What Can Historical Market Cycles Tell Us About Today’s Environment?

Dan Wantrobski, Associate Director of Research at Janney Montgomery Scott, talks about the four potential disruptors responsible for market volatility and when he thinks the markets will start to stabilize. Wantrobski also shares what we can learn from historical data. 

 
Why have the markets seen volatility this year?

 

Coming out of the pandemic and into the recovery in 2020, we found that there were four potential disruptors that money managers were focused on (in no particular order): Pandemic containment/variant spread & vaccine efficacy; the presidential election; Fed policy (at the time the Fed was injecting massive amounts of new liquidity to stabilize the economy & markets); and interest rate/bond market volatility. 

 

As the markets recovered and we moved past the election, focus shifted to Fed policy and interest rates, and in 2021, the narrative turned to concern over budding inflationary pressures in the economy. If you look closely, the actual correction in our U.S. stock markets began in early 2021, not 2022, in the small and midcap stocks, which peaked early in 2021 and traded sideways thereafter. 

 

That de-risking triggered a rotation into the safer haven large cap areas like the S&P 500, which continued to move higher in 2021 and reached new all-time secular highs by the end of the year. But by that time, concern over inflation was now being supported by data, triggering a de-risking in large caps at the start of 2022. 

 

The initial sell-off in broad-based equities this year was then exacerbated by significant pivots in Fed policy where the central bank reversed from being ‘inflation inducing’ during times of instability (lower rates and inject liquidity) to inflation-fighting (raising rates and reducing liquidity) because of the inflation data being reported. 

 

So, investors were confronted, very abruptly in our opinion, with the challenge of how to model for economic growth and multiple expansion in a rising rate environment. And that really triggered broad-based selling into early summer (May-June), which came close to major capitulation by mid-June. 

 

Think also about the demographics of investors driving this tape, Baby Boomers, GenX and Millennials, not one of these groups has experience in investing in rising rate environments. Rather, for the last 40+ years, we have been investing in a disinflationary/declining rate environment where the Fed’s response to instability was exactly the same every time (lower rates and inject liquidity).

 

Like Pavlov’s dogs, investors became used to a certain, specific response from the Fed to direct their investment decisions. What happens when you take this away for the first time in 40+ years? It creates widespread confusion and uncertainty – and the markets hate uncertainty. That was the overriding problem this year in our view.

 
When do you believe the markets will start to stabilize? And why?

 

We believe the markets have already started to stabilize and will continue to do so this year, however our work on historical market bottoms shows that the process can take time (up to two years in the past) and will produce volatility in both directions – big surges upward (oversold rallies, like what we have experienced since the June lows), as well as sharp reversals lower. 

 

During this process, the lows can be tested and even broken temporarily, so watch for support on the S&P 500 first toward the 3500-3600 zone, then closer to 3100-3200 as potential downside targets for the remainder of the year. 

 

The purpose here is not only to exhaust sellers and compress multiples, but to entice new buyers for a ‘buying surge’ to spark a new uptrend in pricing. Thus, even though we may exhaust sellers this year, we will still need to see a surge of new buying power enter the equation as well. 

 

Until that does, we are likely to see more of a “U”-type bottom on the charts, as opposed to the sharp “V” recoveries that we have become accustomed to over the last several decades.

 
What can historical market cycles tell us about today’s environment?
 
We believe they can tell us a lot – history doesn’t repeat itself, but historical data proves with little doubt that market cycles occur with regular frequency and even magnitude/duration. Our work has uncovered that there are 4 major market cycles that occur with regular frequency here in the U.S. and when all 4 have been completed, the cycle starts again.
 
Inflationary / reflationary expansion (secular bull market)
Inflationary contraction (secular bear market)
Deflationary expansion (secular bull market)
Deflationary contraction (secular bear market)
 
Data shows that on average, secular bull markets / expansions can last 10-15+ years; while bears/contractions (again, on average) 5-10 years:
 
Early-1900s-1920: inflationary contraction / bear market
1920-1929: deflationary expansion / bull market (Roaring Twenties)
1930-1942: deflationary contraction / bear market (Great Depression)
1940s-1960s: reflationary expansion / bull market (WWII; post WWII expansion)
1960s-1980: inflationary contraction / bear market (stagflationary 1970s period)
1980-2000: deflationary expansion / bull market (massive secular expansion after peak in interest rates)
2000-2010/11: deflationary contraction / bear market (tech bubble; housing/credit bubble)
2012-present: reflationary expansion
 
Our model using cycle analysis implies that the U.S. has entered a reflationary expansion period, coming out of the deflationary contraction/bear market cycle of 2000-2011. This suggests we are likely to see a generational transition in interest rate trends, where we are likely to see the resumption of multiple expansions in stocks and broader economic expansion in the U.S. against a rising rate environment in the coming years. 
 
The drivers behind these cycles are underlying cycles in valuation, demographics and financial conditions, all which are flashing positive signals (based on our analysis) for the coming years. This should propel the S&P 500 toward our target of 5,000-6,000 as the 10-year trades closer to the 4-5% range, as opposed to the 0-1% band that occurred during the last deflationary cycle.

How should investors position their portfolio in today’s environment?

We would recommend shifting some allocation to those areas more sensitive to a reflationary environment ahead. This would include sectors like value. This is not to say that growth/tech won’t work at all, but better relative performance may be experienced in other areas.

Growth, to large extent but not completely, relies more on lower financing costs to finance their multiple expansion (lower/declining rates), whereas value players tend to have strong balance sheets and are well funded, so they can withstand higher costs (yields).

We have charted the correlation between rising rates and sector ratios like value/growth and it does show a loose directional relationship here. So again, do not completely throw away current portfolio allocations but rather going forward consider which sectors will perform well in a rising rate environment, since that’s where our model shows we are headed.

What are some of the major news headlines you are following?

Watch what the Fed is doing vs what they are saying. The Fed has telegraphed that it is going to raise rates and drain liquidity to fight inflation. However, look beneath the surface and you will note that the Fed is actually not doing all that much in the way of real liquidity destruction at this stage. In fact, liquidity conditions remain accommodative and we believe they will continue to be going forward. 

Hiking interest rates does not necessarily destroy liquidity, rather it slows money velocity and changes the trajectory of where money goes (money always goes where it is treated best); the Fed is allowing the Street to do a lot of the heavy lifting in terms of policy effects but the reality is the Fed understands that draining the liquidity it created as a result of the pandemic (in any significant way) would likely lead to market instability far greater than we have seen thus far. The Fed publishes reports weekly and monthly that detail what they are actually doing in terms of liquidity creation and destruction – watch those closely.

This interview originally appeared in our TradeTalks newsletter. Sign up here to access exclusive market analysis by a new industry expert each week. We also spotlight must-see TradeTalks videos from the past week.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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