Has the S&P already reached its low for this recession?

The S&P 500 has rallied by more than 30% since hitting the 23 March low triggered by the Covid-19 crisis. With the US recession barely even started, it would appear that the market has already priced in a “V-shaped” recovery. However, a strong recovery is increasingly in doubt given the significant growth impact from the virus and the difficulties of lifting lockdown measures (see here).

If history is a guide, then a recession that is more protracted than a V-shaped path would suggest that the market has yet to reach the bottom. In fact, the longer the recession the more likely that the US market experiences bear market rallies or false dawns (see here).

While this recession is unique in that it is self-imposed as a result of Covid-19, we can still draw useful parallels with history.

How long does it take for the market to bottom in a recession?

The Great Depression was the longest US recession of the 20th century and it took nearly three years before the S&P 500 reached its bottom. By contrast, the US stock market troughed over a month (41 days) after the start of the 1980 recession. This was the shortest recession on record since the 1800s as it only lasted for six months.

Chart 1 shows that equity markets typically take their time to bottom when recession periods (defined by the National Bureau of Economic Research) are longer as they digest the depth and severity of the recession. The S&P has generally bounced back from the lows at a faster pace during recessions that were shorter in nature. This is because the market has tended to look through the collapse in economic activity and expect a sharp rebound in growth.

Chart 1: Length of US recessions and time taken for the S&P 500 to trough

Source: Refinitiv Datastream, Yahoo Finance, Schroders Economics Group, 18 May 2020.

Chart 2 shows another way to look at the trough in the S&P and the number of days before the end of the recession. Here there is greater uniformity in the length of time when the recession period concludes, which averaged just over 3.5 months (113 days) after the market bottomed. If we expect the current US recession to end before 2021, and historical patterns are anything to go by, then this would suggest we have yet to see the low in the market.  

Chart 2: Number of days before the end of US recessions after the market had bottomed

The macro has generally lagged the market - but not always

Unsurprising, the S&P generally reaches a low point before the macro hits the bottom as equities tend to be forward-looking in nature (see here). This makes it challenging to use the economic data to decipher whether the market has truly troughed. Nonetheless, it would appear that key macro indicators such as the ISM survey and industrial production are less likely to be behind the market lows when recessions are longer.

Table 1 shows that during some of the lengthier recessions, the number of months the ISM trough before or after the low point in the market tended to be smaller and on a few occasions the survey even hit the bottom before the S&P. This comes back to the point that when recessions are deeper and take longer to recover, investors need greater reassurance that they have seen the worst in the economic data before returning to the market.

Table 1: S&P 500 lows compared to troughs in the manufacturing ISM and industrial production growth

What has economic momentum looked like prior to the bottom of the market?

During past recessions we find that momentum behind economic indicators, such as the manufacturing ISM and industrial production, has generally improved or turned less negative prior to the market bottom. Chart 3 illustrates the trends behind the monthly changes in the ISM over the last five recessions. (We have examined recessions going back to the 1950s but the charts include the most recent episodes to make it easier to read.)

Chart 3: ISM momentum when the market troughs during recessions

Source: Refinitiv Datastream, Schroders Economics Group, 18 May 2020.

We have also included the latest profile for both indicators where we assume the drop in the S&P on 23 March was the market low.

Interestingly, the latest momentum path of the ISM is similar to the short-lived 1980 recession whereby the growth dynamic behind the survey turned less negative prior to the market trough. Despite the subsequent collapse in the momentum of the ISM, US equities continued to rally. So far, the retracement of the S&P from the low in March indicates that the market is carrying on regardless of dismal macro news.  

Meanwhile, the path of S&P earnings during recessions has been mixed; the caveat to this analysis is the small sample size (the data starts in the late 1980s). Chart 4 shows the smoothed earnings revisions ratio of the forward EPS (earnings per share). During the last global financial crisis (GFC), the EPS ratio was trending upwards before the bottom in the market. However, in the 1990 recession, the earnings revisions ratio dropped off prior to trough in the S&P. More recently, the EPS revisions ratio slumped even before the market low in March.

Chart 4: S&P 500 EPS revisions ratio during past US recessions

Source: IBES, Refinitiv Datastream, Schroders Economics Group, 18 May 2020.

Valuations are looking richer compared to past recessions

Looking at the trailing price-earnings ratio (PE) of the S&P during recessions since the 1950s, current PEs are not only trading at the higher end of the historical range but the levels are above the average over past downturns (chart 5). The latest PEs are also trading closer to the elevated levels experienced during the 2001 dotcom bubble. This is partly being driven by the more expensive growth and quality areas of the S&P such as tech. Overall, US equity valuations are looking richer compared to past recessions when the market troughed, which suggests that there is less valuation support for the recent re-rating in the S&P.  

Chart 5: S&P trailing price-earnings ratio range and average during recessions since the 1950s

Policy support unprecedented this time around

It could be argued that the latest PE levels are justified given that the Federal Reserve (Fed) has already aggressively cut interest rates and promised unlimited quantitative easing. Chart 6 highlights that PEs trade on higher multiples when interest rates are lower, as earnings are being discounted at a lower risk-free rate. With monetary policy expected to remain very accommodative into recovery, PE multiples can continue to trade higher than previous market lows during recessions.

Chart 6: S&P 500 trailing price-earnings ratio and the Fed funds rate during recessions

Source: Refinitiv Datastream, Schroders Economics Group, 18 May 2020.

So, what does history tell us? 

In essence then, history tells us that the more protracted the recession, the longer it takes for the S&P 500 to hit the bottom. With the base case increasingly looking like more of a U-shaped than a V-shaped recovery for the US, the strong rebound in equities suggests that the market is discounting a rather optimistic outcome for growth and we may see the S&P test lows later this year.

While the macro tends to lag the market, the lead times between the market and economic indicators are likely to be smaller the longer the recession. This is because investors need to see the worst in the macro data before returning back to the market. We also find that momentum behind key economic indicators generally improves or turns less negative before the trough in the market. So far, however, the S&P has carried on performing well despite the significant fall off in growth momentum, which suggests that there is scope for market disappointment.  

US equities are trading on richer price-earnings multiples compared to previous recessions when the market bottomed. This suggests that the S&P is more vulnerable to a de-rating in PE multiples without the support from earnings. However, the unprecedented level of monetary policy action from the Fed could mean that PE multiples remain elevated relative to previous market troughs during recessions. The Fed is therefore one of the key factors that could keep the market from re-testing March’s lows.