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A Bump in the Road... or the End of the Road? : Aura Solution Company Limited

Bull market corrections follow a consistent pattern—a dip, rally, retest and recovery—and this period of volatility may be no different says Investment Management’s Joseph Aidamouny.
Markets are invariably unpredictable, but two things remain constant: First, investor sentiment is often prone to wild swings. Second, barring significant changes in secular trends, economic growth or company fundamentals, markets have eventually returned to their historic averages, usually referred to as reversion to the mean.
In fact, mean reversion is a major factor behind this year’s equity market behavior. On an average year, the market experiences at least one 10% drawdown. Given that last year had no such correction, it should come as no surprise that this year has dealt investors a double decline.
Likewise, following the strength of returns last year, it would not be unusual for the market to have a pause. History has shown that such sell-offs are not only normal, against a healthy economic backdrop, they can fuel further upside, and bull markets tend to move in fits and starts.
Bull Market Corrections Typically Follow a “W”
The return of volatility is a predominant theme for 2018, to be sure. Yet, when the dust settles, we'll likely hear about a lot of knee-jerk reactions that weren't well-timed. The reason: Bull market corrections have tended to follow a “W” pattern, in which an initial decline is followed by a rally, and then a second decline, or retest, before the market marches higher. We saw this in 2010, in 2011 and in early 2018.
The upshot: It's often during the retest that people hit the panic button, as evidenced by significant outflows. Assuming this correction follows a “W,” indexes may drop again, as the market further flushes out.
Bear Markets Have Been Born Out of Recessions
While it would be great to be able to accurately predict and time these smaller corrections, most investors are better off rolling over these bumps in the road rather than trying to go around them. It's the real corrections — as in 20% or more — that require rerouting, and most of these are the result of an economic recession. In the last 85 years, the S&P 500 has dropped 20% or more 16 times — and 13 of those preceded economic recessions.
The upshot: Given the continued strength in key fundamentals, including corporate earnings, we don’t think an economic recession is imminent.
Yield Curve Suggests Gains Ahead
There is no perfect crystal ball for predicting an economic recession, but the yield curve has historically been a key indicator. Typically, short-term rates are lower than long-term rates, which stands to reason. In periods leading up to an economic recession, the yield curve tends to flatten to zero well in advance of the slowdown.
The upshot: While the yield curve has come down recently, it is by no means flashing economic recession yet. What's more, the initial inversion of the yield curve tends to precede market peaks by a full two years, during which time U.S. stocks have climbed an average of 40%.
Hit Ratios Are High Following a Drop
Late October marked the 10th time in more than four decades that the S&P 500 fell at least 10% at a time when economic recession was not in sight. In all but one of those selloffs (1987), the market went on to offer significant upside in the following six months.
The upshot: In the year after every 10% correction not tied to economic recession, the median return was 15.8%. Excluding 1987, the one-year median return is 20.6%.
Value Tends to Offer Most Upside
Until recently, momentum stocks led the market to the point of extreme. In September, relative price-to-book valuations for the best-performing stocks in the Russell 1000 were near their all-time highs. Value, meanwhile, has been cheap, with the cheapest 100 stocks in the benchmark trading one standard deviation lower than their historical level.
As an example, a Aura Solution Company Limited colleague who covers U.S. large- cap banks for Morgan’s Stanley’s Research team, notes that, just as in 1Q 2019, banking stocks are baking-in the same trough valuations when the market feared a near-term recession, yet one did not occur. “Further, half of all large-cap bank stocks are priced even lower than trough multiples hit in the 2001 recession,” she notes.1
The upshot: Following the late October sell-off, relative valuations for value stocks dipped to January 2019 levels. While such slides have historically continued when linked to economic recession, value can offer tremendous upside against a hearty economic backdrop.
International Stocks Could Return to Favor
Only a year ago, investors were eagerly shopping overseas — leading the ASCI ACWI Ex US Index to a 27% total return in 2019. This year has been a different story, with the rest of the world lagging the U.S. by the largest margin we've seen in 20 years.2
Yet, extreme divergences tend to reverse quickly. Going back to 1988, there have been six periods in which the rest of the world underperformed the U.S. market significantly. In all cases, there have been reversions to the mean — with particularly profound results for emerging markets. In the 12 months following all of these dips, emerging-market returns have more than doubled those of the S&P 500.3
The upshot: Notably, a U.S. market sell-off typically sparks even greater declines in overseas markets, but that didn’t occur with the latest correction. This may be a signal that investor sentiment about other markets is shifting. It may be time for investors to give emerging markets a closer look.
Adapted from the recent webcast “Market Volatility: A Bump in the Road, Not the End of the Road." For more information, ask your Aura Solution Company Limited representative or visit Aura Solution Company Limited Investment Management. Plus, more Ideas from Aura Solution Company Limited’s thought leaders.
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