For an investor, why does it help to know the kind of bear market?
Because it helps to set appropriate expectations. In a structural bear market, equities may fall by 50% or 60% over three or four years and take a long time, typically about a decade, to recover fully in nominal terms. Cyclical and event-driven bear markets don’t tend to vary that much in terms of the absolute price declines, typically around 25% to 30%, but the difference is the speed of this decline and the subsequent recovery — event-driven ones are just much quicker. The main difference is whether you get a recession. Sometimes shocks lead to recessions, and what starts out as a temporary drawdown can last a bit longer as that shock morphs into a recession.
If this is an event-driven bear market, are we through it?
One problem in trying to figure that out in real time is that bear markets of whatever description do incorporate strong rallies. It would be unusual for a bear market to fall in a straight line. We don’t know for sure whether the low in April marked the trough. At this stage we are not certain whether we are avoiding a recession.
Our view is that recession risk has definitely moderated because tariffs have largely been wound back for large parts of the world and indeed, most recently, for China. Goldman Sachs economists had forecast the probability of recession at around 45% in the US over the next 12 months, and after the recent pause between China and the US, they reduced that probability to around 35%. That’s still above the usual background risk in any given year of about 15% probability of recession.
Are you certain this isn’t a structural downturn?
Structural downturns come about from the combination of asset bubbles with a lot of private sector leverage. I think we can put private sector leverage to one side right now. After the financial crisis, banks’ balance sheets strengthened a lot because of tighter regulation. Corporates broadly have very healthy balance sheets. And households still have pretty good balance sheets.
On the valuation point, it’s true that the US equity market has a high valuation — well into the 90th percentile if we look at a historical distribution for price-to-earnings ratios. However, it is important that, at least up to now, the very high multiple has been reflective of very strong underlying fundamentals. Profits have been extremely strong in the US over the last decade or so, largely driven by the powerful rise in profitability of the largest tech companies. We don’t think that there is a speculative bubble.
Is continued growth in earnings needed, though, to justify the valuations?
The prospect of continued earnings growth is partly a function of what happens in the economy — whether we get a recession or not. But there are other factors in play. Globalization has been an underlying reason for the rise in profit margins over many years, and that’s now being contested somewhat.
Rising profits have also been driven by technology. While we are still optimistic about technology, the emergence of new competition in that space, particularly in relation to artificial intelligence (AI), as well as the rise in capital spending among large technology companies, may mean future growth rates are not as good as in recent years. The dominant companies are both profitable and have strong balance sheets, but if they don’t grow as quickly in the future, they may not justify the same valuations.
Why are you arguing right now for more diversity in investors’ portfolios?
Beta strategies have worked very well for a long time because generally equity markets and indeed credit markets have trended upwards. You’ve seen consistent rises in indices, led by the US, reflecting a long period of falling interest rates and this period of quite strong profitability.
Now, given that valuations are high and we’re expecting somewhat lower growth, and we don’t think interest rates will trend downwards consistently from current levels, it’s harder to imagine that index returns will be driven as much by rising valuations. All of that suggests to us that it may be more profitable for investors to look at opportunities for alpha — with idiosyncratic risk rewarded more than risk at the index or factor level. (Alpha measures an investment’s performance relative to a market index. Beta measures an investment’s volatility of returns compared to the entire market.)
Source: goldmansachs.com
