The legendary investor Sir John Templeton said, “The four most dangerous words in investing are: ‘This time is different.’” In that spirit, the fourth-quarter market carnage conjured up memories of 2008’s drawdowns and ignited debate about the timing of the next recession.
In short order, the S&P 500 Index fell 19% from its late-September peak, vindicating the bears. Liquidity is tightening, stirring calls for investors to prepare for further drawdowns in equities.
But are fears of a U.S. equity market crash warranted?
ClearBridge Investments defines market “crashes” as drawdowns of 20% or more that last longer than one year. By contrast, we define other large selloffs (15% or more) that last less than one year as “pullbacks.” The added dimension of time is important. Many investors can ride out the shorter-term turmoil of a pullback, but they will feel the impacts of a crash much more severely.
Market crashes and recessions typically go hand-in-hand. Crashes typically last three times longer, with drawdowns 2.3 times more severe than pullbacks. Most significantly, crashes are 2.5 times more likely to coincide with recessions, historically.
ClearBridge’s Recession Risk Dashboard tracks key data along four vital economic fault lines: financial, inflation and consumer factors as well as business activity. Analysis of 12 variables within these categories can help determine whether the U.S. economy is heading toward a recession.
The key question for investors is whether the U.S. is heading into an economic downturn. The current dashboard suggests these fears may be overblown: Eight of the 12 indicators are green, four yellow — and zero red. Although three factors switched from green to yellow (yield curve, credit spreads and commodities), the consumer and business segments remain solidly green. The picture our dashboard paints remains quite healthy overall.
Yet many ask whether this time will be different — will a market crash ensue without a recession?
Given the health of the ClearBridge Dashboard, we believe U.S. equity market turmoil will be relatively short-lived. That should render this period a pullback rather than a market crash.
It can be hard to pinpoint the level at which equities find a bottom. It is important to view non-recessionary pullbacks through three dimensions: price, time and sentiment. While several sentiment surveys have ticked down recently, they remain at broadly elevated levels.
Overall, we may be close to an inflection point. A great deal of negative news is priced into the market. This should allow for positive surprises relative to expectations.
One casualty of the recent market volatility has been price-to-earnings (P/E) multiples. The combination of a strong earnings environment and negative returns brought valuations down considerably. In fact, 2018 witnessed the third greatest annual decline in P/E levels over the past four decades, even greater than the P/E compression experienced in 2008.
Today’s environment is similar to several periods when market weakness and substantial P/E compression occurred against a backdrop of economic and earnings strength. Historically, these periods have been followed by solid stock rebounds.
The market multiple is near five-year lows, a level consistent with the last two major growth scares. P/E contraction has been concentrated in cyclical sectors, which are overly discounting the chances of a recession in 2019. The backdrop shares several attributes with 1984 and 1994: a strong economy, robust earnings growth, substantial P/E compression and a weak stock market.
In 1984, earnings growth was 21%, real GDP roughly 7%, P/E multiples contracted by two turns, and the market finished up 2%. Similarly, in 1994, earnings growth was 19%, real GDP was 4%, P/E multiples came in three turns and the market fell 1.5%. Following these years of lowered expectations and derating, the market bounced back: a 26% return in 1985, a 35% gain in 1995. Key to these rebounds was a lack of recession in the year following the resetting of expectations.
Several risks remain for stocks, including trade tensions, slowing earnings growth and potential policy errors by the U.S. Federal Reserve. Tariffs likely will remain in the headlines as negotiations continue between the U.S. and China.
Ultimately these risks will be bricks in the wall of worry that the market climbs higher in 2019. The healthy fundamental backdrop — combined with attractive equity valuations, a possible Fed pause and more Chinese stimulus — all point toward a rebound, rather than a prolonged crash.
Jeffrey Schulze, CFA, is an Investment Strategist at ClearBridge Investments, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.