The S&P 500 hit a low of 3,577 on October 12, a decline of about 25 per cent from its January peak. Since then, mixed corporate earnings and the potential softening in the pace of interest rate rises from the
US Federal Reserve have lifted risk sentiment and the equity market has gained about 7 per cent.
Investors are looking for the market trough and starting to wonder if it has already passed. However, multiple
bear market rallies are not uncommon, and it could be too early to call the trough right now.
November is the time when many market commentators are releasing outlooks for the year ahead. These are likely to hint at better market performance, given the painful experience of 2022 and expectations that the trough must be close.
From a macroeconomic perspective, the only thing that matters in this respect is
inflation. The outcome for equities could come down to who wins the race between inflation falling and the impact of tighter financial conditions on economic activity and the corporate outlook. Can inflation slow enough before financial conditions become too tight and interest rates too high, choking off economic activity completely?
Equity markets are forward-looking and build in expectations for the outlook for the economy and company earnings. Historically, this has resulted in markets finding the floor even as economic growth and corporate earnings continue to fall or before financial conditions have started to ease.
This occurs because the equity markets are not concerned with the absolute level of these indicators but their rate and direction of change. For example, equities can rise even as the
economy is contracting because a quarterly gross domestic product report that shows it is in recession but contracting at a slower pace than the previous quarter might actually be a positive.
Beyond inflation, when it comes to looking for guidance that the US equity market has bottomed out, there is not one indicator that does it all. Two that have been used in the past to varying degrees of success are the ISM manufacturing index and equity market valuations.
In prior
bear markets, the equity market trough has occurred in the months around the low for the ISM survey. While this is a useful guide, it’s not precise enough to make accurate investment decisions. We might actually only know the market has reached the bottom by looking in the rear-view mirror.
Looking at previous bear markets, equities have turned once valuations have bottomed out. While it is true that the earnings multiple for future earnings of US companies – i.e. the forward
price-to-earnings ratio – is well down from where it was at the start of the year, it is by no means cheap by historical standards.
At the start of the year, the S&P 500 traded at a multiple of 21.4 times, well above the average of the past 15 years of 15.6 times. Today, the S&P 500 valuation is 16.6 times, still above average but not by as much and not nearly close to the lows of prior bear markets. The troughs in the price-to-earnings ratio for the S&P 500 in the 2000, 2007 and 2020 bear markets were 13.8, 10.2 and 13.3 times, respectively.
This might sound quite negative on the outlook for equities, but there is potential for upside as well. If inflation cools faster than expected and the Fed pivots, thus avoiding a
recession, bond yields would fall and the equity market would rise, given the more positive outlook.
The complicating factor in predicting when US equities will bottom out is the outlook for the US economy itself. The fall in equity prices this year suggests the market is pricing in some
probability of a recession in the coming 12 months, but it is not guaranteed.
It is that uncertainty that is lingering over risk sentiment. The sooner a full recession is either priced in or not, the sooner equity markets can start to recover.
Kerry Craig is a global market strategist at JP Morgan Asset Management
