exactly what is happening globally. All the mistakes made in the prior bull cycle are now cruelly exposed.

Whether it be on valuations, absolute growth estimates or sustainability of growth, many investors are looking foolish at the moment. How could you have bought XYZ company at a price/sales ratio of 40? How could you have assumed that digital penetration in ABC sector would continue growing at 35-40 per cent even after the pandemic? These are a sample of the stock-specific, micro level issues being discussed.

At a macro level, how could one have assumed zero interest rates forever? Why did you not expect inflation to surge, given the global fiscal and monetary policy dump in 2020? With the benefit of hindsight things look far clearer and obvious!

All types of awkward questions are being asked, and almost as if to apologise for their inability to have seen the excess, many commentators today are going out of their way to be as cautious and cynical as they can be. There are reams of research being written currently on why the world is coming to an end and markets are poised to collapse further. The usual suspects and masters of doom are out in full force. The fears are understandable and real. We are probably already in a recession in Europe and poised to see at least a mild contraction in the US in 2023. Inflation is still not under control and real rates remain negative. Earnings expectations are bound to decline by 15-20 per cent, typical for a recession and we have these cuts still ahead of us. Unemployment rates are at record lows in the US. There has been no recession that has not seen employment levels fall. There are tremendous fears around normalisation of central bank policies. What will be the impact of quantitative tightening (QT)? We don’t know because we have never seen it before. How will the financial system handle the rising interest rates? Again, as the crisis and near-meltdown in the UK pension/insurance industry demonstrates, no-one can predict the unintended consequences of the normalisation of liquidity and rates.

All this doom and gloom is well-understood, rational and we are in certain aspects like QT, truly in uncharted territory. Despite this, there is a hard reality in financial markets. Equity markets are discounting mechanisms. The reality, if one were to go back and look at almost all prior recessions, is that the equity markets bottom before all other real economy and financial market metrics. They tend to bottom several months before all the other indicators that investors are focused on. It is for this reason that equity markets are a part of the series of leading economic indicators used to forecast economic conditions in the US.

The normal pattern seems to be that equity markets bottom about six months before gross domestic product (GDP). After GDP, payrolls bottom and then we have earnings bottoming following that. Thus, when equity markets bottom, GDP, payrolls and earnings are still dropping. Markets will look through these indicators, even as they are declining and set up for the recovery to come. Thus, just because the news will remain poor on GDP, payrolls and earnings for some time to come does not mean that equity markets cannot bottom.

The only time equity markets were a lagging indicator was the technology bust of 2000, wherein equity markets bottomed after earnings had already stabilised and started rising again. Earnings bottomed almost a full 12 months before equities troughed and there was hardly a recession at all. The unwinding of the excesses in the technology universe took much longer and the Nasdaq fell much faster and further than the broad indices, which bottomed much later.

The one economic indicator, which tends to bottom at approximately the same time as the equity markets is the Institute of Supply Management or ISM purchasing manager’s index, which has historically bottomed within one to two months of the equity market trough. This is an indicator every investor should keep an eye on.

Illustration: Ajay Mohanty

It is also my belief that in most large market declines, like the one we are going through, the bulk of the damage and drawdown tends to happen in the first 12-15 months of the decline. After this initial fall, markets either start moving up again (normal pattern) or if we have had severe sectoral and financial system excesses then the markets will just drift sideways for an extended period. Given that the US equity markets topped out in the last quarter of 2021, we should by the end of 2022/ Q1 2023 be near a point where a large part of the drawdown may be done.

While markets will remain very volatile with big daily moves in both directions, as we get towards the end of the year, an opportunity to increase the weight of equity in global markets will likely present itself. It is important to remember that the news will still remain unambiguously negative when this happens. It is also likely that the very commentators who caught the shift in market sentiment and were bearish in time, will not catch the more bullish turn. It is very rare for the same people to be right on the way down and the way up as well. At the turning point you will need to read other market commentators.

A scenario where this whole equity markets leading the bottoming process thesis will not play out is if we go through some type of financial shock. Coming after years of zero interest rates and abundant liquidity, there is a very vocal school of thought that is convinced that we cannot normalise monetary policy setting without an accident occurring in the financial system. Such an accident will mean all bets are off and it will become impossible to assess how markets will eventually play out. Another scenario is that inflation has truly broken out and will need years to get back to target. In this case again the above playbook may not hold.

A bottoming of global and especially US markets is very important from the Indian equity markets perspective. The biggest risk to Indian markets is global factors. Most allocators are convinced India is just too expensive. The markets have performed very well over the last few years and, even in 2022, have shown great resilience. India will be an ATM market for many, the one place they can still book profits, take money out and not decimate their remaining holdings. As long as global and emerging market portfolios remain under pressure, the temptation to sell out of India will be immense. We have seen $40 billion of secondary markets selling in the last 12 months. This will continue as long as global markets remain under pressure. Domestic flows have cushioned and offset this capital outflow, but it would be nice for this headwind to turn into a tailwind of capital inflows.

Yes, it makes sense to remain cautious on global markets for the time being, but one must be careful not to get too caught up in the bearish rhetoric. Equity markets will turn even with all the economic noise while still being very bearish.

The writer is with Amansa Capital