Investors looking for clues to the end of the current market turmoil should stop making “dangerous” comparisons with past sell-offs and instead focus on understanding the excesses that need to be washed out of the system, MFS’ Rob Almeida argues.
With markets going through an extended sell-off, many investors were seeking reassurance and making comparisons with past corrections in the hope of finding the light at the end of the tunnel.
However, Almeida, global investment strategist at MFS International Australia, said: “During bear markets, a wildly overused, and I believe, dangerous, frame of reference is historical drawdowns and their implied assumptions about future market returns.”
A typical ‘formula’ attempted to predict the potential returns after a sell-off and could look something like this: recessions last an average of w number of days, and equities fall an average of x% followed by a recovery of y% in z days.
“Market commentators use formulas such as these to ease clients’ mental anguish and imply that better days are ahead,” Almeida said. “Better days are ahead. However, they can take longer than you expect to materialise and may be accompanied by significant financial pain.”
The strategist pointed out that averages only told us about the central or typical value in a data series; they shed no light on the variation of outcomes within that.
For example, the bear market that accompanied the Great Depression ran from 1929 to 1932 while the 2020 COVID bear market lasted little more than a month – neither of which would be apparent from the duration of the ‘average’ bear market.
“Economic and market cycles don’t die of old age. They end when excesses are corrected due to a financial crisis or a recession,” he said.
“These, often painfully, wring out overinvestment in both the real economy and financial markets. The length of the business cycle is irrelevant. What matters is the level of excess and the magnitude of the needed rebalancing process. That determines how much further we may still have to fall.”
Because profits ultimately drove future returns, Almeida argued that the market would be unable to return to a healthy state until the excess of over-leveraged profits had been corrected and margins settled at sustainable levels.
“Currently, many companies are telling investors they can sustain all-time-high post-stimulus margins despite rising fears of recession and a step-function jump in costs (explaining why earnings expectations remain elevated in the face of obvious revenue and input cost pressures), but we don’t believe them,” the strategist concluded.
