This Selloff Feels Different But It’s No 2018

Summary

• The equity selloff so far resembles the four selloffs in 2021 in magnitude.
• This one differs in that winners and losers are roughly balanced, with value gaining and growth being hit hard.
• Unlike 2021 selloffs, when concerns about the economy were a big factor, investors now appear more sanguine about the economic outlook.
• There is still risk that investors’ outlooks could darken, sparking a further selloff, perhaps similar to late 2018

Investment Recommendation

• Our base case is that this selloff is more of a tremor, and growth in particular will recover.
• Key indicators for when the market finds a bottom could be when the 10-year Treasury yield settles into a new range; or the 4Q earnings season, which starts in earnest on January 14.
• We recommend investors be looking for opportunities to reenter the growth and tech sector.

The surprising thing about the equity selloff of the past week wasn’t that it happened, but that it bypassed the initial optimism that investors often bring to the new year.

Given the degree of shock and pessimism expressed in the financial press it is worth stepping back and noting that the factors driving this market – fears about the Fed and rising rates, hopes that the economy is on the verge of returning to normal, stretched valuations, and sheer uncertainty about Covid – have been with us for the past year.

And that led to several short and sharp selloffs of 4% since the election (see Chart 1 and Table 1). Really, this is quite normal in this age of Covid.

Several other interesting points emerge when we parse the data further. Chart 2a-c shows the percent of the S&P 500 growth and value sectors that post negative and positive returns during the selloffs.

It is readily apparent that growth always takes a big hit during selloffs, with – 70% or more registering negative returns. Value has been more variable. In September and November, about 90% of value posted negative returns. The economy was a key concern. In September, markets were concerned about the end of Covid fiscal support, regulations in China, and rising inflation and potential Fed action. In November, Fed Chair Powell turned sharply hawkish, and Omicron surfaced just after Thanksgiving, raising fresh concerns that resurging Covid could hamper the economy.

The 2022 selloff has been notably different in that it has been concentrated in the growth sector. Across the entire index, gainers and losers are clustered around 50%. This is not a market worried about the economy.

Could This be the Big One?

So, the previous selloffs were tremors. Is this yet another, or is this the Big One? It is still too early to say – we are only four days into this selloff and the previous 2021 ones lasted two to three weeks.

In our view, for the Big One to happen markets have to be anticipating that the economy is headed for recession or a significant slowdown. There is little in the fundamental data to suggest that is likely any time soon, and so far we haven’t had some major shock that suddenly makes recession likely. And as noted, investors seem sanguine at this point.

What if That View Changes?

The last big selloff before the March 2020 collapse was in late 2018. Between early October and Christmas Eve, major equity indices dropped by 20% or more – bear market territory. During October and November the decline was mild – on order of what we saw in 2021 selloffs – then sold off sharply in December (Table 2).

At the time, the Fed had raised its policy rate to 2.5% and markets were deeply concerned that it planned to raise it further. President Trump was making noises about trying to fire Powell. Markets were worried about the impact of Trump’s tariffs on steel and aluminum imports and a slowdown in China. Tech was coming under closer regulatory scrutiny. And valuations appeared stretched by historical standards. A perfect storm in other words.

Some of these factors are in play today. Valuations appear stretched. There is concern about Fed policy. China’s economy is expected to slow. On top of that is inflation and geopolitical tensions, particularly in Ukraine.

Base Case: This is Another Tremor

Our base case now is that this tremor (or tantrum?) will run its course and equities and growth in particular will recover.

But there is also risk that investors’ current positive economic outlook darkens, which will surely spark a further selloff, perhaps on order of 2018.

One key indicator of where and when markets find a bottom may be when the 10Y Treasury yield seems to settle into a new trading range. A second one will be the 4Q earnings season, which gets underway in earnest on January 14 when major banks start reporting.

We recommend investors be looking for opportunities to reenter the growth and tech sector.

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.)