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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.

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Exhibit 1: A robust recovery in the latter half of October

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^{Source: Wilshire. Data as of October 31, 2022.}

October saw a continued preference for Value vs Growth style

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.

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Exhibit 2: A continuation of the sustained preference of Value vs Growth in 2022

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^{Source: Wilshire. Data as of October 31, 2022}

Financials and Energy sectors delivered the largest performance contributions

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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.

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Exhibit 3: October performance driven by Financials and Energy

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^{Source: Wilshire. Data as of October 31, 2022}

The Year-to-Date drawdown of-24.9% is the sixth largest in 40 years

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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.

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Exhibit 4: Putting the YTD drawdown into perspective

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 ^{Source: Wilshire and Refinitiv. Data as of October 31, 2022}

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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’.

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Exhibit 1: Bear markets typically see numerous tradeable rallies

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^{Source: Wilshire and Refinitiv. Data as of October 31, 2022}

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Just under half the days in a bear market register positive returns

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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%.

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Exhibit 2: The trading pattern of bear markets

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^{Source: Wilshire and Refinitiv. Data as of October 31, 2022}

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How to differentiate a bear market rally from a sustained inflection point?

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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.

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Exhibit 3: The ‘Golden Cross’ helps identify key inflection points

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^{Source: Wilshire and Refinitiv. Data as of October 31, 2022}

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The US has experienced one of the largest PE de-ratings in 2022

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.

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‍Chart 1: The scale of PE de-rating experienced across the regions in 2022

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_{Source: Wilshire and FactSet. Data as of October 16, 2022}

Putting the valuation shift into a longer perspective

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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

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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

The US 'fed model' (equity vs bond) valuation analysis

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.

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Chart 3: The US 'fed model' valuation looks stretched versus the last 10-year range but not versus the pre GFC period

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_{Source: Wilshire, Refinitiv and FactSet. Data as of October 17, 2022}

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^{15827064 E0123}

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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 2022drawdown into 50-year context

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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.

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Chart 1: So far 2022 ranks as the fifth longest bear market in the FT Wilshire 5000’s history

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‍^{Source: Wilshire. Data as of October 16, 2022}

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Sentiment indicators have reached levels last seen in the GFC of 2008-9

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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.

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Chart 2: The US Composite Sentiment Indicator remains at extreme lows

^{Source: Wilshire, FactSet and Refinitiv. Data as of October 16, 2022}

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The pattern of subsequent market returns after reaching sentiment lows

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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.  

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Chart 3: The returns delivered three months after hitting sentiment lows

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^{Source: Wilshire, FactSet and Refinitiv. Data as of October 16, 2022}

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August witnessed a significant reversal in risk appetite mid-month in response to a succession of hawkish Fed guidance. This brought an end to the +18.6% two-month rally (and optimism) that started on June 16 and peaked on August 16. Since the mid-August peak, the FT Wilshire declined -16.7% over the remainder of the quarter to produce a -4.4% return for the three-month period. The strength of the rotation to risk aversion has now driven the index below the low point reached in mid-June.

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Exhibit 1: A rapid reversal in returns over the last six weeks of Q3

One of the largest six-week drawdowns since 2006

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Exhibit 2 puts the scale of the drawdown in US equities over the latter half of Q3 into perspective - showing that it is almost a three standard deviation event. Outside of the GFC and COVID sell offs, this is one of the largest six-week drawdowns since 2006.

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Exhibit 2: Putting the six-week drawdown into perspective

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The YTD drawdown of -24.9% is the sixth largest in 40 years

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The YTD drawdown of -24.9% as of Sept. 30 is now the sixth largest witnessed over the last 40 years as shown in exhibit 3.

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Exhibit 3: Putting the YTD drawdown into perspective

_{Index no. 15738341}

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.

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Exhibit 1: The dollar is back to levels last seen over 20 years ago

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The quantum of the appreciation of the dollar accentuates regional equity return differences

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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.

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Exhibit 2: Comparing UK and US (unhedged) equity return profiles for Q3

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The strength of the dollar is mitigating the impact of declining commodity prices

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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.

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Exhibit 3: The impact of the dollar on regional oil price moves

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_{Index no. 15738341}

US growth rate stability and downgrading in Asia Pacific and EM, however…

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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

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…Growth rates might be giving a false sense of security

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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.

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Chart 2: US consensus EPS trails - starting to wobble

Most sectors have seen negative EPS revisions over the last month

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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 in response to hawkish Fed and global central bank guidance, elevated inflation, and a significant tightening in financial conditions.

Global interest rate forecasts continue to ratchet higher

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

US interest rate forecasts have risen 100bp in the last month

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

US financial conditions are facing a perfect storm

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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15699901 E1222

August witnessed a significant reversal in risk appetite mid-month in response to a succession of hawkish Fed guidance. This bought an end to the +18.6% two-month rally that started on June 16 and peaked on Aug. 16. Since the mid-month peak, the FT Wilshire has declined -8.1%, producing a -3.8% move for the month of August.

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Exhibit 1: August brought an end to the two-month rally  

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‍August saw a rotation back to small cap and value stocks

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The mid-August reversal also produced a rotation in style performance. The table below shows that most of the underperformance of large cap relative to small cap in August was attributable to the larger negative contributions from the financials, digital info and services, health care and technology sectors.

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Exhibit 2: Four sector-weighted contributions account for small cap outperformance

Rising bond yields cause growth to lose momentum vs value

Rising bond yields impacted the highly valued long duration growth stocks in August and this resulted in the growth style (with its large exposure to the technology and digital information sectors) losing momentum relative to value as the month progressed.

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Exhibit 3: Two sector weighted contributions account for growth underperformance

Still a way to go before the growth vs value trade reverts to 2016/17 levels

Exhibit 4 puts the growth vs value rotation into a longer perspective. Despite the scale of value outperformance so far this year, the relative trade still has a long way to go in order for it to mean revert back to 2016/17 levels (parity levels).

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Exhibit 4: The long term perspective on Growth v Value relative performance

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