What history tells us about market volatility and recovery

While volatility in the US equity market has subsided a bit, it still remains high relative to history. To help make sense of the recent market moves, we thought it would be useful to look at them through a historical lens.

The chart below shows historical periods of drawdown for the S&P 500 and the subsequent performance of the market. In general we can see that after the initial drawdown of more than 15%, in most cases the following twelve months return was positive. After a drop of more than 15%, the subsequent median twelve month return has been over 20%.

At first glance, that should give some comfort to investors concerned about the recent market moves. The picture is also consistent with what we’ve seen in the recent past, when periods of high equity market volatility – as measured by the VIX – have been followed by strong equity market performance.

Inevitably, it’s not that simple. The table also shows four periods when the subsequent twelve months were negative: 1929, 1973, 2001 and 2008 – we’ve excluded 1946, when the return was virtually flat. As the chart below illustrates, each of those periods saw a US recession, according to the National Bureau of Economic Research (NBER).

But we can’t extrapolate too much from that. A recession doesn’t necessarily mean continued weakness in equity markets. We also saw recessions in 1981-82, 1991 and 2020, and the twelve month returns after drawdowns around those recessions was positive. 

It’s also not easy to generalise based on valuations, especially over a twelve-month time horizon. Looking at a long-term valuation metric (cyclically adjusted PE), we can see that valuations had risen sharply prior to the equity weakness in 1929 and 2001 – but that wasn’t the case in 2008, for instance.

Corporate profitability also gives a mixed picture since 1970. The years 2001 and 2008 saw pretty sharp drops in US profit margins, as you can see in the chart below. But the margin decline in 1973 – not shown – was much more muted. Margins also fell in the early 1990s, but that didn’t hold back the recovery in US equities.

So, where does that get us? On average, history suggests that the returns going forward could be positive. But the exceptions show that it’s certainly not guaranteed. Each period of market volatility has its own nuances. 

For now, tariffs remain in focus – particularly their impact on global growth and inflation. We think we’re now in a period of negotiation on the extent of trade barriers. That could last some time, particularly given the tension between the US and China.

Wherever we end up, it seems clear that trade barriers will be higher than they were six months ago, and we think that will act as a brake on global growth, even if it’s tough to assess just how significant the impact will be. 

Slower growth is likely to hit corporate profitability. But, as the chart above shows, the extent of the margin decline has varied. In 2008 we saw a sharper than usual drop in corporate profitability, while margins proved fairly resilient in 2020. 

The comparison between 2008 and 2020 highlights another point on policy support. In 2020, policy support, both fiscal and monetary, was large and arrived quickly. In 2008, the policy support did arrive, but took a bit longer.

This time around, we think margins will drift lower if the economy weakens, but we’d still expect to see them remain quite resilient. On the policy side, the picture is mixed: the US administration looks set to increase its fiscal deficit, which could be supportive for growth.

At the same time, Federal Reserve officials appear less keen to cut rates sharply given uncertainty over the inflation outlook. It looks like we’ll need to see much weaker growth before the central bank intervenes.

In terms of portfolio positioning, we remain on the conservative side, relative to our internal benchmarks. We expect trade policy to continue to weigh on sentiment and on growth. We believe that the current equity market reflects an expected slowdown, but not a deep recession. That seems reasonable to us at this point. We’ll continue to focus on the outlook for growth and corporate profitability, as we evaluate the dynamic political and market environment.