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What Happens After The Bottom?

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by Tyler Durden
Sunday, Jul 10, 2022 - 01:20 PM

By Nick Colas of Datatrek Research

What happens after US large caps bottom? The 1997 – 2013 experience, where the S&P 500 round-tripped 700 – 1500 twice, shows why that question matters. Consider the question of “when can the S&P see its January high of 4,797 again?” Based on typical compounding rates, the answer is 3-5 years. That’s good news. From 97 – 13 it took 5-7 years.

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Topic #1: Instead of just focusing on where US stocks may bottom, let’s also consider what happens afterwards. The first bit is getting all the attention of late, but the second part is just as important.

To understand why, remember the 1997 – 2013 experience:

  • The S&P 500 began 1997 at 737. It doubled over the next 3 years and peaked in March 2000 at 1,527.
  • The 2000 – 2002 bear market took the S&P back down to 777 in October 2002. It then rallied to a high of 1,565 in October 2007.
  • The Financial Crisis took the index back down to a low of 677 in March 2009. The S&P 500 finally made a new all-time high on March 28th, 2013 at 1,569.

In short: the S&P 500 essentially round tripped 700 – 1500 not once, but twice, over a 15-year period. Three points about that journey:

  • Yes … From January 1997 to March 2013 (S&P 500 from 737 to 1,569), the index compounded annually at 5.2 percent. Long-term investors did OK.
  • But … They had to live through 2 boom-bust cycles, with 49 – 57 percent drawdowns from peak to trough, to get that result.
  • At least the next 10 years were better, with the S&P compounding annually at 11.3 percent through March 2022.

This history is one reason why there is so much attention on the question of “where is the bottom” right now. Recession worries explain part of that fixation, since we do not really know where corporate earnings will trough in an economic downturn. More important for the longer-term investor, however, is the possibility of low returns for years to come. The 1997 – 2013 period is recent enough that we all know picking attractive entry points can meaningfully help returns.

Now, consider this question: when will the S&P 500 see 4,800? The all-time high for the index was on January 3rd, 2022 at 4,797, so we’re just rounding up a few points to get to that price target. Three thoughts in terms of a possible answer:

#1: How “wrong” was the January 2022 high? The March 2000 S&P 500 high was very, very wrong in terms of accurately predicting future economic conditions and corporate earnings power. Was January 2022 a similar sort of mispricing?

  • Consider that 4,797 on the S&P was 42 percent higher than the last pre-pandemic high in February 2020 at 3,386.
  • The only defense for the January highs was that S&P earnings were expected to be around $230/share this year, up 44 percent from the 2018 – 2019 run rate of $160/share.
  • If we apply the 10-year average price-earnings multiple of 17x to $230/share, we get an S&P 500 of 3,910, essentially the same as today’s close of 3,845. Even at today’s levels we are still up 16 percent from the February 2020 highs, perhaps a more realistic 2-year gain than what we had at the start of the year.

#2: January’s S&P 500 high of 4,797/4,800 was therefore an overly optimistic price, but that’s the target we are discussing, so how long before we get there again? Here are 3 scenarios to consider, based on different annual price compounding rates and today’s close:

  • 5 percent compounding rate: 5 years to 4,800
  • 7.5 percent compounding rate: 4 years
  • 10 percent compounding rate: 3 years

While waiting 3-5 years for a price we had 6 months ago may seem like bad news, it is not. Those timeframes are all shorter than the 7 ½ years it took to recover the losses after the March 2000 highs or the 5 ½ years after the October 2007 highs. The S&P may have been overvalued in January 2022, but nowhere as much as in March 2000. And, even with the Fed’s moves to dampen inflation we think there is little reason to think there is another Great Recession in the offing. Expecting a positive compounding rate over the next 3-5 years is reasonable enough.

#3: Stocks don’t just magically compound – corporate earnings must grow as well. To get an S&P 500 at 4,800 we likely need index earnings of about $280/share (using a 17x multiple again). Assuming the next 12 months will show earnings of $200/share and 10 percent growth thereafter, the index should get to $280/share in five years.

Takeaway: there is an old Wall Street saying that “stocks take the elevator down but the stairs up”. The math we’ve shown you today proves that sentiment correct. We still believe stocks have not yet fully discounted recessionary earnings and there will be more attractive entry points ahead. They are worth looking for and, when they come, buying. Even 1997 – 2013, as rough as it was, led to a decade of very good returns.

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Topic #2: US mutual fund and ETF investors finally got around to buying the latest dip in stocks, but only in small size. The data here is courtesy of the Investment Company Institute (link):

  • For the week ending June 29th, fund investors added $2.1 billion to their US equity holdings. That is somewhat lower than the prior 4-week average of $2.8 billion, but flows have been choppy recently. For example, during the week ending June 22nd US equity funds saw $11.5 billion in redemptions.
  • Fund investors continue to sell down their fixed income fund exposure, with outflows from these products totaling $11.5 billion last week. That is in line with the prior 4-week average of $11.1 billion in outflows.
  • Commodity funds (mostly physical gold) saw $2.5 billion in outflows last week, a remarkably high number. All of May, for example, had $2.8 billion in outflows for this asset class.

Comparing Q1 2022 to Q2 2022 fund flows shows how the investment landscape has changed in the last 90 days:

  • In Q1, fund investors added $73 billion to their US equity fund holdings. In Q2, they sold $21 billion. The same trend holds for money flows related to non-US stock funds: Q1 saw $35 billion in net purchases, Q2 had $22 billion in outflows.
  • Bond fund outflows accelerated from Q1 (-$69 billion) to Q2 ($154 bn).
  • Commodity fund flows were positive in Q1 (+19 billion) but flipped negative in Q2 (-$3 bn).
  • Total fund flows have gone from positive in Q1 (+$47 billion) to resoundingly negative (-$226 bn) in Q2.

Takeaway: fund investors remain in redemption mode, consistently taking capital from fixed income and only occasionally adding to stocks.

Sources: Investment Company Institute fund flow data: https://www.ici.org/research/stats/weekly-combined

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