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Uncommon truths: Seeking reasons to buy US equities

Uncommon truths: Seeking reasons to buy US equities

After a 24% year-to-date decline in the S&P 500, we ask what could make us turn positive on equities. A 30% further decline would help but short of that, some combination of the start of recession, VIX above 40 and falling bond yields would do the trick. 

Before turning to the main topic, we want to address recent questions about allocations to UK assets. Luckily, we had reduced our Model Asset Allocation weighting in UK government bonds to zero and that to UK equities to Neutral before the UK’s mini budget, though remaining Overweight UK investment grade credit and UK REITS (see Figure 6). Most of the volatility in recent weeks was in sterling and in government bond yields. We suspect we may have seen the bottom in sterling (versus US dollar) and the peak in gilt yields. However many doubts remain about UK government finances, so we expect further volatility and are not changing our allocations for now. 

The S&P 500 is down 24% since the start of the year. Is that enough to make it safe to put a toe in the water (we are Underweight global equities within our Model Asset Allocation see Figure 6). We are wary but want to consider what conditions could force a change of mind. The ideal list includes a further 30% decline in the S&P 500, amid signs of capitulation (VIX index going above 40 and ideally above 50), in the midst of a US recession, with bond yields falling.   

However, that seems like an extreme wish-list and the signals may not be so clear cut. Figure 1 is the basis for saying that a further 30% S&P 500 decline would encourage us to look more favourably upon equities. There has historically been a reasonable inverse correlation between the level of the Shiller P/E and US equity returns over the following 10 years. If this relationship were to continue, the current Shiller P/E of around 28 is consistent with moderate (perhaps negative) returns over the coming ten years.   

That is not very encouraging. The full history of the Shiller P/E shows that the best future returns have been achieved when it falls below 10 (around one-third of the current level). Further, they have often (but not always) been associated with recession, which provokes the equity sell-off that provides the springboard for generous future returns. However, in recent decades (since the mid-1980s), those strong returns appear to have been associated with Shiller P/E ratios in the 15-20 range (and often associated with recession). A 30% reduction in the S&P 500 from current levels would bring the Shiller P/E to around 20. Ideally, a recession would already be under way, which would remove a lot of uncertainty. 

As economic data (and the declaration of recessions) often comes with a lag, one indicator that we have found to be a help is the ISM Manufacturing Index. We note that US equity returns over the coming 12 months are often at their strongest when this index falls to its weakest i.e. below 50 (the Institute of Supply Management calculates the breakeven for the full economy moving from expansion to contraction is 42.8 and the index was 50.9 in September). While the September employment report confirmed that job gains in the manufacturing sector are well below early 2022 levels, overall job gains remain respectable (if on a downward path). Apart from the housing sector, signs of US recession remain scarce. 

Figure 1 – US Shiller P/E, recessions and future equity returns (1881-2022)
Figure 1 – US Shiller P/E, recessions and future equity returns (1881-2022)

Notes: Past performance is no guarantee of future results. Monthly data from January 1881 to September 2022. “Shiller P/E” is constructed by Robert Shiller and compares price to a 10-year moving average of earnings, with adjustments for inflation. “Next 10-year returns” is the annualised gain in a broad US equity index (excluding dividends) over the next 10 years. NBER recessions are periods of US economic recession as defined by the US National Bureau of Economic Research. See appendices for definitions and disclaimers.  Source: Federal Reserve Bank of St. Louis, NBER, Robert Shiller and Invesco 

Indicators of market sentiment are likewise not yet suggesting there has been a capitulation from which a solid rebound is likely. New York colleague Talley Leger follows eight tactical indicators, four of which are giving the green light (American Association of Individual Investors Sentiment Survey, CBOE Equity Put/Call Ratio, US Economic Policy Uncertainty Index and the NYSE Composite Advance/Decline Ratio). Talley reports that the other indicators are moving in the right direction but are not yet extreme enough to warrant a positive outlook. 

Among Talley’s other indicators is the CBOE VIX index (a measure of implied volatility), which we also like as a barometer of distress in markets. Though the current VIX index of around 31 is elevated compared to its lifetime average of 19.6 (since the start of 1990), it is not extreme. The VIX has gone above 40 on only eight occasions since 1990 and on six of those the S&P 500 rose by 20% or more over the next 12 months. It has gone above 50 on only two occasions (in fact going above 80 both times – during the Global Financial Crisis and the Covid pandemic), leading to the two highest 12-month returns since 1990. Hence, it would give us more comfort if the VIX went above 40 and ideally above 50. 

As we have recently noted (see The Big Picture 2022 Q4), the decline in global equity markets during 2022 has not been about falling corporate earnings (there has not yet been a noticeable decline). Rather, it has been due to valuation multiple compression that has correlated with a rise in bond yields. In other words, equities have fallen because bond yields have risen, rather than because earnings have fallen. 

Figure 2 shows an inverse correlation between the 10-year US treasury yield and the Shiller P/E since the mid-1960s. The correlation is not perfect but it seems that lower bond yields have been associated with higher valuation multiples. Bond yields would also have helped better judge the return potential indicated by a particular level of the Shiller P/E. For example, bond yields gave a reasonable guide to the extent of the overvaluation during the dotcom bubble and also the extent of the opportunity created during the GFC. 

The rise in the Shiller PE after the initial shock of the Covid pandemic was in some way justified by the fall in treasury yields, just this year’s decline appears linked to the rise in bond yields. If anything, the current Shiller P/E, though elevated in a historical context, appears appropriate given the current 10-year treasury yield.   

As discovered at the end of last week, a rise in treasury yields is likely to drive stocks lower. On the other hand, we suspect falling treasury yields could help offset the negative effect of a decline in earnings and perhaps even justify a rise in the stock market. 

In conclusion, if a US recession is to occur (and we think it increasingly likely, given Fed policies), then we would feel more comfortable switching to an Overweight equity position once the recession has started (our analysis of past bear markets associated with recession suggests they rarely end before the recession has started).   

However, mitigating factors that could persuade us to take a more positive stance on equities, whether recession has started or not, would be a 30% further decline in the S&P 500, with the VIX index going above 40 (and ideally 50) and/or a sizeable decline in long-term bond yields.   

Unless stated otherwise, all data as of 07 October 2022. 

Figure 2 – US Shiller P/E, bond yields and recessions
Figure 2 – US Shiller P/E, bond yields and recessions

Notes: Past performance is no guarantee of future results. Monthly data from January 1881 to September 2022. “Shiller P/E” is constructed by Robert Shiller and compares price to a 10-year moving average of earnings, with adjustments for inflation. NBER recessions are periods of US economic recession as defined by the US National Bureau of Economic Research. See appendices for definitions and disclaimers. Source: Federal Reserve Bank of St. Louis, NBER, Robert Shiller and Invesco 

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