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What does an equity market bottom look like?

Nick Petrucelli, Portfolio Manager
2022-11-30
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My short answer to the question posed in the title here: A typical market bottom doesn’t really look much like what the US equity market experienced in June 2022, at least not historically speaking. Let’s consider the evidence.

June 2022: Likely not a bottom

Amid the S&P 500 Index’s recent (and, as of this writing, still-ongoing) rally, I’ve been fielding a lot of questions around whether or not the US market may have reached its 2022 low this past June. I’ve been inclined to think not, along with many other observers, but the market has clearly been testing that assessment over the last few months. With that in mind, I decided to turn to market history in search of some guidance on the matter.

I updated a prior analysis, focused on key factors — market volatility levels, inflation rates, price/earnings (P/E) ratios, credit spreads, and market drawdowns — that have historically been correlated to US equity market bottoms. Based on this model, which included the 22 US market bottoms since the late 1940s (Figure 1), the hypothesis that June 2022 may have marked this year’s bottom seems unlikely.

A deeper dive on my research

My analysis examined every time the S&P 500 went into a “downtrend” over the past 70+ years. Then, for each month within such a downtrend, it looked at the different factors cited above to determine the probability that the US market had in fact bottomed at that month-end. With the caveat that attempting to extrapolate the results to the current market environment is hardly an exact science, there were some interesting takeaways for equity investors.

Historically, in rank order, here are a few potentially telling indicators of a likely market bottom, vis a vis today’s market setting:

  • A spike in the VIX: A spike in the Chicago Board Options Exchange's CBOE Volatility Index (VIX), the so-called “fear gauge,” has often preceded a US market bottom. (The same goes for widening credit spreads.) A very sharp uptick in volatility, such as occurred in 1987 and 2020, could be enough to overwhelm other factors. Recently, we saw a big upward move, along with credit spread widening, but nothing extreme enough to signal a bottom without additional signs.
  • Relatively low inflation: Tame inflation versus recent history, which typically allows for more accommodative monetary policy (read: lower interest rates), has been correlated with a number of shallower market bottoms, such as we saw in 1994 and 2015. Inflation is of course quite elevated these days, which is not consistent with a market-bottom scenario.
  • A reasonable market P/E ratio: A low P/E ratio for the market as a whole has often been another characteristic of a market bottom. The S&P 500’s June 2022 P/E would be the highest such ratio on record for a market bottom going back to the late 1940s. 
  • A substantial market drawdown: The least predictive of the factors discussed here, but not surprisingly, having already suffered a larger drawdown has been associated with a greater likelihood of being at the market bottom. Where are we today on this score? Roughly "middle of the pack" on a historical basis.

The five lefthand colored columns in Figure 1 highlight “z-scores” on these metrics (where high/green = higher probability of a bottom). The next column shows the probability of that particular month-end being the market bottom from a regression-based model. All previous bottoms had a 10%+ probability, with a norm in the range of 20% – 30%. Today’s odds are only around 5%.

Putting it all together

To recap, using the approach described above, my overarching base case is that the US equity market has not yet found a near-term bottom. Essentially, while volatility certainly rose significantly in the second quarter, setting the market up for a tactical rally, it was still not enough to offset persistent headwinds from high market valuation and lofty inflation.

If you’re wary of relying on a quantitative model to make this assessment, the right-hand columns of Figure 1 show a simple alternative framework. The vast majority of market drawdowns ended when either: 1) the US economy was already in recession; or 2) the US Federal Reserve (Fed) had already cut interest rates. Exceptions to this rule involved either very little credit spread widening (1962, 1978, 1994), or the Fed backing off from hiking rates soon after the market had bottomed (as with the 2016 rate-hike pause and the 2019 policy “pivot.”)

These conditions are not in place right now:

1) While slowing to some degree, the US economy remains in pretty strong shape overall;
2) The Fed is continuing to raise rates, with no near-term prospect of a policy reversal; and
3) Investment-grade credit spreads have nearly doubled since the fall of 2019.

Figure 1
what does an equity market bottom look like fig1

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