This Selloff Could Persist

Summary

• Despite headlines, only the tech sector has hit correction territory so far, and only in the last few days.
• Versus the last 90 years, the past decade’s corrections are more like intermittent flash crashes – sudden, but very short.
• But the current selloff could persist due to many headwinds: high valuations, uncertainty about inflation and Fed policy, and a tight labour market.
• While the economy recovers, we anticipate equities will trade in a range. The primary risk is markets thinking the Fed is making a major policy error.

Market Implications

• We recommend investors overweight the large-cap value sector, via the RPV ETF, and underweight growth via the RPG ETF.
• We also suggest going long major tech companies such as Microsoft (MSFT), Apple (AAPL) and Amazon (AMZN). They should maintain growth and margins.

Equity markets have always endured selloffs and corrections. That said, there is a big difference between corrections before the Great Financial Crisis and those of the past decade. How does this ongoing selloff stack up against those of recent and more distant vintage? Let’s start with the long view.

A correction is a selloff of more than 10% from a recent high. For much of their history, equities have trended higher, so the recent high is usually the high-water mark. But there have also been extended periods where the market traded below its all-time high for years – or even decades in the case of the 1929 market crash.

Chart 1a examines corrections in the S&P 500 since 1928. The blue area represents periods where the market sold off at least 5%; the orange area is where it moved into correction (between -10% and -20%) or bear market territory (more than -20%). The S&P 500 hit a high on 16 September 1929 and did not cross that level again until 22 September 1954.

Comparing the market to the previous all-time high, it is apparent that when equities get to extreme valuations, corrections and bear markets can last a long time. This happened notably in the late 1960s, the 1970s, the early 2000s, and after the Global Financial Crisis (GFC) of 2007-2008.

But life (and investing) goes on even if the market is trading below its all-time high. We can also compare market performance against recent highs, in this example the high of the past rolling one year (Chart 1b), to gauge the risk of intermediate selloffs. We find corrections usually occur in conjunction with recessions – but not always. Also, selloffs of 5% to 10% are quite common.

Finally, the five corrections over the past decade barely register compared with most previous corrections, either in magnitude or duration.

What About Recent Corrections?

There have been a few corrections since the GFC – five for the S&P 500 and about eight for the NASD 100 (Charts 2a and b). As before, the blue area represents selloffs in the -5% to -10% range and orange correction territory.

We note several points:

• Unlike corrections in previous decades, recent corrections for both indices have been very brief. Several of the NASD 100 corrections have lasted a matter of days, although most last at least a week or more.
• Selloffs of 5% or more are fairly frequent, especially for NASD 100. And while some approached correction territory, none entered.
• For all the recent talk of corrections, the S&P 500 has yet to close in correction territory.
• The NASD 100 has been in correction territory for a few days now, although on the above chart’s scale, it barely registers yet.

The Selloff Has Been Broad-based

On 10 January, we noted the selloff to that date hit all the major S&P sectors except energy and financials. Now, only energy has managed to rally – on a 15% jump in oil prices since the beginning of 2022. That said, financials and consumer staples are only down about 1.8% so far (Chart 3).

But when we segmented the market into growth and value, value (RPV ETF) was up 7% and growth (RPG ETF) down 7%. Since then, the selloff turned more broad-based, with value down 6% from the high and growth falling an additional 7% (Chart 4).

This Selloff May Mark a New Regime

The question is, are we seeing another post-GFC short selloff and correction? Or does this selloff mark a reversion to more extended pre-GFC corrections?

There are good reasons to think this selloff could last:

• Investors will likely remain on edge about the Fed and monetary policy at least until inflation calms.
• The economy will not have the fiscal stimulus of the past two years, and consumer spending growth will likely slow.
• With workers demanding and getting higher wages, earnings growth will depend on companies’ continuing ability to pass on higher costs – but inflation will be an ongoing problem as long as this is the case.
• The Fed could also err and push the economy into a nasty recession.

These are all headwinds facing markets, and nothing is on the horizon that could alleviate these concerns. Nor is a spring thaw coming that could soften the bearish mood. We can do little but wait and see what happens.

Base Case is Ongoing Recovery but Heightened Uncertainty

Our base case is that the recovery will continue, although perhaps unevenly at times. We expect markets will trade in a range but have difficulty mounting a sustained rally. The big risk in our view is markets thinking the Fed has made a major policy mistake (e.g., tightening too fast or misreading inflation signals).

We still favour value (via the large-cap RPV ETF). We also favour major tech companies such as Microsoft (MSFT), Apple (AAPL), and Amazon (AMZN), which should be able to maintain growth and margins.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)