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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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After a period of relative stability, we are starting to see a deterioration in the EPS or profit cycle through the prism of estimate trail analysis
Chart 1 shows the status of regional consensus EPS growth forecasts for this year and next and the revisions (deltas) to the forecasts over the last month. The notable negative revisions have been in Asia Pacific and Emerging Markets. In terms of 2023 growth rate projections, the US is still predicted to deliver the highest growth rate among developed markets.
Chart 1: Regional consensus EPS growth forecasts
Growth rate analysis does not provide insight into the status of the cycle as it simply measures the difference in EPS forecasts over two distinct time periods. If both periods see EPS decline by 10%, the growth rate remains the same. That is why EPS cycle analysis must be viewed via EPS trails that map the changes to calendar year forecasts over time. Chart 2 shows the EPS trails for the US and that after a period of stability both 2022 and 2023 EPS estimates have started to decline. The cycle seems to be deteriorating.
Chart 2: US consensus EPS trails - starting to wobble
Chart 3 shows revisions to 2022 and 2023 EPS estimates versus the August market high for both the US and World ex US at a sector level. Energy remains the only sector to see positive revisions to 2022 and 2023 estimates for the US and World ex US.
Chart 3: A broad deterioration in sector EPS revisions
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Markets have been gripped by risk aversion since mid-August
Markets have been gripped by risk aversion since mid-August in response to hawkish Fed and global central bank guidance, elevated inflation, and a significant tightening in financial conditions.
Chart 1 shows the status of regional market interest rate forecasts for 2022 and 2023 as well as the respective central bank forecasts. It can be seen that except for Japan, all other regions have witnessed significant uplifts to interest rate curves over the last three months.
Chart 1: Regional consensus and central bank 2022 and 2023 interest rate forecasts
Both the Fed dot plots and market interest forecasts have risen by 100 basis points. While the Fed forecasts point to a continued gradual increase in rates, peaking at 4.6% by the end of 2023, the market is predicting a gradual decline in rates over the course of the second half of next year.
Chart 2: US market consensus and Fed dot plot interest curves
Our Financial Conditions Indicator (FCI) is designed to reflect the impact on market risk appetite through the combined impact of related financial components. Since mid-August, the US FCI has increased and is in restrictive territory (a key driver of risk aversion). Some of the key elements pushing the FCI higher have been the rise in the USD (REER), interest rate forecasts, government and corporate bond yields and a contraction in real M2 money supply growth.
Chart 3: US financial conditions being driven higher on many fronts
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US consumer durables, technology and retail have led the re-rating of the US market since mid-June
After a significant PE de-rating in the first half of the year and a narrowing of valuation dispersion, US consumer durables, technology and retail have led the re-rating of the US market since mid-June.
Chart 1 shows the current regional 12m forward PEs, the scale of the de-rating from the start of the year to the lows in mid June and the re-rating since. Following a 30% decline in the PE from 22.5 to 15.7x in mid-June, the US has been among those to see the biggest re-ratings since, along with Emerging Markets and Europe ex UK.
Chart 1: Scale of regional PE de-ratings in the first half of the year and the recovery since mid-June
Looking into what has driven the US re-rating, Chart 2 again shows the latest 12m forward PEs and the shifts in valuations at the US sector level. As we can see, the consumer durables, retail and technology sectors have seen the largest re-ratings since mid June. These sectors saw some of the largest de-ratings in the first half of the year.
Chart 2: Status of US sector 12m forward PE and the journey traveled so far in 2022
Drilling further into the dynamics within the US market, Chart 3 looks at the top quintile PE relative to the median stock PE. As we can see, the cluster of top quintile PEs has witnessed a significant relative PE expansion since mid-2017. The upshot of the market sell-off in the first half of the year, which had an outsized impact on more highly valued growth and tech stocks, is that we have seen a narrowing in the valuation dispersion between the top quintile and median stock PEs in the US, with the premium falling back toward pre-COVID levels in June. However, with the growth and tech sectors regaining market leadership since the US recovery, more recently we have seen the valuation dispersion beginning to widen again.
Chart 3: Top quintile US PE relative to the median stock PE
Source: Wilshire, Factset and Refinitiv, 10 August 2022
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Following a record-breaking decline in the first half of 2022, markets have staged a recovery led by the US.
The trough in June coincided with our US Composite Sentiment Indicator hitting, similar levels of pessimism seen during the midst of the Global Financial Crisis (GFC).
Chart 1 shows the FT Wilshire 5000 index relative to the World ex US. After underperforming the World ex US index from the end of December through mid-June, the US has seen a big improvement in relative performance over the past two months. The recent period of outperformance has seen the US claw back most of the year-to-date underperformance, returning toward the peak levels seen at the end of 2021.
Chart 1: FT Wilshire 5000 relative to World ex US almost back to peak levels seen in December 2021
It was noteworthy that the rebound in the FT Wilshire5000 has coincided with sentiment hitting statistically significant levels. Chart 2 shows our US Composite Sentiment Indicator (CSI), which incorporates nine technical analysis and market breadth measures, and aims to identify levels of exuberance and pessimism. This has proven a useful market timing tool and contrarian indicator. The market rebound in June coincided with the US CSI hitting extreme levels of pessimism—over a 2.5 standard deviation move relative to a long-term average, and similar levels witnessed during the GFC. We can see that once these levels have been hit, the indicator does not stick around for long before moving higher. Should the market recovery continue, a key question will be when sentiment will approach overbought levels, at least in the short-term.
Chart 2: Our US Composite Sentiment Indicator hit extreme lows in June
Looking at the breadth of the recent recovery in the markets, Chart 3 shows the percentage of stocks registering a Relative Strength Index (RSI) of over 70, which forms part of our Composite Sentiment Indicator and typically indicates an overbought signal for a stock or index. We show the latest readings versus the lows in June, as well as the five-year average level. The US has seen a fairly rapid rotation in sentiment, moving from 0% to around 16%, now at a similar reading to the peak levels we saw in December last year, and well above the five-year average. Conversely, using this measure of breadth the Chinese equity market has experienced a deterioration in sentiment over the same short period.
Chart 3: The percentage of stocks registering an RSI of over 70 in the US has risen rapidly during the recovery
Source: Wilshire, Factset and Refinitiv, 10 August 2022
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The scale of decline in valuations was one of the largest de-ratings witnessed in 30 years
As can be seen in Chart 1 the US and UK markets witnessed the largest proportionate decline in their PE levels comparing mid - year valuations with those as at year end 2021.The US PE valuation has fallen -26.8% from 22.5x to 16.4x over a six-month period.
Chart 1: Regional 12M PE ratios - now v levels at the end of 2021
Measuring the six month change in the market PE and comparing this to historical moves we can see in Chart 2 that the recent decline US has experienced a statistically significant (3 standard deviation) valuation correction. This is one of the largest moves over the last 30 years.
Chart 2: Measuring the 6-month change in the US 12M PE
Chart 3 below decomposes market return drivers into three categories - the contribution of changes to EPS forecasts, Dividends and Valuations. YTD data as at end June 2022 clearly shows the scale of performance drag delivered by the decline in PE valuations
Chart 3: YTD regional market return decomposition
A function of the US market experiencing a proportionately large PE de-rating is that it has seen its PE relative premium (comparing the PE of the US market to that of the World ex US market) decline from a peak of 55% in March this year to a current level of 32%.
By contrast the PE relative for Emerging Markets has moved from a c. 20% discount to parity - something last seen in 2016.
Chart 4: PE relatives comparisons
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Consensus EPS growth forecasts have been resilient - is this reassuring or highlighting the risk that an EPS downgrading cycle is yet to commmence?
Despite the significant economic, monetary policy and geo-political induced volatility in equity markets in the first half of 2022, consensus EPS growth forecasts have been remarkably resilient. Is this reassuring or is it highlighting the risk that an EPS downgrading cycle is yet to commence?
Chart 1 shows the status of regional market consensus EPS growth forecasts for this year and next and measures the revisions (deltas) to the forecasts made at the end of last year. US growth forecasts have hardly changed over the last six months.
Chart 1: Regional consensus EPS growth forecasts
Source: Refinitiv, FactSet
The US 2022 and 2023EPS trails emphasize the steadiness in the forecasts over the last few months - showing no impact (so far) from the uncertainty and volatility of the market.
Chart 2: US Estimate trails
Source: Refinitiv, FactSet
The resilience in consensus forecasts could be providing a false sense of security. One of the key areas of concern is that analysts have a poor track record in predicting macro driven falls in EPS.
Chart 3 compares consensus12M forward EPS forecasts with trailing (reported EPS), and the forward estimates tend to follow (not lead) reported EPS down. Are analysts waiting for guidance and reported data to decline before they start reducing their forecasts?
Chart 3: Comparing US consensus EPS forecasts to reported (lagging) EPS
Source: Refinitiv, FactSet
The significant rise in input prices (both labor costs and materials) creates top-down headwinds for corporate margins. Some find it hard to reconcile these headwinds with unchanged EPS estimates.
Chart 4: US labor costs and input prices
Source: Refinitiv, FactSet
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Stung by the persistency and level of inflation and the accusation of being behind the curve the Federal reserve has cranked up its hawkishness
This is reflected in a significant shift in market interest rate expectations since the Russian invasion of Ukraine in late February.
Chart 1: A significant shift in US interest rate expectations since late February
Source: Refinitiv
The next few FOMC meetings are expected to deliver 50bps increases in the Fed funds and see the contraction of both Treasury and MBS holdings.
What is unusual is that the Fed are tightening at a time when both Consumer Confidence and Real Incomes have fallen to levels last seen at the lows of the GFC recession. Normally the Fed would be considering accommodation with indicators at these levels.
Chart2: The Fed are tightening into extremely weak Consumer Confidence and Real Income levels
Source: Refinitiv
Another clear risk is that the Fed have turned more hawkish just as aggregate financial conditions ( a measure of the combined impact of shifts in monetary policy, the credit cycle and foreign exchange) have tightened very rapidly( much faster than during the previous cycle) and are on the cusp of turning restrictive.
Chart 3: US FCI's have risen very rapidly and are on the cusp of turning restrictive.
Source: Refinitiv
When rates are seen as above the neutral rate each incremental move is seen as creating significant headwinds for subsequent growth. Gauging neutral rates by measuring the ratio between consensus nominal GDP growth rates and terminal interest rate forecasts the US is now at neutral rate levels.
Any more tightening from here could start to be perceived a policy mistake.
Chart 4: US rates are already approaching 'neutral' levels
Source: Refinitiv
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