A typical bear market rally

Bear markets, where equity markets fall by over 20% from their previous peak, are all-in-all a rare phenomenon. Over the last 70 years, the S&P 500 has entered bear market territory a total of 11 times before peaking again. Some of these bear markets were over and done with rather quickly, like the pandemic-related drawdown in 2020 or the 1987 Black Monday crash. Others, like the one following the burst of the dot-com bubble or the one related to the Great Financial Crisis, were usually associated with severe recessions or financial turmoil, and they lasted longer and brought equity valuations significantly lower. These can be qualified as ‘secular bear markets’. Finally, there were bear markets that we would call ‘cyclical bear markets’, which lasted for shorter periods of time and were ultimately milder.

The last two categories of bear markets were characterised by one or usually more bear market rallies, where equities bounced back rapidly and violently before retesting or even undercutting their previous lows. In cyclical S&P 500 bear markets, the most prominent rally episodes typically lasted, on average, a little over two months, with equity prices rising +12.4%, on average. In that sense, the summer rally that pushed US equities up +17.4% by mid-August as compared to their mid-June low was slightly shorter (lasting only two months), but it was stronger, when measured against the historical average.

The summer rally petered out in Jackson Hole

Ultimately, the short-lived uptrend was upended, as the hawkish message from the US Federal Reserve (Fed) became clearer in the run-up to the anticipated annual central bank symposium at Jackson Hole, Wyoming. Many market participants expected the Fed to strike a more accommodating tone, with inflation peaking and interest rates supposedly having reached neutral territory. Fed Chairman Jerome Powell disappointed markets, which quickly moved to reprice for a somewhat longer and more aggressive tightening cycle. As of 13 September, the S&P 500 is down -18% from its January 2022 highs.

Since we expected an eventual piece of bad news to trigger a renewed slump in prices and a subsequent retest of previous lows, we hedged our portfolios in mid-August. This lowered our equity exposure without requiring us to modify our balanced portfolio construction. Once we see evidence that markets have reached their bottom, unwinding that trade by taking profits should be much simpler than attempting to redeploy fresh funds in a most likely still volatile and uncertain environment.

Outlook into year end
Arguably, markets were overly enthusiastic in the run-up to the US consumer price index inflation data release for August. What followed was a violent sell-off across asset classes amid the prospect of more aggressive central bank action going forward. While a retest of the June equity market lows certainly remains in the cards, we see the Fed becoming less hawkish by year end, on the back of falling commodity prices. On the corporate side, while earnings estimates have been revised down, except for the oil & gas sector, profit margins remain resilient for now. Against the backdrop of a violent reset in the cost of capital, the market is looking for a new equilibrium, as we are exiting financial repression territory. Undoubtedly, this is a painful process.

On the flipside, however, the outlook with regard to forward-looking returns is much better than at the beginning of the year. In the short term, better-than-expected inflation numbers and a ceasefire in Ukraine remain the two catalysts that could trigger a sharp rally in risk assets. If the US enters a technical recession, US Treasuries should outperform bonds exposed to credit risk. Should the Fed manage to engineer a soft landing, it will be the other way around. We remain invested with a hedge, as the bottoming process has been postponed for now, until incoming data paints a more encouraging picture regarding price pressures in the economy, but we are prepared to use continued weakness in the markets to reposition our portfolios for 2023 and beyond.