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The FT Wilshire 5000 has appreciated 14.5% from the mid-October low
Anticipation of a pivot in the degree of Fed hawkishness was the catalyst behind the recovery in risk appetite that commenced in mid-October last year. This positive momentum continued in January producing a return of 6.9% for the FT Wilshire 5000 for the month. From the mid-October low, the FT Wilshire 5000 had appreciated 14.5% to the end of January.
Exhibit 1: The risk rally that started in mid-October last year continued into January
Source: Wilshire. Data as of January 31, 2023.
Exhibit 2 breaks the rally in the FT Wilshire 5000 since mid-October into two phases (October to December versus January). In the first phase, the rally was still defensive in nature represented by the marked outperformance of the Value style. By contrast, January saw a similar return for the market but this time it was driven by the outperformance of the Growth style.
Exhibit 2: A rotation to the Growth Style in January
Source: Wilshire. Data as of January 31, 2023.
Exhibit 3 shows relative performance of the FT Wilshire large Cap Growth versus Value and the US 10yr TIP real yield inverted. Style rotation responds to inflections in the real yield. The decline in the real yield in January has contributed to the Growth style outperforming the Value style by 5.7%
Exhibit 3: Growth style outperformed in January helped by falling real yields
Source: Wilshire, Refinitiv. Data as of January 31, 2023.
Exhibit 4 compares the sector weighted contributions to the returns for the Growth and Value style indexes in January. Growth benefitted significantly from the larger respective contributions generated by four sectors - Digital Information, Technology, Consumer Goods and Transportation. These tend to be seen as long duration growth sectors that respond positively to declining real yields.
Exhibit 4: Comparing the sector weighted contributions for Growth and Value
Source: Wilshire Data as of January 31, 2023.
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Markets are convinced that inflation has already peaked and that interest rates should follow suit by Q2 this year.
The Fed remains more skeptical and awaits evidence of services inflation turning a corner.
Chart 1 shows the returns accrued by the FT Wilshire 5000, US bonds and the US dollar from the low point reached on October 14th last year and performance YTD for 2023. While both equities and bonds have rallied strongly the dollar has fallen sharply. The common denominator between these divergent moves is growing conviction that US inflation has already peaked and that US interest rates will follow suit.
Chart 1: Move in US assets since October 14th low and YTD
Source: Wilshire, Refinitiv, FactSet. Data as of January 17, 2023
Chart 2 plots the key US inflation indicators and shows a profile of inflation peaking (and subsequently declining) over the last six months. In fact the Fed's key indicator the Core PCE deflator peaked in February 2022. It also appears that the Fed ramped up its hawkishness as evidence of the peak started to appear.
Chart 2: Key US inflation gauges appear to have peaked several months ago
Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023
Chart 3 shows that the key driver behind the peak in inflation has been the rapidity of the decline in both goods inflation and input prices as measured by the PPI indicator. Services inflation has yet to peak, and the Fed will probably need to see this confirmed in subsequent data to change tack on interest rates.
Chart 3: Declining goods inflation but services inflation (the Fed's focus) remains elevated.
Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023
Chart 4 plots both the markets interest rate and Federal reserve dot plot curve forecasts. The market expects rates to peak close to 5% in Q2 but then to 'fade' lower into the second half of the year as growth headwinds and disinflationary pressures push rates lower. However, Fed forecasts paint a picture of continued increases throughout the course of the year reaching peak rate by the end of the year (higher for longer).
Chart 4: Mind the gap between the market and Fed interest rate forecasts
Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023
While the Fed is still waiting for more evidence of inflation peaking it has been concerned that the deliver of restrictive financial conditions runs the risk of slowing the economy too aggressively and has subsequently started to rein in (taper) the scale of interest rate increases it is delivering at the FOMC meetings (see Chart 5). Tapering has been a contributory factor behind the weakening of the dollar.
Chart 5: The Fed is tapering the magnitude of rate hikes - impacting the dollar
Source: Wilshire, Refinitiv and Federal Reserve. Data as of January 17, 2023
Read more in our latest Market Driver Insights report.
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The second half of 2023 has seen the 2023 EPS growth rate forecast start to decline
As can be seen in Chart 1, the second half of 2023 has seen the 2023 EPS growth rate forecast start to decline. This has clearly been connected to the rapidity of the commensurate decline in forward looking GDP growth forecasts.
Chart 1: 2023 EPS growth forecasts have followed GDP forecasts lower
Source: Wilshire and FactSet. Data as of November 15, 2022
Chart 2 shows the sector weighted contribution to the aggregate 2023 market EPS growth rate. In May the forecast was for 12% EPS growth, and this has now declined to 7.9%. The main contributors to this 4.1% decline were the negative contributions from the tech and health sectors.
Chart 2: Comparing the US vs World ex US PE ratio moves over the last 20 years
Source: Wilshire and FactSet. Data as of November 15, 2022
Chart 3 shows the progression of quarterly US EPS forecasts out to the end of 2023, with the blue bars showing the Q/Q growth rates and the grey line showing the quarterly forecast EPS (USD). As the chart shows, there is high levels of seasonality forecast over the next 12 months or so.
After flat or negative EPS growth expected for the next three quarters, a lot appears to be hinging on a recovery in EPS in Q3 and Q4 of next year.
Chart 3: A lot is riding on the delivery of a positive EPS inflection in Q3 2023
Source: Wilshire and FactSet. Data as of November 15, 2022
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The likelihood of the delivery of sustained disinflation in 2023
Despite persistent fears that financial conditions are sufficiently restrictive to cause a slowdown next year, the positive market reaction to the weaker than expected October CPI data seemed to indicate a transition to a new phase of inflation dynamic analysis - the likelihood of the delivery of sustained disinflation in 2023.
Bad economic news feeds this narrative and therefore could now be seen as good news.
Chart 1: On the cusp of phase 3 of inflation analysis
Source: Wilshire, Refinitiv. Data as of November 15, 2022
Intensified focus on the Fed’s disinflation forecast for 2023
Chart 1 plots the progression of the Fed’s core PCE inflation indicator. The twelve month period between February 2021 and February 2022 saw the inflation rate almost triple, generating the hawkish tilt by the Fed. Since then, the inflation rate has plateaued (albeit at an elevated level).
The focus now turns to the plausibility of inflation moving sequentially lower next year as predicted by the Fed. Their current forecast of year-end 2023 inflation reaching 3.1% requires a monthly run rate of 0.3%. A run rate of 0.2% a month would deliver a 2.4%-year end inflation level.
Forward looking indicators such as the ISM prices paid index point to continued downward pressure on headline inflation in the coming months.
Chart2: The ISM manufacturing prices paid index points to lower US CPI
Source: Wilshire, Refinitiv. Data as of November 15, 2022
Perception that inflation could be peaking and then encountering disinflationary headwinds (after the October CPI report) produced a downward shift in the US interest rate curve as can be seen in Chart 3.
Any further signs of weakness in final demand (bad news) could now be the catalyst for continued downward shifts in the interest rate curve (good news).
Chart 3: US market rate expectations fell after the lower-than-expected US CPI numbers
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Bear markets are not linear – they typically witness numerous rallies
From January 3rd to the recent low on October 14, the the FT Wilshire 5000 had registered a drawdown of -25.9% the sixth largest since 1980. The key observation about bear markets is that they are not linear – in fact they often move in a sawtooth manner marked by numerous bear market rallies. This has been observable in the trajectory of the FT Wilshire 5000 returns this year (see chart below). Bear market rallies reward the ‘sell the bounce’ discipline, the antithesis of ‘buy the dip’.
Exhibit 1: Bear markets typically see numerous tradeable rallies
Source: Wilshire and Refinitiv. Data as of October 31, 2022
To reiterate the point that bear markets are not linear we have measured the trading pattern of bear markets (lasting more than three months) registered by the FT Wilshire 5000 since 1980. This shows that around 45% of the trading days witness upward moves. The bear market is driven by the compounding effect of the average daily move in a down day being -1.4% vs the average daily move on an up day being +1%.
Exhibit 2: The trading pattern of bear markets
Source: Wilshire and Refinitiv. Data as of October 31, 2022
If bear markets witness numerous bear market rallies, how can we identify when a rally is marking a nadir followed by a sustained positive move?
One answer to this is to wait for key technical signal confirmation. The ‘Golden Cross’ (the positive intersect of the 50-day moving average with the 200-day moving average where the latter has bottomed) is a useful tool aiding the identification of major market inflection points.
Exhibit 3: The ‘Golden Cross’ helps identify key inflection points
Source: Wilshire and Refinitiv. Data as of October 31, 2022
The FT Wilshire 5000 rallies 8.2% in October
Having fallen sharply over the prior four-week period the FT Wilshire 5000 started to inflect sharply higher from mid-October closing out the month with a +8.2% return. There were two principal catalysts behind the recovery in risk appetite. The first was the market registered as significantly oversold in mid -October, reaching levels that typically see a subsequent rebound. The second catalyst was speculation that the Federal Reserve was becoming increasingly concerned about tightening too aggressively given mounting recession headwinds.
Exhibit 1: A robust recovery in the latter half of October
Source: Wilshire. Data as of October 31, 2022.
A key attribute of the recovery in risk appetite was the notable preference for Value over Growth as measured by the FT Wilshire 5000 style indexes. In October the Large Cap Value style index delivered a return of 11.6% while the Large Cap Growth style index only appreciated 4.2%. This rotation has been a dominant theme through the course of 2022 with Value outperforming Growth by 21.3% year to date.
Exhibit 2: A continuation of the sustained preference of Value vs Growth in 2022
Source: Wilshire. Data as of October 31, 2022
Dissecting market returns using sector weighted contributions ( the combined impact of sector performance and sector weighting) October saw the largest positive contribution from Financials followed by energy. Real estate and transportation sectors delivered the lowest contributions.
Exhibit 3: October performance driven by Financials and Energy
Source: Wilshire. Data as of October 31, 2022
The YTD drawdown of-24.9% as of 30th is now the sixth largest witnessed over the last 40 years as shown in Exhibit 3.
Exhibit 4: Putting the YTD drawdown into perspective
Source: Wilshire and Refinitiv. Data as of October 31, 2022
The FT Wilshire 5000 has experienced a technical bear market in 2022 (defined as at least a -20% drawdown)
We examine the scale of the drawdown in the context of the 50-year history of the index and also look at return characteristics after reaching sentiment indicators lows.
Putting the 2022 drawdown into a historical context, Chart 1 shows FT Wilshire 5000 bear markets since the inception of the index in 1970, looking at the peak to trough move, as well the duration. As we can see the 2022’s bear market (so far) ranks as the seventh largest in history, and the fifth longest.
Chart 1: So far 2022 ranks as the fifth longest bear market in the FT Wilshire 5000’s history
Source: Wilshire. Data as of October 16, 2022
Chart 2 shows our US Composite Sentiment Indicator (CSI), which incorporates nine technical analysis and market breadth measures aiming to identify levels of exuberance and pessimism. As we can see, the CSI continues to languish around levels experienced during the GFC in 2008-9, when sentiment continued to remain at low levels for an extended period of time during the recession.
Chart 2: The US Composite Sentiment Indicator remains at extreme lows
Source: Wilshire, FactSet and Refinitiv. Data as of October 16, 2022
Examining periods of statistically significant levels of low sentiment, Chart 3 shows that our US CSI has fallen below 2 (more than 1.5 standard deviations below the long-term average) thirteen times over the past fifteen years. In the post GFC period, the US market has subsequently posted positive returns after the CSI falls below 2. However, we can observe this was not the case during the GFC, which was the last example of a prolonged recession.
Chart 3: The returns delivered three months after hitting sentiment lows
Source: Wilshire, FactSet and Refinitiv. Data as of October 16, 2022
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Scale of the drawdown in global equities in 2022 has produced a significant de-rating with US equites experiencing one of the largest PE contractions
Chart 1 shows the status of regional 12m forward PEs, where these sat at the end of last year and the scale of the de-rating experienced so far in 2022. The UK and US have seen valuations decline by around a third, China and Europe ex UK by a quarter.
Chart 1: The scale of PE de-rating experienced across the regions in 2022
Source: Wilshire and FactSet. Data as of October 16, 2022
Taking a longer-term view of valuations, Chart 2 shows the 12m forward PE for the US and World ex US over the past 20 years. The chart shows the sheer scale of the de-rating over the past 2 years. From its peak in September 2020 the US 12m forward PE has declined 36%, with World ex US also declining by the same quantum from its peak in July 2020. Although valuations are not far from the Covid sell-off lows, they are someway from the lows of the GFC, where the US and World ex US 12m forward Pes fell to 8.7x and 7.1x, respectively
Chart 2: Comparing the US v World ex US PE ratio moves over the last 20 years
Source: Wilshire and FactSet. Data as of October 17, 2022
Chart 3 shows the Fed Model valuation (equity earnings yield minus 10-year government bond yield) since 1992 and looks at the average levels over 3 distinct periods. As we can see, although the current Fed Model valuation is below its post-GFC average, it is above the pre-GFC 2002-2008 average, and well above the negative levels experienced in the 1990s. From a Fed Model valuation standpoint, the rise in bond yields this year has partially offset the impact of the US equity market de-rating.
Chart 3: The US 'fed model' valuation looks stretched versus the last 10-year range but not versus the pre GFC period
Source: Wilshire, Refinitiv and FactSet. Data as of October 17, 2022
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A key feature of 2022 has been the sustained strength of the US dollar
2022 has seen persistent strength in the US dollar aided by positive interest rate differentials, haven status and the perception the US is less exposed to the Ukraine invasion energy shock. Exhibit 1 shows the long-term performance of the DXY dollar index and the 16.8% YTD return has pushed the dollar back to levels not seen since the turn of the century.
Exhibit 1: The dollar is back to levels last seen over 20 years ago
FX swings can have a large impact on unhedged regional equity returns depending on the location of investors. Due to GBP, Euro and JPY weakness, investors in the UK, Europe and Japan have a very different perception of regional market returns based in GBP, Euro and JPY versus the returns seen by a US dollar-based investor over both Q3 and YTD periods. For instance, it can be seen in exhibit 2 that UK unhedged investors (courtesy of the 8.2% decline in the pound) saw a positive return from US equities in Q3.
Exhibit 2: Comparing UK and US (unhedged) equity return profiles for Q3
Most commodity prices are denominated in dollars. Consequently, when the dollar appreciates it offsets the impact of any fall in prices to non - US dollar-based participants (and vice versa). For instance, exhibit 3 shows that although the oil price declined 22% in Q3 in dollar terms, due to the depreciation of sterling, euro, and the yen against the dollar the oil price drop denominated in those currencies is more muted. The distortion of the move in the dollar on the regional oil price is even more extreme looking at two-year data.
Exhibit 3: The impact of the dollar on regional oil price moves
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