From Fear to Hope

After a tough year for equities, is a recovery imminent? While nobody can predict when the market will bottom, we do know what happened after sharp downturns in the past. Patient investors can find comfort knowing that strong recoveries are common after sharp drawdowns.

Stock market volatility continues to rage, even after recent glimmers of hope. Despite recent gains, the S&P 500 was down by 15.1% this year through November 15. Outside the energy sector, there have been few places to hide in equity markets, with sharp declines across Europe, Asia and emerging markets.

Setting the Stage for a Healthier Recovery

Severe stock market drawdowns are always unsettling. But they often set the stage for a healthier recovery. That’s why market downturns are commonly known as “corrections.” Share values are reset to better reflect a company’s long-term earnings expectations. This process can be volatile, especially when share prices in parts of the market are unreasonably high and when the earnings outlook is extremely uncertain. Both conditions have been present this year.

But what happens after a drawdown is encouraging. Following sharp US market declines since 1950, equities typically roared back with gusto. From the low point in eight US market downturns of more than 20%, equities delivered a 51.1% forward return after one year on average, and a three-year return of 82% (Display). Five and 10 years later, investors also enjoyed handsome gains.

Skeptics might argue that conditions today are extraordinarily bad. While we agree that there is plenty of uncertainty, bad conditions are what drive sell-offs, and their underlying circumstances are often different when they occur. Today, inflation and its knock-on effects are challenging economic growth. Higher energy prices, rising global yields and roughly two years’ worth of global central bank tightening are filtering down to economic activity with a lag. It would be foolish to declare that the coast is clear.