How to Navigate Equity Bear Markets
Leonardo Mazza
Junior Fund Manager

Russia’s invasion of Ukraine, high commodity prices, inflationary pressures and tightening monetary policies have significantly impacted most major economies. The U.S. is in a slowdown phase with a 50% probability of recession within 12 months, while Europe might enter a recession by the end of the year.

Most equity markets show a tendency to move in cycles that to some degree mirror economic and business cycles with an expected sequence of phases alternating between expansions and contractions. This is to say that they are inevitable and recurrent, but not periodic, because they may differ in duration. An entire business cycle, which consists of four distinct phases, can last anything from 1 to 12 years. Bear markets may also differ in intensity, depending on the factors triggering the recession. As the probability of a shift in phase increases, understanding the business cycle allows investors to adjust their exposure to sectors that have historically outperformed the market in the next phase.

RECOVERY EXPANSION SLOWDOWN RECESSION
Economic Activity Activity measures stabilize and then begin to increase. Activity measures show an accelerating rate of growth. Activity measures show decelerating rate of growth. Activity measures show outright declines.
Employment Layoffs slow and the unemployment rate remains high. Business begins full time rehiring, and the unemployment rate falls. Business slows its rate of hiring. The unemployment rate continues to fall but at a decreasing rate. Business first cuts hours and freezes hiring, followed by outright layoffs. The unemployment rate rises.
Consumer & Business Spending Upturn in spending often most pronounced in housing, durable consumer items and orders for light producer equipment. Upturn in spending becomes more broad-based. Business begins to order heavy equipment and engage in construction. Capital spending expands rapidly, but the growth rate of spending starts to slow down. Decreased spending most evident in industrial production, housing consumer durable items.
Inflation Inflation remains moderate and may continue to fall. Inflation picks up modestly. Inflation further accelerates. Inflation decelerates but with a lag.

CFA Institute description of the four phases of a business cycle. Source: CFA Institute

Moreover, yield levels are crucial when analysing the correlation between equities and bond prices. In fact, when yields are above 4-5%, the fixed-income diversification benefits vanish, because the monthly correlation tends to be positive. As a further matter, when interest rates are on normal levels, equities have historically benefitted from rising bond yields. Because of the poor expectations for earnings growth and the overall state of the economy, prices might experience sharp falls, but history has taught us that it is possible to find good investment opportunities, even during a recession…

The following table shows the excess return of equity sectors across US business cycles since 1962:

Phase Top Performing Sectors Worst Performing Sectors
Recovery Consumer Discretionary/Real Estate/Materials Consumer Staples/Utilities/Healthcare
Expansion Financials/Technology/Communications Healthcare/Utilities/Consumer Staples
Slowdown Consumer Staples/Healthcare/Industrials Consumer Discretionary/Real Estate/Materials
Recession Consumer Staples/Utilities/Healthcare Real Estate/Technology/ Communications

Relative performance of U.S. equity sectors since 1962. Source: Bloomberg

The business cycle is a standard feature of market economies that rely mainly on business enterprises; decreases in investment spending result in decreases in household incomes and in GDP growth rates. Nevertheless, the problem with business cycles and especially with bear markets, is that investors overgeneralise them while triggers, timing and even the recovery profile vary significantly. Some are triggered by unexpected shocks and events (Russia’s invasion of Ukraine and the subsequent energy supply shortage being just one example)

Peter Oppenheimer, in his book “The long good buy”, identifies 3 types of bear markets:

1. Cyclical Bear Markets
Triggered by rising interest rates and/or inflation expectations together with recession fears.

2. Event-Driven Bear Markets
Triggered by exogenous and unexpected shocks (like a pandemic) that increases uncertainty and pushes down stock prices.

3. Structural Bear Markets
Usually associated with the bursting of major asset price bubble and/or unwinding of structural imbalances that result in deleveraging and often banking crises, like the Great Financial Crisis in 2008.

Personally, I think that the most interesting aspect is that there are some recurrent characteristics that are extremely useful to help navigate bear markets. For example:
• Equity bear markets (except for event-driven ones) display significative falls in profits or earnings. Usually valuations start to decline 5 months before the actual slowdown in the profitability because the market is discounting the negative earnings outlook

• Cyclical and event-driven bear markets are associated with an average market drawdown of about 30%, whereas structural bear markets, have historically been characterised by much larger falls, of about 50%

• Event-driven bear markets are usually the shortest, lasting on average 8 months, while cyclical ones last on average 1.5 years and structural ones for about 2/3 years

The recovery profile for event-driven and cyclical bear markets is usually quicker because markets have historically reverted to their previous highs after about 1 year, but structural ones can take up to 10 years.

Since the beginning of the year, persistent inflation and rising hawkishness by Central Banks have had a significant impact on equity markets. So far, we have seen valuations pressure, record low consumer confidence, negative forward corporate guidance, PMI falling below 50, housing sector slowdown and earnings growth also starting to slow. In addition to this, the ongoing energy crisis has significantly reduced growth expectations, particularly in Europe and in the UK. Nevertheless, I think it would be reasonable to expect a modest downturn in Europe because of the ongoing fiscal support, with more energy-related measures to come. Most European dividends look protected, even in a downturn, because the region’s firms have been conservative in their pay-out policies: the ratio of dividends to earnings is near its lowest in 25 years, providing grounds for resilience if profits start to contract. Moreover, markets have already corrected significantly, equity valuations are below the long-term average, banks are well capitalised compared to 2008 and the labour market remains solid.

Each recession is different, and so is the performance of various equity indices, as each sector and industry has its own specific drivers. However, understanding the business cycle and analysing different economic periods, can be helpful to identify and navigate various market phases.

RECOVERY EXPANSION SLOWDOWN RECESSION
Outperforming Economically & interest rate sensitive Economically sensitive Defensive and inflation sensitive Defensive
Underperforming Defensive Defensive Economically sensitive Economically sensitive

Relative performance during the four phases of the business cycle. Source: Bloomberg

Leonardo Mazza is a Junior Fund Manager at Cantor Fitzgerald Ireland.

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