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Allocators often find that current markets “remind them” of some historical period and, on the basis of that similarity, predict what might happen next if history repeats itself. However, what is remembered is often highly subjective and imprecise. We have developed a framework that seeks to address these shortcomings and that we think is very relevant today, as allocators sort through the macro and market uncertainty for clues about the future.
Defining the market environment
We use a data science technique (Mahalanobis distance) to formally identify the historical periods that are most similar to today’s, based on specified market characteristics. This technique measures the aggregate difference between the characteristics of the current market and those of historical periods, after adjusting for correlation. The characteristics that we use to define the market environment are:
The top panel in Figure 1 shows how similar (by percent, with 100% being perfectly similar) historical periods are to the current period (second quarter 2022) based on these eight market characteristics. The three periods that are most similar to the current period are the first quarter of 2001 (62% similar), the fourth quarter of 2018 (61% similar), and the fourth quarter of 2008 (53% similar). The three charts at the bottom of Figure 1 look at what drove this similarity by examining each period’s market characteristics.
A closer look at the results
Beyond the quantitative technique, these results also make intuitive sense, as it is easy to draw parallels between these historical periods and today. For example, in both early 2001 and late 2018, markets were worried about a possible recession as a result of the Fed aggressively hiking interest rates. From 2000 to 2001, the Fed was determined to cool the economy following a period with a significantly overvalued stock market, which induced a mild recession starting in March 2001. And just like today, volatility (VIX) was elevated, the yield curve was flat, value stocks and EM stocks were outperforming, and the US dollar was strong. The main difference was the significant outperformance of small-cap stocks that we saw in 2001 coming out of the dot-com crash. Late 2018 also looks very similar to today using this framework: Markets were worried about a slowdown in global economic growth and the possibility that the Fed was raising interest rates too quickly.
The end of 2008, the third most similar period, was slightly different from the other periods in that a global recession was ongoing and central banks were lowering rates, as evidenced by the yield-curve steepness in the bottom chart in Figure 1. We also saw strong underperformance in EM equities, which is different from what we have seen the last few months.
Once we have identified the most similar periods, we can see what might happen next if history repeats itself (with the usual caveat that history does not guarantee future results!). Figure 2 plots the market returns 12 months after each of these similar periods, and a weighted average based on the level of similarity.
We see that these similar periods were, on average, followed by equity rallies, tighter high-yield credit spreads, and marginally higher bond yields. Following early 2001, the most similar of the three periods, markets spent the next 12 months going sideways. Equities, bond yields, and high-yield credit spreads all ended up close to where they started. This was driven by continued uncertainty over global growth, and the September 2001 terrorist attack in the US. On the other hand, following the 2018 period, we saw a quick rebound in risk assets as the global economic slowdown and Fed policy errors that had been feared did not materialize. In the 12 months following the 2008 period, we also saw huge gains in equities and over 10% tightening in high-yield credit spreads.
So, the question for investors is whether we are likely to see a replay of the 2001 – 2002 challenges, or whether markets find a bottom and can rally from here like we saw following 2018 and 2008.
For more on the current market environment, see our Mid-2022 Investment Outlook.