Interactive Investor

History suggests markets are heading for a correction

16th August 2021 11:17

Kyle Caldwell from interactive investor

Over the past 90 years, every economic recovery has had a substantial market sell-off in the first two years.

The “astonishing” speed of the Covid-19 market recovery could soon lead to a notable stock market correction, according to research published earlier this month by Bank of America.

The bank points out that over the past 90 years every economic recovery has had a substantial market sell-off in the first two years.

“While trading has been choppy at times and we've seen idiosyncratic corrections and rotations across growth, value, and re-opening trades, we have yet to see a sustained drawdown and correction across risk assets,” it notes.

The bank continued: “However, looking over the past 90 years, we find that every economic recovery has run into a substantial drawdown at some point in the first two years following troughs in US GDP, with the S&P 500 falling an average of 18-20%, and only one episode below 10%. Given this regularity in recovery dynamics, is history bound to repeat?”

The bank also notes that “peak growth may well be behind”. It cautioned that fiscal policy in the US is likely to fall short of expectations and said the risk of the Delta variant remains.

The bank added: “Furthermore, the recovery in risk assets has already matched or exceeded those of the first two years of previous recoveries in half the time. With this confluence of risks and how fast and far markets have gone, caution seems warranted, especially given history.

“Given the risk of being past peak growth, rising inflation, impending central bank tapering and the spread of the Delta variant weighing on the economic recovery, is the new bull market heading towards a correction?”

It took the S&P 500 index under five months to recoup its losses from the Covid-19 sell-off last March, which has gone down in the record books as one of the fastest recoveries in history. On average, it has historically taken around two years for markets to recover, according to research by Schroders. The fund firm’s research examined the 11 other occasions the index fell by 25% or more.

From its low point, on 23 March 2020, the S&P 500 index has gained over 100% (in US dollar terms). A UK investor tracking an S&P 500 index fund or ETF will have seen returns of around 68.3%, figures from FE Analytics show.

Over the same time period (in sterling terms), the MSCI World Index is up 65.3%. In the UK, the FTSE All-Share, FTSE 100 and FTSE 250 indices have risen by 58.4%, 51.2% and 87%.

There have been some very strong gains for fund investors over this period. The top five sectors are: UK Smaller Companies (with the sector average returning (112.8%); European Smaller Companies (97.5%); North American Smaller Companies (92.4%); Technology & Telecommunications (85.9%), and UK All Companies (72%).

Outlook for the rest of 2021

Of late, some fund managers have struck a more cautious tone in their market outlooks for the rest of the year. Many have highlighted inflation as being top of their worry list.

Gervais Williams and Martin Turner, who manage the Diverse Income investment trust (LSE:DIVI), one of interactive investor’s Super 60 choices, are wary of a potential market pullback and have acted by investing in a FTSE 100 derivative. Under the ‘put option’ the trust will profit if the FTSE 100 falls below 6,200 from now until December 2022. At the time of writing, the index is currently trading around 7,150.   

The duo said: “We are concerned that market liquidity could narrow in future, and new risks might emerge such as the US Senate starting to game the forthcoming budget ceiling negotiations. Alongside, the global recovery in the first half was smoothed by the running down of global inventories. Unfortunately, we are worried that the component and staffing problems will persist, and the global economy could struggle to even sustain the output of the first half of 2021.

“When this is set in the context of a stock market where corporate valuations are already standing at very elevated levels, even a slight reduction in market liquidity could lead to a pullback in stock market valuations.”

Other fund managers are in a more optimistic camp. Paul Niven of F&C Investment Trust (LSE:FCIT) notes that higher inflation is currently the big risk for investors, but is upbeat on his outlook for the post-pandemic economic recovery.   

He says: “Growth rates in the global economy and in corporate earnings are likely to exceed many of the most optimistic forecasts in 2021, as the recovery accelerates following one of the sharpest downturns in history. Growth momentum is broadening globally and, while there remain risks, the backdrop should remain favourable.

“Beyond the near term, it seems likely that the balance of risks has shifted in favour of somewhat higher inflation. This will present challenges but modest rises in inflation, slightly higher interest rates, but still good rates of growth, present a favourable backdrop for our portfolio. In addition, while markets have been narrowly focused in terms of geographic, sectoral and stock leadership, the recovery should deliver more balanced performance.

Time in the market, not timing the market

Perfect market timing is virtually impossible to pull off, a point acknowledged by Bank of America’s research report.

It said: “Even investing at the absolute highs before recovery drawdowns has shown that time in the market can save mistiming the market. True while returns are dampened...investors can find some solace despite the impossible feat of timing the arrival of drawdowns.

James Klempster, deputy head of multi-asset at Liontrust, says history shows that when it comes to market timing, such as attempting to ‘buy the dip’, “even the most successful investors have struggled to get these calls right with consistency”.

“We believe in what we call noise-cancelling investment as far as possible: staying the course in a well-diversified portfolio and ignoring market fluctuations,” he says.

Research by Liontrust found that missing the best 50 days in markets over the 11 years from March 2009 to February 2020, which works out at just 1% of trading days, would have reduced the return from £100,000 invested in an average Cautious Managed fund from £218,700 to just under £130,000. This equates to 75% lower returns.

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